One of the most popular Google searches about personal finance is “What is debt consolidation?”¹ Many people who are looking for more information about consolidating their debt are in real trouble and seeking quick relief. Will consolidation help?
What is debt consolidation?
Sometimes your finances spiral out of control and you find yourself overwhelmed by unsecured debt. This could include things like:
- Credit cards
- Personal loans
- Medical bills
- Defaults on loans you have cosigned
Debt consolidation allows you to roll those debts into a single payment. This can be accomplished in a number of ways. If you have a lot of high-interest credit card debt, you can roll those balances onto a card with a lower rate. If you are a homeowner, you can apply for a home equity loan. You can even look into various consolidation plans.
Be mindful when you are considering consolidation options, though; some questionable organizations will prey on the desperation of people buried in debt. While debt consolidation can be a helpful tool, you need to be careful of the minefields.
Debt consolidation companies.
There are thousands of debt consolidation companies out there, but they are not all legitimate.
Some practices of consolidation companies can put you in a worse financial situation. For instance, they might want you to quit paying your debts and put that money into an account which they will use to negotiate with creditors to lower your debt principle. Many well-intentioned folks have seen this strategy backfire as creditors have turned their debts over to debt collection agencies.
Other companies will promise government help through a “Debt Relief Grant.” This is sold as debt bailout assistance from the federal government. But there is no national debt relief program that helps people pay off credit card debt.
Finally, do not be taken in by companies who advertise themselves as nonprofits or faith-based organizations. Do your due diligence. Look into their credentials and read reviews to determine whether they are trustworthy and effective. One of the easiest ways to check the validity of a consolidation company is to make sure they are approved by the Consumer Financial Protection Bureau (CFPB). You also want to make sure that they are accredited by the Better Business Bureau.
Any genuine company will want to look closely at your situation. If a company does not seem to be interested in the specifics of your financial situation, look elsewhere.
Read all of the fine print. Do not pay upfront for work a company is promising to do. If a company promises to renegotiate your principle or interest rate with your creditors, but they want you to pay them first, walk away.
Taking a close look at your debt.
Before you even consider debt consolidation, it is important to inventory all of your debt. Believe it or not, this is one of the hardest parts of the process. Most people struggling with debt know they are in trouble but are too overwhelmed to itemize their debt. The thought of taking a clear debt inventory makes them feel hopeless.
As hard as it is, you need to have an accurate picture of what you own, what you owe, and how much you are spending. This information empowers you to make the wisest decisions.
Evaluate your assets. This includes savings and business accounts, and any equity you have in your home and properties.
Next, make a list of your debt amounts and interest rates. This includes:
- Credit cards
- Student loans
- Car payments
- Mortgages
What about your credit score?
You should also look into your credit scores. Once a year you can get a free report from each of the three credit bureaus (TransUnion, Equifax, Experian). It is good to know where your credit score currently sits.
If you attempt to consolidate credit card debt yourself by rolling your balances onto a new lower card, you can end up hurting your credit. But if you combine your debts through a loan, your score can improve (provided you leave the cards open after you pay them off).
Is consolidation a good idea?
This is where you want to do the math. Look at the principle and interest rates for the debts you would consider rolling into a consolidation loan. At your current payment rate, how long would it take to pay them off? Now compare this to potential consolidation loans. Will combining your debts into one loan take you longer to pay it off? When you are struggling with debt, lower monthly payments can seem attractive, but it might not be worth it in the long run.
If a consolidated loan payment would be more than you are currently paying toward your debts, but is an amount you can afford, consider whether it is smarter to simply increase the amount you are paying to your debts. If the promised loan payment is lower than you are currently paying, you are likely going to end up making more payments and paying more in interest. In the end, it could cost you more.
But this does not mean consolidation is always a bad idea.
If you are completely underwater with your debt, it might be time to consider consolidation. If you have tried and failed to negotiate lower interest rates on your cards and you just cannot make the payments you have, consolidating could be the best tool for your situation. Check out part two of this debt consolidation explainer to learn more about the different types of debt consolidation and the pros and cons of each option.
Forging a new path.
Before jumping into a debt solution, it would be wise to talk to a credit counselor. They might be able to suggest some ideas you had not considered. Sometimes a credit counselor will help you come up with a slow and steady course that will have a better impact on your credit score and overall debt load.
In the long run, you want to be able to pay off your debt without adding to it. Consolidating and paying off your debts can be helpful, but you don’t want to stop there. Consider what you can do to avoid finding yourself in this situation again. Are there any unhelpful money management behaviors or activities that got you into this position to begin with? If you struggle with spending issues, debt consolidation is going to be a short-term fix to a long-term problem.
By looking at the big picture, getting wise advice, and using the tools available to you, it is possible to forge a new path and experience a lighter future without the pressures of debt.
¹ “The 15 Most Googled Financial Questions,” AdvisorPedia, September 18, 2018, https://www.advisorpedia.com/advisor-tools/15-most-googled-financial-questions/#:~:text=1.,I%20JOIN%20A%20CREDIT%20UNION?.
