It may seem like a good plan to consolidate your debts if you have a lot of different debts that all have different interest rates, repayment schedules and balances.
Consolidating debt can be appealing because of the lower monthly payment, and the reduced interest rate.
Some people may find debt consolidation a sensible solution. Others will make the debt consolidation firm rich.
Truthfully, salesmen for debt consolidation or debt relief will say whatever you want to to get your business. Do not fall for any gimmicks and false promises.
Learn the truth about debt consolidating before you sign the dotted lines to determine if it is the right strategy for you.
Table of Contents
What is debt consolidation?
How does debt consolidation work?
How to Get a Debt Consolidation loan
Does Debt Consolidation Really Work?
What is the average debt consolidation interest rate?
How debt consolidation affects your credit score
The Debt Consolidation and Debt Settlement Programs are Very Different
What is the best way to consolidate debt?
What is the best option for debt consolidation?
A debt management plan
What is debt consolidation?
Consolidating your debts is the process that combines all of them into one debt. You can consolidate your debts if you have multiple loans with different interest rates.
It can result in a monthly payment that is only one and lower rates of interest. It can be easier to track your payments if you combine all your debts in a single loan.
Consolidating debt can include auto loans, credit card debt with high interest rates, student loan balances, medical bills, or any combination of these.
You can do this by taking out a loan or consolidating all your debts onto one card.
How does debt consolidation work?
You may think it’s a good idea if you have payday loans spiraling out-of-control, along with high interest credit card debts and your car loan.
The interest and fees associated with payday loans can be stopped by debt consolidation. This is done by consolidating your debts and paying them off in full using another loan.
This article will provide you with some important facts about debt consolidation.
The consolidation of your debt will add additional fees and taxes to your current balance, and also extend the time it takes for you to pay off your debt.
How to Get a Debt Consolidation loan
You can consolidate your debt in several ways. The credit score is a major factor in determining the options available to you for obtaining a consolidation loan.
Zero Percent (0%) Interest Cards
If the credit limit of your card is high enough, depending on how much debt you have outstanding, you might be able transfer it all to a card with 0% interest.
Some people transfer their outstanding debts onto several credit cards with 0% interest and then play the shuffle as they pay off their debts on each card.
Remember that most 0% credit card companies charge a fee to transfer outstanding debts onto the card. Also, the 0% interest rate on credit cards has a set time frame before it expires and the regular rates kick in.
If you do not pay off the card in the timeframe, the interest rate can jump up to 20%.
This dangerous game should be avoided.
Private Loan to Consolidate Debt
A private loan can be obtained by contacting a lender (usually a bank) and requesting one.
You would use this loan to pay off all the debts you wish to consolidate/combine. The loan would be used to consolidate all your debts into one payment.
It is usually the best option to use if you are using a loan with a fixed interest rate.
Debt Consolidation Companies
Most debt consolidation companies can also handle the paperwork, refinancing and debt repayments. They charge a fee, which is often rolled into the loan.
Home Equity Line of Credit (HELOC), Loan
A second strategy is to use your home’s equity as a way to consolidate your debt and get a Home Equity Loan (HELOC). This will add fees to your loan, and extend the time to pay back your mortgage.
If you add $50,000 to your outstanding home loan debt, depending on the loan structure you have, you could be committing to paying off that additional amount in 30 years.
The extra time you spend on paying off the debt will often result in a higher amount than if you had used the snowball or avalanche methods.
Borrowing from your retirement plan – 401k, 457, 403b loans
You may be eligible to borrow from your retirement plan if you have a 401k, a 403b or a 457.
The amount of money you can borrow is limited. You are generally allowed to borrow up to $50,000, or the half of your retirement portfolio.
Refer to my article on the subject, Is it Smart To Borrow from My 401k For Debt Reduction?
Does Debt Consolidation Really Work?
Many people have asked me whether debt consolidation and credit consolidating works. This is a general question that needs more explanation and insight to answer.
To answer this question simply, yes, debt consolidation works to combine your outstanding debts in one loan.
The interest rate on this single loan is often lower and it can reduce your monthly payment. Depending on your circumstances, consolidation of debts may end up costing you more in the long term.
Even though your interest rate may be lower and you might have lower payments, consolidating debts does not guarantee you will save money.
Debt Consolidation Example Scenario
Below is a graph showing a debt consolidation scenario. This person wanted to consolidate debts worth $35,000. These numbers were calculated using the Credit Karma debt payoff tool.
What Is the Best way to consolidate debt? What You need to know
You can see in the graph that even if you have a lower rate of interest, the extra time and origination fees add up. When it comes to repaying debt, time is not your friend.
Some loans charge prepayment penalties if you intend to pay off your debt consolidation faster.
If you wish to pay the principal off by making higher monthly payments, there will be additional fees.
Read the fine print.
What is the average debt consolidation interest rate?
