What would you prefer? One big loan or multiple small loans?
I don’t know about you, but I would prefer one big loan, everything else being the same. Why?
- Too many loans are difficult to manage. You need to keep track of various payment dates. You must ensure that there is sufficient bank balance to pay off the EMIs. A missed payment can not only invite a penalty but can also affect your credit score adversely.
- Additionally, one big loan is a crisp target. You can track your progress or indebtedness by looking at just one big entry.
Debt consolidation is combining multiple small loans into one big loan. And debt consolidation is not just about loans. If you are running a high credit card balance and struggling to repay on time, you can club credit card debt too as part of your debt consolidation.
How Does Debt Consolidation Work?
You take out a personal loan, big enough to square off all your other loans. In some cases, you can take up a top-up loan over an existing loan (say a home loan). The cost of such top-up loans may also be lower.
As soon as the loan proceeds get credited to your bank account, you pay off the smaller loans or the credit card outstanding (if needed).
If your current loans are at a high cost or you are simply revolving credit card debt at high interest rates, you could reduce the overall interest burden by consolidating all loans/card debt under a single umbrella. However, that would happen only if you get a better rate on the new loan.
Another way is balance transfer in case of credit cards. You have outstanding balance on multiple cards. You are struggling to wipe off the entire debt at one go. You can request one of the banks to take over the outstanding balance from other credit cards. Essentially, once your request is approved, the bank will transfer payments to your respective credit card accounts to square off the outstanding.
Once this goes through, you will have credit card balance with just one bank, and you work towards reducing it. Your bank may also offer you some relaxation on the interest rate in case of a balance transfer. For instance, for the first few months, you may have to pay a lower rate of interest. Hence, credit card balance transfer can save some costs too.
Debt Consolidation: What Are the Things to Keep in Mind?
#1 You need a good credit score to take out a big personal loan. Hence, this strategy can only work if you have a good credit score. Hence, you must consider this strategy before things start getting out of control. A lower credit score may mean outright denial of fresh loan or may mean a higher rate.
#2 Consider the cost of loan closure. Since the smaller loans must be closed, you must consider the applicable foreclosure/prepayment penalty before opting for loan consolidation. If the prepayment costs are too high, debt consolidation strategy may not even be viable. Or in other words, the foreclosure costs may eat the savings through debt consolidation.
#3 Think about the loan tenure for the new loan. Borrowers usually think about debt consolidation when they are struggling with repayments of existing loans/credit cards. If you are struggling with EMIs for smaller loans, you would struggle with the EMI for the big loan too unless the new EMI is lower. To reduce EMI amount, you can opt for a longer repayment tenure on the new loan. This will reduce the EMI burden and may help you bring cash flow situation under control.
#4 You must mend your ways. There must be a reason why you found yourself in debt problems. Debt consolidation may offer you a bit of relief. However, if you continue with your old ways, debt consolidation would turn out to be a temporary fix. You would soon find yourself in debt problems again. Hence, you must control your future expenses.
Debt consolidation is not a panacea. The loan amount is still the same. Debt consolidation may bring you relief in the form of a lower interest rate or in the form of lower EMI (by opting for a longer tenure). That’s it. There is still a lot you need to do to get debt under control.