Debt consolidation: How does it work and is it right for you?
When you have debts everywhere you turn, it can feel like you’re completely swamped. Your hands are tied every payday as you funnel money into paying off debts, leaving you with no room to save.
That’s why a lot of people turn to debt consolidation, which is when you use a loan to pay off all of your debt — and it can seem like a godsend.
But wait, how is ANOTHER debt supposed to help?
Of course, you’re right to be suspicious. The thing is, it can help but only if you do it right. Do it wrong and you’ll be kicking yourself from a position worse than you’re in now. So, should I consolidate my debt?
Debt consolidation can work as a way to pay off debt faster. However, if you’re not disciplined and look for help in the wrong places, you’ll end up spending MORE time paying off your debt.
Let’s take a look at what debt consolidation is, how to consolidate debt, the pros and cons, where to find a reputable organization to help you, and ways you can get out of debt fast.
What is debt consolidation?
Debt consolidation combines all of the debt you owe into a single payment with a lower monthly interest rate. This typically works by taking out another loan in order to pay off all of your other debt.
Let’s say you have debt across three credit cards and you owe the following:
- Credit card A: $2,000 at 10% APR
- Credit card B: $1,000 at 20% APR
- Credit card C: $1,000 at 15% APR
Each month, you’re contributing $100 to each card for a total of $300 — however, a portion of each is being eaten by interest:
- Credit card A: $16.67
- Credit card B: $16.67
- Credit card C: $12.50
So in all you’re paying $254.16 towards your debt rather than the full $300.
With debt consolidation, you take out a loan of $4,000 and pay off ALL of the above debt — and you get a lower interest rate for the loan at 10%.
Now each month when you contribute $300 you’ll pay $266.67 towards your debt rather than just $254.16.
In theory, this means you’ll be able to pay off your debt faster.
The interest rate you’re able to get depends on which type of loan you attain:
- Secured loan. This is a loan where you put up an asset (e.g., car or home) as collateral. If you default on your loan, your creditor will repossess said asset.
- Unsecured loan. This is a loan that just uses credit. As a result though, you might end up with higher interest rates than if you had a secured loan.
If you want to get your debt consolidated, you’ll have to go through one of the two routes above — which we’ll get into later.
Before we do that though, it’s important you know the dangers around consolidating your debt.
The problem with debt consolidation
But before you click on one of those scammy internet ads marketing “DEBT CONSOLIDATION — BE DEBT FREE IN 3 HOURS,” consider the big drawbacks to debt consolidation:
1. It could take longer to pay down your debt
If there’s anything we’ve learned about human psychology over a decade of studying behavior and personal finances, it’s that things like that are easier said than done.
For example, if the average person ends up saving $300 in interest payments because of debt consolidation, do you think they’ll use that extra money towards their debt OR do you think they’ll end up spending it?
Most likely, the latter.
Human willpower is limited. It’s the same reason why cutting out lattes or skipping lunch to save money doesn’t work.
A person with 300 “extra dollars” might end up just blowing it on something else.
What happens then is it takes longer to pay down debt. This results in even MORE fees they have to pay.
Aside from diminishing willpower, many debt consolidation loan companies offer up longer loan terms than people realize. So while the interest rate is lower, they end up paying more because they didn’t take into account how long they’d have the loan for.
2. You could lose your home or car
If you decide to put your car or home down as collateral you stand to lose much more than a few thousand dollars off the life of your loan.
A home equity loan is also known as a second mortgage. Taking a second mortgage out on your home means you risk losing your house if you fail to make payments.
Of course there are some advantages to going this route. For one you can deduct the interest payments from your home equity loan from your taxes. Plus you’ll be able to get a lower interest rate than if you went the unsecured route.
Overall, though, it’s just not worth the risk — especially when there are better ways to go about it.
3. Your credit score will suffer
There are a few things that go into making a great credit score. One of them is your credit history — or how long you’ve had credit for.
It actually accounts for 15% of your overall score.
That might seem small but consider this: If you get rid of a bunch of different lines of credit at once, your credit score is going to take a huge drop. That drop gets bigger with more and more lines of credit you close.
How do you know if debt consolidation is right for you?
Debt consolidation can be a great way to plan your route out of debt. But that doesn’t mean it’s the perfect solution for everyone.
The benefits of debt consolidation are hard to argue with. You can simplify your debt, save money on interest, only deal with one creditor, and (hopefully) clear your debt faster. But there are pros and cons you need to know about before you make this decision.
It can be the best move for some, but worse for others.
Signs debt consolidation is right for you
You have high-interest debts
The number one sign that debt consolidation is a good option for you is if you have several high-interest debts. Why pay interest on several debts when you can pay it on just one?
If you know you can secure a lower interest loan, it makes sense to consolidate your debts.
According to Experian, the average personal loan interest rate is 9.41% — whereas the average interest rate for credit cards is around 16%. So, if you’ve got a ton of credit card debt, it’s worth considering debt consolidation.
