Debt consolidation can lower your costs
What is debt consolidation? It's actually a very simple concept: a consumer with multiple smaller debts rolls them all up into a single loan. This new borrowing should come with a lower interest rate than the debts it replaces, and it may be repayable over a longer period. These two factors combined can dramatically reduce a household's monthly outgoings on debt, and it's easy to see why the process is so popular. However, it's important to fully understand its implications, which are explored below, before signing up to consolidate debt.
What Debt Consolidation Isn't
It's important to differentiate between debt consolidation and its distant cousins, debt management and debt settlement. A debt management plan is an arrangement in which the borrower makes one monthly payment to a credit counseling or debt management service, and that payment is distributed among the creditors. The counselor may also negotiate more affordable terms with creditors.
Debt settlement means attempting to get your creditors to accept less than the amounts you owe as payment in full. This is expensive, has tax consequences, ruins your credit and works only rarely. The Consumer Financial Protection Bureau's website carries multiple warnings against the practice.
Secured and Unsecured Borrowing
Debt consolidation loans fall into two distinct categories: secured and unsecured.
Secured borrowing tends to come with much lower interest rates and lower monthly payments. However, it also comes with a major drawback: "secured" means secured by collateral. In other words, failing to keep up payments could result in an asset being seized by the lender -- and that asset is usually the borrower's home. Another potential drawback is that many secured loans have long terms -- up to 30 years in the case of cash-out mortgage refinances. Again, long terms have an upside because they really drop your monthly payments. However, even with today's ultra-low interest rates, the cost of borrowing over many years adds up, and is likely to be more expensive in the end than shorter-term, higher-interest options. (One solution to this problem is to simply make a higher payment – allowing you to get a lower rate but keep your overall costs down.)
Unsecured borrowing carries a much lower and less immediate threat to your home or other assets, and is usually faster and less expensive to set up. Moreover, because it's usually a shorter-term loan, your total cost of borrowing may be lower.
Types of Debt Consolidation Loans
As with all forms of borrowing, the best deals are available to those with the best credit. Indeed, people with low FICO scores could find themselves completely shut out from the mainstream loan market, and may have to turn to debt management or even bankruptcy.
Because few consumers have highly valuable assets besides the real estate they own, secured loans are almost always available only to homeowners who've built up significant equity in their property. Providing they have good credit, they can usually borrow quite a large proportion of that equity.
The principal types of secured loans that may be used for debt consolidation are:
- Cash-out mortgage refinances
- Home equity loans
- Home equity lines of credit
- Reverse mortgages (only available to those age 62 or older)
- Auto refinance (not an auto title loan, which you should avoid because it's extremely expensive)
The main types of unsecured loans are:
- Personal loans also known as signature loans, good faith loans or character loans
- Balance transfer credit cards which may give you 12 to 18 interest-free months in which to pay down as much of your debt as you can
- Check advances or payday loans (these are very expensive short-term loans which should be avoided)
The main thing to remember about debt consolidation is that it merely moves your balances from one type of account to another – you still owe the money! Forgetting this leads about three-fourths of those who attempt to consolidate their debts to fail – instead of using the new loan to pay their debts off faster, they run their newly-zeroed accounts back up and owe more than before. Only those who are good at budgeting and disciplined enough to avoid using too much credit should attempt debt consolidation.
Debt consolidation is supposed to make it cheaper and more convenient to pay off your accounts and become debt-free. The idea is that with a lower interest rate, more of what you pay goes toward reducing the principal balance and getting you out of debt faster.