Debt consolidation is not for wimps. The goal with debt consolidation is to pay off debts with high interest rates and payments with a single loan that has better terms. For example, if your debts look like this:
- Credit Card A: $1,000 balance, 17% interest rate, $50 monthly payment
- Credit Card B: $2,000 balance, 24% rate, $200 payment
- Credit Card C: $4,000 balance, 19% interest rate, $225 payment
You owe $7,000 and pay a blended interest rate (that's a weighted average of your debts) of 20.14 percent and payments of $475 a month. Replacing these accounts with a lower interest loan can reduce your payments and the amount of interest you pay. A three-year personal loan with a ten percent rate, for example, would get you debt-free in three years with monthly payments of just $226 per month.
Newsflash! You Still Owe the Money
Many consumers do not recognize that debt consolidation does not erase debts; it just replaces them with a more affordable pay-out plan. Consequently, any debt consolidation plan that does not include a change in spending and borrowing habits is doomed to fail.
According to Nolo Law, the sudden relief from the stress of overwhelming debt may lure consumers into a false sense of security. With their accounts zeroed out, they repeat their overspending patterns and quickly max out their credit cards, putting them in a worse position. An estimated 75 percent of people completing debt consolidations fail. Debt management plans and consumer credit counseling can help, but ultimately it's your responsibility to create new and better budgeting habits. Willingness and determination are indispensable. According to financial blogger Steve Rhode of the Myvesta Foundation, only 20 percent of people who enroll in debt management plans complete their programs.
Pairing Credit Counseling with Debt Consolidation Loans
There is a range of credit counseling organizations in practically every community. Most charge a nominal enrollment fee. They include college and university cooperative extensions, credit unions, and consumer credit organizations. The U.S. Department of Consumer Affairs recommends that people only work with credit counseling agencies that are accredited by the International Organization for Standardization (ISO) or the Council on Accreditation (COA). It advises that you work with someone who holds a certification from the National Foundation for Credit Counseling (NFCC).
A credit counseling organization may work directly with creditors, arranging lower total costs (including eliminating or lowering interest) to settle an account and structure a payment plan. In addition to creating a comprehensive debt-management plan, the better credit counseling agencies provide classes on money management and budgeting.
Finding the Right Loan
Counseling may also help consumers determine the best debt consolidation strategy, such as home equity loans, balance transfers, cash-out home refinancing plans, or personal loans. Each solution contains elements of risks and benefits.
For example, a home equity loan may come with a low interest rate, but places the secured property in jeopardy if the borrower cannot make payments. It also has a long repayment period (15 years or longer), which can cost you more interest in the long run. (However, you can prepay the loan and eliminate that issue.)
A balance-transfer credit card is tempting by a very low interest rate and up to 18 months free of interest; however if you miss payments, the rate can skyrocket. In the example above, consolidating $7,000 of debt with a zero percent balance transfer card would get you debt-free in a year and a half by paying about $400 per month.
To be fair, with ever-rising costs for homes, utilities, groceries, medical bills, and education, it's not easy to live a debt-free existence. To hold your own or do better, you have to create realistic borrowing and spending plans to stay out of trouble in the years ahead.