The Truth About Debt Consolidation
What is Debt Consolidation
Simply put, debt consolidation involves taking out one simplified loan in order to pay other outstanding debts. This is done by acquiring a loan with a fixed rate of interest that is often much lower than the interest rates currently held, especially on adjustable rate loans and variable rate credit cards.
Consumers can then pay off their higher balances with higher interest rates on multiple accounts and repay the one debt consolidation loan at a much lower rate. While it is possible to find a debt consolidation loan that is unsecured, for the most part, these loans are secured, and do require some form of collateral, typically a house or other property.
In this case, a form of mortgage is issued against the property, thereby allowing for a lower rate of interest than a loan without some form of collateral. The loan issuer assumes a lower risk and the owner agrees to give up the asset if the loan is not paid back according to the terms set forth in the agreement.
There are also times when debt consolidation can be used to actually lower the amount of money that is currently owed. If the person holding the debt is at risk of filing for bankruptcy, a debt consolidation company may purchase the loan at a discounted price.
This allows smart debtors to shop different consolidators in order to find the best deal at the best interest rate. That being said, debt consolidation can impact the ability of the person holding the debt to be able to discharge debt through a bankruptcy, so choosing to consolidate should be considered carefully.
Why Do People Use Debt Consolidation
For a variety of reasons, more and more people are finding themselves in a precarious financial situation that leaves them at the mercy of credit card and loan companies, and with the feeling that they are drowning in debt they will never be able to repay. This often leads to a downward spiral that can destroy a person’s credit report and force them to pay higher interest rates, making it even more difficult to make any progress. Of course, one of the main reasons people often find themselves in this situation is credit card debt. As can be seen from the chart below, the number of households that use credit cards on a regular basis has steadily increased, which has led to mounting debt that has skyrocketed out of control.
If the above chart does not paint a clear picture of the dire financial situation many people face, consider these alarming statistics regarding consumer debt:
- By year end of 2010, consumer debt in the United States neared the $2.4 trillion mark. This tallied up to about $7,800 debt for every person in the country.
To further illustrate just how out of alignment debt has gotten when compared to disposable income, please take a look at the chart below. As can be seen, the statistics mentioned above definitely hold true, with the amount people are spending well surpassing the amount they can afford, a situation which has continued to grow steadily in recent years.
How Debt Consolidation Can Help You
From the statistics provided, it is easy to see why debt consolidation has become so popular. It should also be no surprise that because of the dire financial condition in this country, more and more debt consolidation firms have popped up. These companies promise that the service they offer has helped a large number of people to erase their debts for good, but are these claims really true?
To help answer this question, it is first necessary to understand exactly what debt consolidation involves, and how it will impact overall credit history. Essentially, to consolidate means that all current debts are combined, including all high interest balances and put into one loan account with a lower interest rate. This loan is then paid off over the course of a certain number of months, usually a fixed period of time that can range from six months to five years.
It is important to note that a debt consolidation loan is not the same thing as a balance transfer, which is usually only offered by a credit card company. Credit card companies like to tempt consumers into transferring balances from other cards by offering very low interest rates for a particular length of time. However, when the fine print is examined, the promotional low rate is only good for a short period and then shoots up to a much higher rate.
The main reason that debt consolidation can be a good thing is that it can help consumers save a great deal of money in interest charges. Interest rates on these types of loans are generally just a fraction of those offered on credit cards, which can amount to a substantial savings. By moving balances over to one loan, with a lower interest rate, more of the amount paid each month goes toward paying the actual debt, rather than just to finance and interest charges. This makes paying off balances much easier, and faster.
Another reason that debt consolidation can be a good thing is that it helps people to create a budget to which they can easily adhere. Having many different accounts with many different balances and many different rates of interest makes it quite difficult to plan each month and keep track of expenses. This often leads people to forget payments, incurring more charges and penalties, and actually lose track of how much money is owed in total, and to whom. Having just one loan bill come in the mail each month, that is to be paid on the same date, makes budgeting, saving and planning much simpler.
How Debt Consolidation Can Hurt You
Although there are a number of benefits to a debt consolidation, it is still something that needs to be approached with a certain degree of caution. Many people who seek this type of loan have serious debt problems that led them to this stage. The result could cause trouble in finding a consolidation loan that has a lower interest rate as it may be difficult to qualify.
In order to help plan for this, it is important that all the numbers be calculated in advance. Time should be taken to determine if the consolidation loan will actually reduce the amount of total payments that need to be made on a monthly basis, including the total amount of interest that needs to be paid for the duration of the loan.
It is for this very reason that some financial counselors do not recommend debt consolidation at all. This issue, coupled with the fact that as many as seventy percent of consumers who do take part in debt consolidation programs do not change their spending or saving habits, can cause them to end up in a similar or worse financial situation within a two year period.
How the Debt Consolidation Process Works
There are several different ways to go about the debt consolidation process. If the debtor has a reasonably good credit rating, and a basic knowledge of finance to calculate total costs and interest rates, he or she can take it upon themselves to seek a personal loan, home equity loan, or second mortgage to use to pay off their debt balances.
If the debtor does not feel comfortable undertaking this task on their own, he or she can meet with a debt expert to discuss the available options. These experts will examine the total monthly obligation that is owed, and discuss the options available to help relieve these debts. Working with a debt expert, the debtor will have a program developed just for them and their specific situation.
