If your debt levels are becoming burdensome and you’re struggling to make monthly payments it might be time to consider either refinancing your debt or a debt consolidation loan. These two debt management options are both relatively quick and easy ways to bring your debt under control. We will explore their differences along with examples of when each option, debt consolidation vs refinancing, might make the most sense for your situation.
What is Refinancing?
Refinancing is when you renegotiate the terms and interest rates you are paying on your debts. You can refinance a variety of different types of loans including vehicles, student loans, mortgages, and credit cards. Often times refinancing your credit card debt is referred to as a balance transfer. The purpose of refinancing your debt is to lower your monthly payments or pay off your debts faster. This is usually accomplished through lowering the interest rate you are paying on your debt. You will usually qualify for better interest rates when your credit score increases or overall interest rates have dropped. Refinancing your debt is a great option to consider when trying to gain control of your debt by making your payments more affordable. It will be easiest for you to refinance if you are current on your existing payments.
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When Refinancing Makes Sense
Refinancing makes the most sense when you have higher interest rates on debts like signature loans, automobiles and houses, and you are able to qualify for a lower interest rate. For example, if you've owned your car for two years and you have a five year loan; it would make sense to shop around for a better interest rate if your credit score has improved during this time. The same can be said for other types of loans like mortgages. If you plan on staying in your home for a while, it would make sense to shop rates and try to get a lower interest rate after you have been in your home for at least 10 years.
Refinancing also makes sense if you'd like to pay off your debt faster. Let's say you have 15 years left on a 30 year mortgage. It may make sense to refinance that loan to lower the term so the loan is paid off faster. You would also likely benefit from the lower interest rate that comes with shorter loan terms. In most cases however, your payment will be slightly higher because you've lowered the term of the loan. If this slightly higher payment fits into your budget, then it may be an option to consider. However, if you are looking to lower your payments you may need to refinance at the same term, but just a lower interest rate.
What is Debt Consolidation?
A debt consolidation loan is actually a form of debt refinancing. The major difference between refinancing and debt consolidation is the number of loans you are refinancing. With debt consolidation you are refinancing multiple debts into one single loan, so you are only making one loan payment instead of multiple. Whereas when someone refers to refinancing, they are typically referring to one single loan. Additionally, with a debt consolidation loan you are able to payoff other unsecured debts such as medical debts or past due utility bills. You cannot do this with typical refinancing. A debt consolidation loan has a term, usually between three and five years, so you will also know exactly when you will be debt free. The key however, for consolidation to be a successful debt management solution, is to commit to not using those cards again, unless you absolutely have to.
When Debt Consolidation Makes Sense
Debt consolidation makes sense when you have multiple debts, like credit cards, at different interest rates. For example, let's say you have five different credit cards, with five different balances and five different interest rates and your total debt is $25,000. It is highly likely that you are paying on five different payment amounts, to five different credit card companies at different times in a given month. This can really be a pain to manage; a debt consolidation loan would pay off all of those balances. Then you would make one payment, once a month, to one loan. Usually at a much lower interest rate.
A debt consolidation loan may also make sense if you are having a hard time keeping up with multiple payments, or you are only making the minimum payment on those cards. With debt consolidation, you would combine all of those balances into one loan, with one fixed interest rate and one monthly payment. The proceeds of the consolidation loan pay off those five credit cards and you are left with just one loan.
How to Decide Between Debt Consolidation and Refinancing
If you only have one or two debts that you are looking to lower your payments on, then refinancing those debts may make more sense than a consolidation loan. However, if you have multiple debts that have high interest rates it may be better to look into debt consolidation, especially if you are struggling to make on-time payments. Since everyone's financial situation is different, my best advice is to sit with a lender at your financial institution and ask "Should I refinance or consolidate my debts?" Let the lender know your goals, and share your entire financial situation. That way they can help guide you to decide which option, is best for you.