You have good credit
If you’re already in debt, getting another loan might be tricky unless you have good credit. Most creditors will want a credit score of around 670 (FICO Score).
If you have good credit, you’re more likely to get approved, and also get a loan with decent interest rates. Remember, you want a loan with lower interest rates than your current debts, so this part is key. If your credit score isn’t the best, a new loan might not have favorable interest rates.
You want a fixed repayment schedule
With some debts like credit cards, it’s easy to just make the minimum payments or even miss a payment (please don’t do this). This makes it harder to clear the debt because some of it relies on willpower.
With a personal loan, you have a fixed payment and loan term that you have to abide by. This makes it much easier to stay on track and clear your debts. It also means there are no fluctuations in your monthly debt payments like with a credit card so it’s easier to budget for.
Signs debt consolidation is NOT right for you
You have a poor credit score
Having a poor credit score is one reason why a lot of people want to get out of debt as fast as possible.
However, debt consolidation relies on you not only being able to take out a new loan but also getting one without crazy high interest rates.
If the only loans you can take out mean you’ll be paying MORE in interest rates, then it’s not worth it. In this case, the only benefit would be to simplify your loans.
But what you really need is to save on interest so you can clear the debts faster.
You’re on the verge of bankruptcy
If things have taken a downward turn and creditors are threatening to sue, then a debt consolidation loan may not even be accessible to you. Bankruptcy is a scary thought, but if this is your reality, you are unlikely to qualify for a debt consolidation loan.
If this is your current situation, you would be better off looking into debt settlement to try and reduce your debt amount first.
You can’t afford the monthly repayments
Taking on another debt is tricky if you’re already in debt. While you can use this one to clear your other debts, you need to make sure you can cover the monthly repayments.
As it’ll be a higher debt amount (to cover all your other debts), the monthly repayments will be higher. Make sure that you can fit it comfortably into your budget before taking on new debt.
After all, missing repayments can set you back even further.
How to consolidate debt — and get rid of it completely
If you’re STILL interested in consolidating your debt, I want to help you.
Because there are a LOT of scammy consolidation services out there. These “businesses” will promise that they’ll help you get out of debt fast through their loan packages …
… only to screw you with hidden fees, bloated interest rates, and long loan terms.
The trick here then is to separate the good debt consolidation organizations from the bad ones.
Step 1: Find a non-profit debt consolidation firm
Non-profit debt consolidation firms are 501(c)(3) organizations that help provide you with consolidation services, credit counseling, and will even negotiate with your creditors for you.
The best part: They do so with little to no costs to you since they’re funded by third-party sources such as donations and grants.
Unfortunately, even scammers and bad consolidation services have non-profit status. So you’ll have to do your research into finding a reputable one.
Two good signs a non-profit debt consolidation firm is the real deal:
- Fees. A reputable non-profit will likely have monthly maintenance fees. Luckily, they’re relatively low cost — and if you’re in really dire straits, some non-profits will waive the fees entirely for you.
- Non-profit status. This might seem like a no-brainer but it still needs to be said: Ask them for verification of their non-profit status. Too many scam companies pretend they’re non-profits in order to lure people in. Don’t be one of those people.
Make a list of 5 to 10 non-profit debt consolidation firms. Spend the next week calling each of them and getting a consultation on your situation and what they can do for you.
A good non-profit will spend about an hour on your consultation. Beware of any organization that wants to take your money and put you into a plan right away. They are NOT looking out for your best interests.
Step 2: Eliminate temptation
Luckily, a non-profit debt consolidation firm will take care of a lot of legwork for you. That means they’ll call your creditors, negotiate down your debt and interest rate, and work with them to consolidate all of your debt into one manageable monthly payment.
Unluckily, that’s the easy part. The hard part means actually doing the work of paying down your debt — and that’s up to you.
To do that, you need to first get rid of the temptation of using your credit cards until you’re debt-free. If you ever expect to pay down your debt, you can’t add more to it.
Here’s my favorite tip: Plunge your cards into a bowl of water and shove it all into your freezer.
Seriously. Remember what we said about human willpower? It’s very weak — so weak that a solution like freezing your cards is necessary sometimes to delete temptation.
When you literally freeze your credit, you’ll have to chip away at a massive block of ice in order to get it back — giving you time to think about whether or not you want to go through with whatever purchase you were going to make.
You can also give them away to a loved one to keep until you’re out of debt.
Step 3: Confront your debt
It’s good to finally confront your debt. That’s the first step to getting out of it.
While it may be tough to climb out of debt, the sooner you make a plan to do so, the better. You’ll be able to repair your credit score, work on boosting your savings, save on interest, and finally get some sleep at night. Debt can weigh heavily on the mind, after all.
The good thing is, you don’t have to do this all alone. There’s help at hand. You can get in touch with a non-profit debt consolidation firm to help you. Take advantage of their credit counseling services to help steer you through unmanageable debt. Do your research and find a non-profit so you can avoid the scammers out there.