For the most part, a debt consolidation loan will be chosen to remedy the issue. This makes it quite easy for the majority of people to understand the underlying concepts, as well as the associated terms and conditions, due to the fact that loans are quite common. Once the loan is put into place, the high interest debts will be paid off, and one low monthly payment will be made to repay the consolidation loan. Many debt consolidation experts will also work to educate debtors to help keep them from sliding back into the same financial pitfalls they just escaped.
In a relatively short period of time, debtors will notice that they have far less difficulty paying their monthly bills, and may have more cash left over at the end of the month. The main idea behind this type of program is to save a significant amount of money each month by reducing or eliminating individual payments, while whittling down the total balance with just one, relatively easy payment.
How Debt Consolidation Can Affect Your Credit Score
Typically, the process of applying for a debt consolidation loan and paying off higher interest accounts does not noticeably raise or lower a credit score in the short term. Even though those who obtain these loans are technically taking on a new form of debt, credit bureaus tend to look at credit histories on the whole, and will take into account the fact that other debts have been paid off. Over the long term, should all payments be made on the consolidation loan on time for one to two years, the credit score should improve.
That being said, it is important to note that it is necessary to use a bit of caution when paying off accounts. If the debtor has a poor credit history, it is not uncommon to ward off future temptations to spend by closing the accounts once they have been consolidated. However, simply closing an account does not remove its history from a credit report. Also, closing more than one account can reduce the total credit available, which then raises the available credit percentage that is still in use. This does negatively impact a credit score, as it can make a candidate appear to be “maxed out.”
If it is necessary to close some accounts following debt consolidation, newer accounts that have not been in use for a long period of time should be closed first. Having accounts with a long credit history actually help to improve the overall score. Also, a letter should be sent to the creditor for any accounts that are closed, letting them know that the account is being closed by the request of the holder, and should be reported to credit bureaus as such.
Using a debt management agency to negotiate settlements with creditors for less than the total amount owed can also negatively impact a credit score. This is because it will be reported as a failure to repay debts that have been promised to be repaid. Some debt management agencies may also not make payments on some account for months while they are arranging a settlement, thus also adversely impacting a credit score.
How to Avoid Debt Consolidation Scams
Due to the shocking statistics mentioned above, as well as the current state of the economy, there are more and more debt consolidation experts and companies entering the marketplace than ever before. While several of these provide good results and are quite honest and reputable, there unfortunately are also a high number that strive to do nothing but scam individuals looking for help.
In order to ensure an upstanding debt consolidation expert or company is chosen, here are a few tips to keep in mind to avoid a scam.
First, ask others for recommendations and research the options available before signing up with any debt consolidation service. One way to go about this is to call the state attorney general’s office, the Better Business Bureau, and/or the Federal Trade Commission to determine if the company is legitimate, how many complaints have been lodged, and if there have been any other serious issues. The American Association of Debt Management may also be referenced; however, this agency was formed by debt consolidation and consumer credit counseling companies, so their recommendations may not be as unbiased as the other agencies mentioned.
Then, when speaking with a debt consolidation company, be sure to keep personal information private. These companies only need to know the debtor’s name, the names of the debtor’s creditors, the debtor’s total balances, and the debtor’s current interest rates. There is no need to provide any other personal information such as Social Security numbers or account numbers.
Next, not only compare monthly payments, but also look into the fees. The same rates should be offered by every legitimate debt consolidation service, as they all receive the same incentives from creditors. If one company is offering a rate or a monthly payment that is much lower than the others, it is most likely because they are going to charge a higher rate of interest. While, initially, this may look ideal, it will wind up costing much more over the course of time.
Also, be on the lookout for extra fees. Consumers should not be charged for an initial analysis or a quote. Be wary of some companies that may charge high fees, either upfront or hidden, that will crop up over the course of months. Other fees may be built into the monthly payment schedule. This is because some companies charge for taking the payment from the debtor and forwarding it to the creditor. The amount charged can be as much as ten percent, on top of the ten to fifteen percent rebates they receive from the creditors for payment.
Finally, take a bit of time before making any final decisions. Most credit counseling services and debt consolidation services have employees who are taught to use a certain script to encourage people in financial trouble to sign up quickly. When meeting with these people, it is a good idea to take someone else along, to help listen and prevent decisions that may not be ideal. Taking a bit of time to think about things allows for all details to be reviewed, which may help ward off a scam.
Final Things to Consider
When researching into a debt consolidation loan or deciding to sign up for a debt consolidation program, be sure to read every last bit of the fine print. Several of these loans and programs charge transaction fees, require collateral, and may require other secured measures such as direct bank withdrawals. It is also important to calculate the average rate of interest on all current debts and compare that number to the total interest rate that will be paid on the new loan. If this rate is definitely lower, it is quite probable that you will save a good bit of money with the consolidation.
Lastly, once the debts have been consolidated, spending habits need to change, and change for better. If this is not done, it is quite possible to undo all of the progress that has been made, and end up with a bigger financial mess than was originally started with. Debt consolidation should be thought of as a last resort, for those truly serious about repairing their situations. It is not something that should be undertaken lightly, and it should not be thought of a means to free up money for frivolous spending.