Credit card debt is common in the U.S., with the average American carrying a credit card balance of more than $5,000 in 2020. With high-interest payments and large principal balances, it can be hard to pay off credit card debt, resulting in a snowball effect that makes getting out of debt seem difficult or even impossible.

One common way around this problem is called debt consolidation. This practice can be useful, simplifying the debt payment process. It may also help you secure a lower interest rate that allows you to pay more toward the principal debt, paying down the total faster. But, there are some drawbacks to debt consolidation. Before taking this step, it’s critical to know as much as possible about how it works and how it will impact your finances.

How does debt consolidation work?

There are a lot of debt consolidation programs and products available. In general, debt consolidation means taking out a new loan or credit card and rolling all your existing debts into one monthly payment that you pay via that loan or card. You then make one payment each month to the new line of credit.

What are the types of debt consolidation?

There are three common types of debt consolidation.

  • Credit card balance transfers occur when you open a new credit card and then transfer the debt from various existing accounts to that card.
  • Debt consolidation loans offered by a bank or credit union can be used to pay off debt. You then must pay on the loan every month.
  • Credit counseling services work with you to tailor a solution to your specific debt problems. These services usually work with your creditors to negotiate lower payments, then make those payments with a fee you pay them every month.
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What are the benefits of debt consolidation?

Debt consolidation can come with a number of benefits, the most straightforward of which is that the number of payments you must make each month is reduced to one, simplifying the payment process and making it easier to keep track of your debt. You’re also much less likely to forget an account and miss a payment since you’ll only have one to remember.

In addition, debt consolidation can result in lower interest rates, which means that more of your payment goes to paying down the principal on the debt. This will help you pay off the debt faster.

Another benefit is the potential improvement of your credit score. Because a factor in determining your credit score is your credit utilization rate, consolidating debt into a personal loan, for example, will have a positive impact on your credit score. Additionally, the faster you pay off the debt, the better your credit score will be.

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What are the risks of debt consolidation?

As with any financial decision, make sure you have all of the information and read all of the fine print before agreeing to a debt consolidation strategy. Some debt consolidation counselors are actually scams with high fees and interest rates that end up hurting your financial situation rather than helping it. If you’re considering consolidation, make sure you’re getting the best product by shopping around and comparing interest rates, loan terms, and fees.

For example, even if your interest rate goes down, if you’re paying off a debt over a more extended period of time, the total interest you pay could be higher than in your current situation. Make sure you’re working with a reputable institution and do your research to ensure that the actions you’re taking are really in your best interest.

Finally, no amount of financial maneuvering will help if you routinely spend more than you make. When considering debt consolidation, you should first examine your spending, create a budget, and cut back where you can. Debt consolidation will not solve existing financial problems that result from irresponsible spending. Debt consolidation in the right situation and under the right terms can be a useful tool for paying down debt. By rolling it all into one place, you can simplify your payments and pay off debt more quickly. But, you should use these tools with caution and always conduct proper research before making a big financial decision.

Finances FYI is presented by 1st Security Bank.

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