It’s easy to feel bad for yourself and avoid confronting your debt. It’s harder to actually step up and do something about it.
Since you’re here, that means that you’re willing to put in the work to dig yourself out of your financial hole which is amazing!
What is the difference between debt consolidation and debt settlement?
Another term you’ll likely come across in your quest to clear your debt is debt settlement. But what is it?
Both debt settlement and debt consolidation are used to handle personal debt, but they work in very different ways.
Debt settlement is used to reduce the total amount of debt owed. Whereas debt consolidation is about reducing the number of creditors you owe.
With debt consolidation, you combine multiple debts into one. Debt settlement is when you ask one or more of your creditors to accept less than you owe.
If the creditor agrees, you both reach a settlement agreement in either a lump sum or installments.
Which one is best for you?
This depends on your circumstances and what the creditor will agree to. If you want to make your monthly repayments more manageable and reduce the amount of interest you pay, then debt consolidation is the way to go.
If you’re already behind on payments and are struggling to meet them, then debt settlement might be a better option.
In this case, if you’re already behind on payments you might struggle to get a debt consolidation loan anyway because of the impact on your credit score. So, debt settlement is definitely something to try out to reduce the burden.
Debt settlement is the next logical step if you’re out of options, have poor credit, and want to avoid declaring bankruptcy if at all possible.
It may mean taking a hit on your credit score, but you might have to just accept that. Once the debts are clear, you can get to work on repairing that damage.
How does debt settlement work?
Debt settlement is a tricky one and requires you to whip out your negotiation skills. There’s no guarantee the creditor will agree, but there’s no harm in asking.
The process is pretty simple. You can ask your creditor if they would be willing to negotiate a settlement. Do this over the phone or in writing to keep a record of the conversation.
A creditor can do one of three things:
- Accept it
- Reject it
- Make a counteroffer
With the counteroffer, you will need to consider if the amount they want is affordable in your budget. Make sure you’re agreeing to something that’s realistic and fair.
Once you agree on a settlement amount, all that’s left is to arrange the payments. This can either be a lump sum or through installment payments, whichever you agree to.
After you’ve made the payments, the remaining balance that’s been hanging over your head will be a nice round zero.
If negotiating debt settlement on your own sounds like a nightmare, don’t worry. There is help at hand. You can hire a debt settlement company to negotiate on your behalf. However, this does involve paying them a fee, and again, you have to do your research to avoid hiring a scammer.
Pros and cons of debt settlement
You reduce your debt amount
The biggest pro to debt settlement is simply that you reduce your debt amount. A lot of people don’t know that you can ask your creditors for this. So they carry on struggling.
But if you’re struggling, it can’t hurt to ask. If a creditor agrees, you could cut hundreds of dollars from your debt and all the interest that comes on top of that.
You can clear your debt faster
With a smaller debt amount to pay off, you can pay it off faster. Whether you agree on a payment plan or a lump sum, you’ll be able to say goodbye to your debts much sooner.
This means your money will be freed up faster to put into savings accounts or whatever else you want to spend your money on. You can also get to work repairing any damage to your credit score once the debt is clearer. The sooner the better.
It could help you avoid bankruptcy
If bankruptcy is on the horizon, debt settlement should absolutely be a consideration. The last thing you want is a bankruptcy on your record. You can pretty much say goodbye to being able to take out credit for a LONG time if you reach this point.
Your credit score will take a hit
Naturally, debt settlement does not reflect well on your ability to repay debts. If you have debt settlement in your credit history, it signals to future creditors that you are riskier to lend to. This could result in sky-high interest rates or outright credit rejection in the future.
However, if your credit score is already low and your debts are just making it worse, then you pretty much have nothing to lose. Yes, you’ll take a hit, but you’ll also get out of debt sooner if your creditors agree to debt settlement.
You might struggle to get credit again… especially with those creditors
A lower-than-ideal credit score does affect your ability to take out credit in the future. However, if you’ve been in a tricky situation with credit, it’s probably worth avoiding new loans and finance for a little while anyway.
The creditors who agree to debt settlement will likely avoid lending to you again because they will be worried about losing money. This could limit your options in the future. But if it’s your only option, you might just have to just bite the bullet.
There is no guarantee creditors will agree
Unfortunately, if you’re relying on creditors to throw you a lifeline here, you might be out of luck. In an ideal scenario, they’ll be forgiving and offer you a way to climb out of debt in a way that benefits everyone.
But there’s no guarantee they’ll do this. They could outright reject your request or be inflexible with their counteroffer.
There’s little you can do if this is the case. You can try another of your creditors if you have several debts to see if any of them will agree.
Avoiding debt in the future
After you’ve decided on a method to reduce your debt – don’t stop. Ridding yourself of debt is just one key part of building strong personal finance. The other part of the puzzle is to manage your spending so you don’t end up in the same position as before.
The last thing you want to do is put all your hard work into clearing the debt, only to succumb to temptation or poor money management which puts you right back where you started.
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