What Exactly is Debt Consolidation?
Tips for Finding a Reliable Lender
Debt consolidation is simply that, combining all of your debts into one single debt. Theoretically, by combining, the new payment will be less than the sum of all the old payments, and will therefore be more manageable.
It doesn’t always work that way, though. If you’re carrying a high level of debt, a lender may well grant you a debt consolidation loan, but only at a high rate of interest, and you may not realize any savings at all. You will, however, save money if you can obtain a debt consolidation loan, and pay off high-interest debt with a new low-interest loan. The most obvious path here is the home equity loan; since this is secured by real estate, your interest rate will be a lot lower than unsecured credit card debt, and you will lower your total monthly payment.
There is one thing to be aware of though, and that’s increasing the debt again after the consolidation. It’s easy to fall into this trap. You pay off all your credit cards with the debt consolidation loan, and so you end up with credit cards with a lot of available credit again—so if you’re not careful, you can spend up the balance again very quickly, and then be stuck with the same high credit card payments every month in addition to the consolidation loan. In this case, you’ll be worse off than before you consolidated.
If you’re taking a consolidation loan to ward off unmanageable debt, the best strategy is to pay off the cards, and then just keep one, and then use it sparingly. And another big danger—since you’ve presumably traded unsecured debt, such as credit card bills, for secured debt in the form of a home equity consolidation loan, you now risk losing your home if you can’t pay the bills. On the upside, interest on your home equity loan will probably be tax deductible, while credit card interest is not.
Pay careful attention to the interest rate of any debt consolidation loan, whether it is secured or unsecured. In the long run, it may not be worth it. Even if it does yield you lower monthly payments, your overall interest rate may still be higher, and long-term, you’ll end up paying more.
Also, be sure you’re dealing with a true debt consolidation firm. Debt consolidation means taking on a new loan to pay off older loans. Some services offer simple bill paying services. They are not giving you a new loan, they are merely taking your money every month, siphoning off a fee, and sending the rest out to your creditors. Those bills still exist, they are just being handled by a third party instead of yourself. And sometimes, these third party organizations don’t even pay your bills on time—which damages your credit even further. There’s very little value in this service. If you do want a third party to handle your bill paying for you for the sake of convenience and organization, you can hire the services of a local bookkeeper for a lot less, and maintain a lot more control over the process.
Another type of debt consolidation comes in the form of balance transfers. If you carry multiple credit cards, shifting the balances from the higher interest rate credit cards to a new, lower interest rate credit card may result in savings. However, caution must be used here as well. Credit card companies change your interest rates all the time. If you are late even for one payment, your rate may change, and the savings may be wiped out.
Also, having one high-limit card that is close to the maximum looks worse on your credit report than would having multiple low-limit cards, even if you are making payments on time. There are of course, the many zero percent balance transfer offers, and these may be useful, but again, it is only temporary relief. The offer is usually only for six months or so, and then the transferred balance will be charged at the customary rate for that card.
Additional resources:
Federal Trade Commission's Knee Deep in Debt (scroll down)How Do FICO Credit Scores Work?
Getting Yourself Out of Credit Card Debt
Why Debt Reduction is Important
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