ValuePenguin conducted a study of debt consolidation rates and found they vary widely.
Rates vary depending on the company, but are also heavily dependent on credit scores. The data that they gathered is as follows:
FICO Score
Excellent (720-850)
Good (680-719).
Average Or Fair (640-679)
Poor (300-639)
Average Interest Rate
4.52% – 20.57%
6.67% – 28.33%
7.05% – 30.32%
15.06% – 36.00%
How debt consolidation affects your credit score
Consolidating your debts can affect your credit score several ways. Your score may change throughout the process depending on the circumstances.
How Debt Consolidation can hurt your credit score
Your credit score will decrease when you first apply for a new credit card or personal loan (including a HELOC) until you begin making payments to your new lender.
If you accumulate new debts after consolidating, your credit score will be affected.
Your credit score can be affected if you are denied a personal loan, or if you try to consolidate your debts with a company.
If you miss payments after you’ve obtained a loan for debt consolidation or a contract, it will negatively impact your credit score.
How Debt Consolidation can improve your credit score / FICO score
Your credit score will increase if you continue to make timely payments and are consistent after consolidation. Your credit score will improve the fastest if you make on-time payments, reduce your debt and pay it off.
National Debt Relief1 states that your FICO score will improve if your outstanding debts are reduced to less than 30 percent of your credit limit.
The Debt Consolidation and Debt Settlement Programs are Very Different
Debt consolidation is a way to consolidate all your debts into a single payment. It also provides you with a lender who has negotiated 0% interest rates.
Debt settlement programs rely on an outside company working on your behalf in order to reduce your debt.
What is Debt Settlement?
A debt settlement program is a contract between you and a company who will negotiate with your creditors in the hopes of reducing the amount that you have to pay.
These companies charge a fee and will take care of your debt repayment.
Companies that offer debt settlement services advertise they can help you avoid bankruptcy and become debt-free quickly by reducing your debt.
There is no guarantee that debt settlement companies will lower your debt. Lenders are the ones in control and they are not required by law to settle any liabilities at less than their full amount.
How does debt settlement work?
Debt settlement companies have several strategies they use to negotiate with debt collectors. The following are some of the methods used:
You may be asked to stop making payments on your credit card or loan to put pressure on the company to pay your debt.
In order to settle your debt, you will need to contact the lender and try to negotiate for a lower balance. Companies that specialize in debt settlement will handle this for you.
As the borrower, if the debt settlement company does not reduce the debt, you are responsible for the late fees that the lenders added.
Due to the scams, very few companies offer debt settlement services that guarantee anything. The Federal Trade Commission is heavily involved in regulating these companies.
Your credit score will be negatively affected if you stop paying your debts and pay late fees.
Your credit report will reflect any debt reductions and settlements. Unpaid debts may also appear as settled.
You can settle your debts without a company’s help. Check out my article How To Negotiate with Debt Collectors for more information.
Avoid debt settlement companies and programs at all costs. They are full of scams, and there is no guarantee.
You can do everything they offer without paying high fees or damaging your credit.
What is the best way to consolidate debt?
You should consider the pros and cons before making a decision.
Pros Of Debt Consolidation
Consolidating your debt can lower the interest rates you pay by moving the balance from a credit card with 0% interest to a personal loan at a lower rate.
Consolidating your debts can simplify the repayment process by allowing you to pay only one lender each month, rather than multiple lenders.
You can lower your monthly payments on total debt.
Debt consolidation: The Pros and Cons
Your total debt will increase due to additional balance transfer fees
Consolidating debt can lengthen the time you need to repay the loan by adding extra years.
Applying for new loans can damage your credit score (FICO).
You may end up paying more in the long term if you consolidate your debt with a lower rate of interest and a longer repayment period.
Consolidating your debt will not solve the underlying problem of spending and budgeting.
What is the best option for debt consolidation?
The fees associated with debt consolidation and settlement are often higher and your repayment plan will take longer.
You may think you’re saving money by paying less, but you are actually adding time and money to your debt.
If you don’t have a plan to get and stay out from debt, the immediate relief that you feel when you see a reduced payment will quickly be erased.
In very few situations does hiring a consolidation service make sense. It may be mathematically sound to refinance your debt if you are paying off the same or more each month.
If the loan doesn’t have a penalty for early repayment, you can pay more to lower your payment.
Debt Management Plan
Budget your finances
Create a savings structure
Start an emergency fund
You can pay off your debt using the debt snowball method or the debt avalanche.
You can get out of debt with patience and persistence. The most difficult part is to maintain discipline and commit yourself to changing your life.
The consolidation of debts or settlement of accounts is usually a quick fix that does not work out well. These programs are designed to make money for other people while giving the impression that you’re saving money.
Check out these easy ways to earn money at home if you are struggling with income.
You can save money and time if you get out of debt in the right way. This involves hard work, determination and a plan.
This article was originally published on The Money Mix and is republished here with permission.
