How Debt Consolidation Works

Are You Interested in Consolidating Debt?

Creating a budget is essential to understanding your finances.
Creating a budget is essential to understanding your finances.

In today's credit-crazy culture, life's necessities, such as a car, a home or an education, are often impossible to afford without loans. With household credit card debt hovering around $8,650 [source: Center for Responsible Lending], it seems that most people could benefit from greater financial literacy and restraint. But before you decide debt consolidation is your lifeline, it's a good idea to create a budget. Here are the basic steps:

  • List all of your income (including wages, investment income, etc.).
  • List all of your expenses (rent, loans, food, gas, etc.).
  • Enter the amount you receive or spend for each item over a fixed period of time (usually a month).
  • Set realistic limits for yourself to stop unnecessary spending.

By comparing how much you make and spend each month, you can get a better idea of what impact loan payments have on your life and whether it's worth it to consolidate. Read more about budgets in How to Make a Million Dollars.

Merely having debt doesn't necessarily mean you need to rearrange your finances; however, you should recognize the signs that you are struggling [source: Garman, Kiplinger]. These signs include:

  • Consistently making late payments
  • Paying only the minimum amount due on credit card bills
  • Borrowing money to pay for expenses like food and gas
  • Using more than 20 percent of your paycheck to pay debts (excluding mortgage)

Once you do the math, you'll know whether you're ready to consolidate. Consolidating your loans, as we explained before, simply means taking out one bigger new loan to pay off several existing loans. As with any loan, you'll have to pay an extra charge determined by the interest rate, a percentage of the amount borrowed. If you find a consolidation loan with a low interest rate, then reduced payments could make your immediate financial situation more manageable and free up other income for savings and investments. In addition, if you're juggling multiple loans, combining them means that you'll only have to deal with one monthly bill. Since late payments are factored into your credit, having a more manageable payment system could make it easier to build better credit.

Many financial advisors consider bankruptcy a last resort, and recommend evaluating all other alternatives first, such as debt management.

If you have decided that you want to consolidate your debts, the choices you will face could quickly get stressful and overwhelming. Given the risks of losing your home and amassing debt, it's wise to proceed with caution. Read the next page to find out about some of the options you will have.