Investing in a home is an excellent financial move and a dream come true for many people. However, you’ll have to overcome a few challenges along the way, including dealing with your ongoing debt.
If debt prevents you from turning your dream into reality, you might find debt consolidation as your way out. Before you start considering your debt consolidation options, let’s discuss what consolidating your debt means, how it works, how it affects your chances of homeownership, and its advantages and disadvantages.
Debt Consolidation Explained
Put simply, paying off multiple debts refers to the debt consolidation process. It involves using a balance transfer credit card or a new loan to pay off your debts simultaneously. You’ll only need to focus on one monthly payment at a lower interest rate.
A personal loan lets you pay off debts using the proceeds to handle each loan. Though you have various debt consolidation loan options, sticking with a personal loan is the most common way of dealing with debt consolidation.
Lenders approach debt consolidation in two different ways:
- They either disburse the proceeds to allow the borrower to handle due payments on their own;
- They pay off your loans on your behalf.
In addition, consider paying off your debts with a balance transfer credit card, as you can avoid paying into APR for the first six months to two years, depending on the card issuer.
How the process works?
Debt consolidation allows you to merge all that you owe into one loan. That offers you several advantages, such as:
- Simplified finances;
- Increased credit score;
- Pay off your debt sooner;
- Pay lower monthly payments.
The process of debt consolidation involves three vital steps:
- Qualifying and applying for a new loan;
- Paying off your debts;
- Paying off your loan.
Here’s an example to help you figure out how it works.
Imagine you have three different credit cards with a total debt of $20,000. Since each credit card includes an interest rate, your debt only goes higher.
However, bringing in $20,000 through a 5-year personal loan could help you lower the interest and pay off your debt faster. In other words, it’s a reasonable solution if you have no other options.
Does debt consolidation affect buying a home?
Before answering this question, let’s consider how the most common debt consolidation methods affect your homeownership.
One of the most common strategies borrowers use is to combine all they owe into one debt, then take out a personal loan to pay it off.
Aside from simplifying your finances, this strategy lets you track payments and manage your debt more consistently. More importantly, it can also help you qualify for a mortgage loan.
You see, most mortgage lenders will consider your DTI when assessing your eligibility for a loan, and by making consistent payments, you can increase your DTI ratio. That will eventually help classify you as a reliable borrower with a clean track record.
In addition, cleaning out your debt might increase your credit score, increasing your chances of getting approved for a mortgage.
Balance transfer credit cards can offer you a way out of your debt. These cards allow you to transfer outstanding balances to a new card, and there is a 0% or low intro APR, so you’ll avoid paying additional interest while handling your debt.
You could cover the debt with regular payments while decreasing your DTI ratio. If you do this correctly, you can improve your credit score, and you’ll have an easier time getting approved for a mortgage loan.
As you can see, making regular card payments can help you increase your credit availability and positively impact your credit score, but you must keep the cards open after you’ve paid off your debt.
Should I invest or pay off debt?
If you have one or several high-interest loans, debt consolidation might be the best option, but that depends on your credit score. If your credit score has increased since applying for the original loans, you won’t have issues consolidating your debt.
However, this approach might not make sense if your credit score is low because you won’t qualify for a lower interest rate. In that scenario, you would push yourself into a borrower’s abyss.
Here are several instances in which you should consider paying off your debt.
1. Paying off a large amount of debt
If you have a small debt and think you can pay it off with alternative means, debt consolidation isn’t the best choice due to credit checks and fees associated with qualifying for a new loan. However, if you have a large debt, it might be worth a shot.
2. Making financial improvements
Though having some debts is unavoidable, you can get a handle on your finances by avoiding overspending and financial irresponsibility. Before consolidating your debt, consider your current spending habits – use that knowledge to develop a plan to make financial improvements in your life and stay ahead of your finances.
3. Improving credit score
You can save on a debt consolidation interest rate if your credit score is in good standing. If your credit has improved since qualifying for your other loans, you could become eligible for a lower loan interest rate and save on interest over the loan’s lifespan.
4. Having a high enough income
You should consider paying off your debt if your monthly income is high enough to cover the new monthly payment.
Pros and Cons of Debt Consolidation Loans
Though debt consolidation can provide a few benefits, including lower interest payments and faster payoff, it also has some downsides. Let’s consider the good and the bad.
1. Streamline finances
Consolidating multiple debts into a single loan makes it easier to track your mandatory payments, thus reducing the chances of missing a payment. You’ll also have fewer interest rates, so taking control of your debt will be easier.
2. Faster debt payoff
Another benefit is making extra payments on your debt consolidation loan. That way, you will accumulate less interest, paying your debt off faster.
However, pay attention to the loan terms when applying for a debt consolidation loan – you don’t want to spend more on interest in the long run.
3. Save on interest
Debt consolidation should help you improve your credit score, making you eligible for low-interest loans. In fact, saving on interest over the life of the loan is an excellent strategy for recovering from financial entrapment. Instead of paying multiple interest rates, you get one competitive rate.
4. Reduce monthly dues
With debt consolidation, you can decrease your overall monthly payment by combining all your loans into one debt. Instead of making several monthly payments, you’ll make only one.
However, you may need more time to pay off this one debt, resulting in paying a greater sum over the life of the loan, even with the most competitive interest rate.
5. Improve credit score
Though qualifying for a new loan may cause your credit score to decrease temporarily due to the hard credit inquiry, it may also help improve it.
For example, debt consolidation could help you keep your credit utilization ratio below 30% on a revolving line of credit (credit card), which would reflect positively on your credit report.
Remember that making timely payments is the best way to pay off your debt and ensure your score remains intact.
1. Added expenses
Debt consolidation loans may come with additional charges and hidden fees, such as annual fees, closing costs, balance transfer fees, origination fees, penalty charges, etc. Shop for the most competitive loan terms before you trust a lender with your finances.
2. Higher interest rates
Debt consolidation is worth exploring if your credit score allows you to qualify for lower interest. Otherwise, you can end up with even more debt. That’s the thing with consolidating – qualifying for a lower interest rate is no guarantee of success, as you can still pay more interest due to longer loan terms.
Though your overall monthly payment may be lower than before, interest tends to add up over time. Thankfully, exceeding your monthly minimum loan payments can help you fix this problem. Adding something extra over the minimum payment amount can help you avoid the added interest.
Since there are so many factors you have to go over when deciding whether to go with debt consolidation, we recommend seeking professional help.
Talk to professional mortgage lenders and financial consultants before applying to weigh your options and find the most budget-friendly way to pay off your debts.
Loan officers will consider your previous and current financial aims and overall financial situation to provide you with the most feasible solutions for dealing with your debt.
Debt consolidation is a serious process, and if you are not savvy in this area, seeking professional help is paramount to making the right decision at the right time. The experience you gather while going through the process might also help you manage your finances better in the future, thus avoiding going into a lot of debt in the first place.