When people search Google with questions about debt, one of the most often searched questions is, “How do I consolidate my debt?” Many looking for more information about consolidating their debt are usually in real trouble and looking for quick relief. Will consolidation help them?
Let us take an in-depth look at what debt consolidation is and how it works.
What is debt consolidation?
Sometimes finances spiral out of control and people find themselves 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, there are a lot of questionable organizations preying on the desperation of people buried in debt. As you consider your options, 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. One of the easiest ways to check into the validity of a consolidation company is to make sure they are approved of by the Consumer Financial Protection Bureau (CFPB).
Do not be too quickly taken in by companies who advertise themselves as nonprofits or faith-based organizations. Make sure you do your due diligence. Look into their credentials and read some reviews. You want to ensure that they are trustworthy and effective.
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.
If you are considering a debt consolidation company, keep these tips in mind:
- Spend some time researching other’s experiences with this company. You can get a good sense of a company's legitimacy based on the reviews and online chatter associated with them. You also want to make sure that they are accredited by the Better Business Bureau.
- Any genuine company is going to 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.
- Some companies will promise government help through a “Debt Relief Grant.” This is sold as debt bailout assistance from the federal government. There is no national debt relief program that helps people pay off credit card debt.
- 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 take inventory of all your debt. Believe it or not, this is one of the hardest parts of the debt process. Most people struggling with debt know that they are in trouble but are too overwhelmed to itemize their debt. The thought of taking a clear debt inventory would only make 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. It might be that you can deal with your debts a lot faster by making some adjustments to your spending habits.
Look closely at your assets. This includes savings and business accounts, and any equity you have in your home and properties.
Next, you want to get an accurate picture of your debt. This includes:
- Credit cards
- Student loans
- Car payments
What about my 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).
So, is consolidation a good idea?
This is where you want to do the math. Pull out the debts you would consider rolling into a consolidation loan and look at the principle and interest rates. 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? It might not be worth it. When you are struggling with debt, lower monthly payments can seem attractive.
If a loan payment would be more than you are currently paying toward your debts, it is probably smarter to increase the amount you are paying to your debts. If the promised loan payment is lower than you are currently paying, you are going to end up making more payments and paying more interest. In the end, it could cost you more.
But this does not mean a 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, it might be wise to think about consolidating. But it should be considered a last-resort consideration. It should not be a case of paying a financial institution to do what you could do if you applied yourself to creating a strategy for conquering your debts.
Types of debt consolidation
There are several ways to consolidate your debt. Let us examine the pros and cons of each one.
1. Home equity loans
Our home is one of our greatest assets. It is possible to tap into that equity as a way to pay off our debts. This could mean refinancing your home for some extra cash or taking out a home equity line of credit (HELOC).
The great thing about this option is that the interest rate on a home equity loan is much lower than the average credit card. While they vary with the market, most equity loans are under 8 percent, about half of the average credit card interest rate which is closer to 17 percent.
It is also worth considering that the interest on a home loan is tax deductible. That is not the case with the interest paid on credit cards.
The dangerous thing about using your home as collateral is that you are putting it at risk. It might be a helpful way to get yourself out of debt, but if you do not change the behavior that put you in debt to begin with, you could end up in a much worse situation.
The housing market has been volatile over the last couple of decades. It is entirely possible for the market to fluctuate and lower your home’s value. If you have taken an equity loan out on it, you could end up owing an amount greater than its value—turning your good debt into bad debt.
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2. Personal loans from friends or families
There is a chance you have someone who could float you the loan that would cover your debts. Is that a good idea? Maybe. Let us consider the pros.
It can be a win/win. Depending upon where their money is, they can probably get a better interest rate by loaning it to you than leaving it where it sits.
Since they are loaning it to you, you do not have to worry about your credit score. The only thing you need to be concerned about is whether they can trust you to pay it back.
If someone’s willing to give you a loan to cover your debts, it is probably an important relationship—the kind you do not want to put in jeopardy. If there is any chance that you will default on this loan, it can ruin relationships.
Make sure you get good advice. If the interest rate you are paying on your loan is too low, the IRS can end up charging you the difference between what you are paying and typical interest rates. This can make the whole loan a wash.
3. Borrowing against your pension
A lot of people have a nest egg that they could borrow from. This could be an IRA, a 401(k), 403(b), or investment stocks and bonds. This could be an easy way to get yourself out from under your debts.
This is money that’s already yours, so it does not require any kind of credit check to use it. So, if you do not have a lot of credit (or your credit is not the greatest), this can be a trouble-free choice.
You are your own lender, so the lower interest rates get paid to you instead of to a third party. In the case of things like IRAs, there is no interest rate at all.
This is your retirement that you are playing with. If it does not end up getting paid back, you can end up hurting yourself in the future.
You have a certain amount of time to pay a lot of these loans back. If you fall behind on payments, the IRS can treat them as an early withdrawal and charge you a penalty. This is a problem if you do not have the money to pay those fees.
Most advisors warn against borrowing more than 25% of your investment accounts. If the market drops, you run the risk of being forced to pay back the loan immediately.
4. A personal bank loan
It is possible to find personal loans from banks, credit unions, and online lenders. Provided you can get the loan, this can be a good option.
There are a lot of factors that go into the kind of rate you receive, but if you pay attention to the various promotional deals in your town, you can probably find an amazing rate—most often lower than those attached to your consumer debt.
With the length of time attached to the loan, your payments will be significantly lower.
If you are trying to get a loan through your bank, do not be afraid to leverage your history for a lower rate. Banks really do value loyalty and are often willing to go out of their way to make concessions for a good customer.
If your credit score is spotty, you are probably not going to be eligible for a great rate. And some lenders charge an origination fee. This is a cost associated with underwriting the loan, pulling your credit, or verifying your identity and documents. Pay attention to all the potential charges.
5. Using a balance transfer credit card
There are a lot of folks who take advantage of the introductory rates of new credit cards. They get a new card that offers 0% interest for a limited time and roll all of their credit card balances to that card.
If you can pay down the debt during the introductory period, great! That can be a way to avoid paying interest.
Credit card companies are making it harder and harder to play this game. Some companies charge a balance transfer fee or refuse to allow balance transfers at all. Eventually, opening too many credit cards will have a negative impact on your credit score.
Is debt consolidation right for you?
In the long run, you want to be able to pay off your debt without adding to it. Finding some way to consolidate and paying off your debts can be helpful, but it cannot stop there. You need to take a close look at the behaviors and 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.
Before jumping into a debt solution, it would be wise to talk to a credit counselor. They might be able to come up with some solutions that 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.