If you're in a financial hole, debt consolidation can help you climb out -- or it can bury you alive. It takes discipline and smarts to use debt consolidation wisely. Here's what you need to know.
1) What is debt consolidation?
Debt consolidation is a procedure that allows you to replace some or all of your consumer debt (like credit card balances and personal loans) with one loan. The purpose of doing this is to simplify your debts and to potentially help you save money on your debt. To determine if this debt consolidation is a good option for you to save money use LendingTree's debt consolidation calculator.
2) How Does Debt Consolidation Help Me?
People consolidate their debts to pay less interest, lower their payments, or both. Debt consolidation also makes budgeting easier because you have fewer payments to manage, and it can help you become debt-free faster. Here's an example:
Shelley Booth has three credit cards with balances totaling $6,000 and a "blended" interest rate of 14.2%. (The "blended rate" is a weighted average of all of her balances and their interest rates. Ideally, the interest rate of a debt consolidation loan will be lower than this rate.) She qualifies for a debt consolidation loan at 8.00%, and can choose to pay less interest and lower her payments or become debt-free faster.
Shelley's debts will take four years and two months to repay if she makes minimum payments totaling $190.83 each month, and she'll pay $3,542 in interest during that time. But with an 8.0 percent consolidation loan, she can pay her balances off 14 months sooner and save about $2,700, or she can take five years to pay them, lower her monthly expense by $69 and save over $2,200 in interest, or drop her payment by $118 and still save $806 in interest. Debt consolidation creates choices.
3) How does debt consolidation lower my monthly payments?
There are two ways to lower your monthly payments. First, if you extend the repayment period, the monthly expense drops. Many debt consolidation loans have longer terms than the accounts they replace -- for example, you might have 20 years to pay off a home equity loan. Stretching out that repayment lowers your monthly payment, as you can see in this example:
The second way of lowering your monthly expense is to secure a consolidation loan with a lower interest rate. Lower interest rates mean lower payments, assuming that you don't accelerate your payoff schedule.
4) Do I have to be a homeowner to consolidate my debts?
Nope. There are several ways to consolidate debts. You can take advantage of balance transfer offers from credit card companies. Many of them offer low fixed rates for an introductory period; if you use that time to pay down your debt as much as possible, you can save substantial amounts.
Of course, the lowest interest rates usually come with home equity loans because they are secured by a house, which makes them less risky for lenders.
5) Are there any drawbacks to debt consolidation?
Yep. There are potential problems with debt consolidation, and it's only fair to warn you that the majority of people who consolidate their debts run them back up again.
If you aren't very sure that you won't leave your credit cards alone and refrain from running up balances, don't take out a debt consolidation loan -- that's the "burying alive" bit mentioned at the beginning of this article.
Second, if you choose to consolidate debt with a home equity loan, understand that you will be replacing unsecured debt (which can be discharged in a bankruptcy) with a loan secured by your home (which means you can lose your home if you don't make your payments).
Third, understand that debt consolidation can cost you money. You might lower your payment by extending the amount of time it takes to pay off your debts, but you could end up paying more interest -- even if the interest rate is lower, taking longer to repay an account can cause more interest to accrue. That's not necessarily bad, if lowering the payment is more important to you than paying less interest -- but you should be aware of what the tradeoffs are.
6) Is debt consolidation the same as debt management or debt settlement?
Absolutely not. With a debt management plan (DMP), you pay a lump sum each month to a counseling service or debt management company and they divide it up and send payments to your creditors. Part of this service usually involves negotiating lower payments, decreased interest rates, or removal of penalties. This may help you pay less to get rid of your debt.
Debt settlement is another matter. Debt settlement companies may take payments from you as well, but they don't forward them to your creditors. Instead, they keep your payments until they have a lump sum that they try to get your creditors to accept as full payment for your debts. It's a pretty risky and expensive strategy, and you'll also owe taxes on any forgiven debt.