How Does Debt Consolidation Work: A Guide For Beginners

Do you have a lot of debt?  You may have been looking for answers to solve your debt issues with debt relief programs and credit counseling but their is another option you can try, debt consolidation.

In this article I’m going to cover the basics as to how does debt consolidation works, give you some the benefits and negatives, as well show you how to get started.  With that said let’s jump right in.

How Debt Consolidation Works

First off, debt consolidation is the process of combining all of your debts into one specific place.  For example, let’s say you have 3 credit cards totaling $5000 in debt and you transfer all of that debt to a new credit card with a lower interest rate.

Now you might be wondering what would the benefit in doing something like this?  The truth is by combining your debts your not reducing the total amount of debt that you owe but rather for another benefit such as reducing your interest rate or receiving a tax deduction.  Their are several ways to consolidate your debt here are 4 options that I know of.  If you know of another way leave a comment below.

Using A 0% Credit Card

The first option to setting up a debt consolidation plan is using a 0% interest credit card.  If you have a ton of debt on other credit cards you could open a 0% credit card and combine all the debt to one card.

This option is a good way to cut interest down big time however their are a few downsides to this option.  First, if you have to much debt with credit cards you may not be able to move all the debt to one card, however if this is an issue just move the debt from the cards with the highest interest rates.

Secondly, most zero percent credit cards  will only give you the benefit of carring 0% interest on your debt for 6 to 12 months, however you can pay your debt off in this time it might not be a bad way to go after all.

Finally, I don’t want to play devils advocate but you have to consider the worse possible scenario.  If you ended up loading all of your credit cards up with debt again you would be worse off than before, however if your good and managing your debt it may not be a big concern.

Using The Cash Out Refinance

The next option you can use to cut down debt is to do a cash out refinance.  This option allows you to refinance your home and take a portion of the equity out in cash.  In most cases lenders will allow you to take 90% to 95% of the equity out of your home in a cash out refinance.

I used this option a few years ago to help pay for some remodeling I was doing on my home at the time.  The benefit to this option is that you will be able to reduce your debt to a lower fixed interest rate, and second you will also be able to get a tax deduction on any interest paid since the debt has been combined with your home mortgage.

However their are a few down sides with this option as well.  First, be aware of predator lenders.  Some lenders may be able to offer you a cash out refinance for more than the loan is worth.  The problem with this is that the tax deduction benefit would no longer apply on any debt that is over 100% loan to value.  On top of that if you plan to sell your home in the near future you will not be allowed to carry a balance more than 100% of the loan to value and will be required to pay that portion off in order to sell.

Using A Second Mortgage

The next option is a second mortgage.  A second mortgage is a subordinate mortgage to the main home mortgage.  The reason someone might want use a second over a cash out refinance is because the terms of their current mortgage may be so good that they don’t want to give them up.  For example maybe you have a really good interest rate.

However their are also some disadvantages to this option as well.  First, getting a second mortgage also depends on how much equity you have in your home.  If you don’t have much equity this option may not work for you.

Finally, a second mortgage also allows you to enjoy the tax benefit options that come with it as well as a fixed lower interest rate, in fact of all the options to consolidate your debt I recommend this one the most.

Using A Social Lender

Finally, the last option is a new one most people have not heard of, social lending.  Social lending is the process were lenders and barrows can meet in a common place to lend money to others.  One of the biggest social lenders around is Lending Club.

Lending Club can lend you up to $35,000.  The big benefit to this option is that getting approved is a lot easier versus traditional methods.  On top of that interest rates are fixed and will range from anywhere around 7% for good credit to as high as 25% for less than perfect credit.

However, one big disadvantage to this option is you don’t get any tax break as you do with the last two options.  If you would like to learn more about this option read my article about Lending Club.

Final Thoughts…

Debt consolidation can be a viable way to cut down debt big time, however I suggest you contact your local lender to discuss possible options that may be available to you.  So what do you think, is debt consolidation right for you?

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  1. A very popular topic now-a-daze Christopher…. these days we are seeing debt problems across all income strata and financial demographics!

    Curious times indeed….

    Kevin Murphy
    Life insurance wholesaler

  2. What about add that I see talks about reducing your debt for example from $50k to $28k. How does that work? My husband is self employ and have not had an income for 1 1/2 year. Any help or information regarding reducing debt would be greatly appreciated.

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