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How Does Debt Consolidation Work?

If you have a hard time paying off bills in a timely manner, then debt consolidation might be able to help. Debt consolidation work by taking out one loan to pay off existing debts in order to simplify the repayment process and help borrowers avoid bankruptcy.

This article will briefly summarize how debt consolidation works.

Evaluate your debts

The first thing that needs to be determined is what type of loan can actually qualify for debt consolidation. Not all loans qualify since not all loans are dischargeable through bankruptcy laws.

The most common loans that get used for debt consolidation include unsecured personal loans, home equity lines of credit (HELOC), and cash-out refinancing on second mortgages.

Other financing options could also work, but these three types are the most popular options used by borrowers.

Contact Your lender

After a loan is qualified, the borrower needs to request a debt consolidation loan. Once the borrower has found a lender for their consolidation loan, they will then need to provide documentation detailing all of their existing debts and how much each creditor owes them.

The borrower makes one monthly payment to cover both interest and principal for all outstanding balances on past-due accounts until those accounts have been paid in full.

For example:  if you owe $5,000 in credit card debts and $10,000 on your home equity line of credit (HELOC), then the lender will consolidate these two balances into one loan.

You will pay one monthly payment that includes both interest and principal to cover the full $15,000 you owe. Over time, this can help simplify your finances and make it easier for you to keep track of what you owe.

Things to avoid during debt consolidation

Since debt consolidation is an option for people experiencing financial difficulties, there are certain things that borrowers should avoid when repaying their loans:

Avoid non-liquid accounts

It is advised not to use funds from a non-liquid account such as an IRA or 401k unless absolutely necessary.  If possible, avoid dipping into these retirement savings accounts whenever possible.

Avoid borrowing from people close to you

You should not borrow money from family or friends for your debt consolidation unless you are committed to repaying them on time and within a reasonable amount of time.

It can be awkward, but borrowers need to come clean with the people they borrow money from and how they expect repayment arrangements to work.

Avoid investing with the new loan

No matter what type of account you use to deposit funds into (checking accounts, savings accounts, etc.), it is best to keep those funds as liquid as possible until your new loan has been fully paid off in full.

If possible, borrowers should avoid tying up their available cash in long-term investments such as certificates of deposit since this might limit their access to emergency funds if necessary.


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