We continue our article on debt management with another important part of efficiently managing debt: debt consolidation. Debt consolidation, as the name suggests, means consolidating your debt—bringing your debt into one place so that it can be better managed. This is well understood with an example of a typical debt consolidation scenario.

The Challenge of Managing Multiple Debts

In a world where there are so many debt products—including credit cards, lines of credit, and term loans—it can sometimes become too overwhelming to manage, with each debt product having varying repayment terms, interest rates, and payment due dates.

For example, a person has accumulated credit card debt to the tune of $10,000 at an interest rate of 21% (as credit card debt has the highest interest rates among all credit products). He also has an outstanding balance on his line of credit for $6,000 at an interest rate of 11% and has a term loan for a car that he financed with a monthly payment of $500. Now, imagine the debt quagmire that the person is in: he is paying interest on different kinds of debt, has to keep in mind the due dates for each type of debt, and is surely paying a lot of money to the lender in interest.

How Debt Consolidation Works

The best solution for him to help manage his debt profile better is to opt for debt consolidation. Here’s how this works:

• He goes to a lender, most probably a bank, and requests a consolidation of his debt.
• The bank advisor checks his credit score and some other lending parameters to determine if an application for debt consolidation is worthwhile.
• If approved, all of his debt would be consolidated into a single loan payment with an assigned interest rate.

All three outstanding balances are added together (credit card debt of $10,000 + line of credit debt of $6,000 + his outstanding balance on his car finance of $15,000) for a total of $31,000. The interest rate is calculated based on lending policies, and a good repayment history, a strong banking relationship (including multiple products with the financial institution), and a good credit score would get him a competitive interest rate of, say, 8%. So, managing a loan of $31,000 with an interest rate of 8% would be far more beneficial and easier for him, ensuring timely repayments and better debt management.

Why Debt Consolidation is Gaining Popularity

Debt consolidation has gained popularity recently as people are opting for it to manage their finances better, helping them keep track of payment dates and amounts easily.

Paying Off Debt Faster: A Smart Financial Strategy

Everyone wishes they could pay off their debt faster, don’t they? Well, it’s not that complicated to do. Every debt product has an option to pay more toward the principal than what is specified in the combined interest and principal payment.

Let’s say you have a car loan for a 2019 BMW for $24,000 with a monthly payment of $475. This $475 is a combination of a principal payment and an interest payment. The term of the loan is 5 years. So, if you pay the $475 each month for the next 5 years, you would have paid off the loan. But what if you wanted to pay the loan early and not take it over the full 5 years?

What you do in this case is talk to your financial advisor at the bank and inquire about the prepayment privilege that you are entitled to for this loan. This simply means how much extra principal payments you are allowed to make. If you make additional principal payments, you are actually paying off the principal amount of the loan faster, thereby reducing the term considerably. Hence, you are able to pay it off before the stipulated 5-year period.

How one would do that varies. An example would be budgeting the extra payment into the person’s monthly budget or even working another job to pay off the loan faster.

This is especially true for home loans, which are normally for 25 years. People prefer to pay them off earlier and hence make efforts to decrease their principal balances, thereby reducing the amortization or the life of the loan. It sure is a good financial strategy to manage debt better.

Difference Between High and Low-Interest Debt

Not all debt is created equal. In simple terms, just like everything has a price tag attached to it, debt too has a price tag. You can have high-interest or expensive debt, or you could have low-interest or cheaper debt. Simply put, the higher the interest rate on your debt, the more your interest payment will be.

Credit cards have the highest interest rates among all types of debt, which is why it is not uncommon to hear that you should pay off your credit card bill on time and in full. Otherwise, the interest charged on the unpaid amount is exorbitantly high—normally in the range of 21% to 27%, which is very high for any type of debt. Imagine paying 27% on a $10,000 credit card balance! That is why one should avoid getting into high-interest debt and only use it as a last resort if other cheaper options are not available. A line of credit is a cheaper alternative to credit cards, as it offers lower interest rates.

Who Qualifies for Lower Interest Rates?

Interestingly, not everyone is entitled to debt products at lower interest rates, as this is determined by a multitude of factors based on the customer’s profile. A person with an excellent repayment history of previous debts, a strong relationship with the bank (as in the bank being their primary bank), and an excellent credit score would be entitled to better interest rates on debt products. In contrast, another person who has not demonstrated responsibility with repayments, often being late on scheduled payments and having a bad credit score, would not.

The Importance of Timely Payments

This is why it is very important to stay on top of your payments at all times, as this is a contract between the bank and the person taking on the debt that they have to make timely payments as agreed.

What’s Next? Credit Cards and Debt Management

We will delve deeper in the next article and talk more about credit cards, their benefits, how to choose the best one for you, and what happens if one falls behind on debt payments.