Debt Consolidation: What It Is, How to Do It, Tips & More
Debt consolidation is a rather simple concept. It entails paying off a number of different debts with a single loan or line of credit. As a result, debt consolidation requires you to have a substantial amount of available credit at your disposal. If getting access to additional credit is not an option, you should explore debt management, which also affords you a more manageable repayment plan but does so using a completely different mechanism.
Debt consolidation obviously does not reduce the amount you owe, but it should result in you paying less interest in the long run, if done right. Another benefit of debt consolidation may be a lower monthly payment achieved through a reduced interest rate, a longer repayment period, or a combination of the two. The process also provides the simplicity of a single payment for all of your debts as well as the reassurance of having a line of sight to debt freedom.
“Debt consolidation can also eliminate difficult decisions about which debts to prioritize,” says Scott Rick, assistant professor of marketing at the University of Michigan. “Our research finds that people often get this decision wrong (from a strictly financial perspective), focusing on paying off small-balance loans, rather than high-interest loans.”
What Debt Consolidation Is NOT
The one constant with any true debt consolidation program is the availability of additional credit –typically the ability to get a new loan or line of credit.
This is an extremely important differential because true debt consolidation may not be feasible if your debt problems have already damaged your credit standing or your debt-to-income ratio is so high that no one wants to approve you for additional credit.
If you fall into one of these categories, you may want to look into debt management. Debt management is often mistaken for debt consolidation because of the similar outcomes they produce, but the former does not require access to credit.
You see, credit counselors and debt management agencies are frequently able to work out affordable payment plans with all of their customer’s lenders at the same time, and they typically act as an intermediary for monthly payments – receiving a lump-sum from the customer and distributing funds to the various lenders according to the terms of the agreement. But given that such an arrangement does not involve a new loan or line of credit being extended to pay off each individual lender and collectively shift the debt obligation to the issuer of the new loan/line of credit, it does not technically constitute debt consolidation.
Types of Debt Consolidation
Debt consolidation is a rather broad term, and the process can take on a number of different forms as a result. It is important to understand and consider all of your options prior to moving forward with any particular plan.
Personal Loan: While certain loans are branded as being specifically for debt consolidation, the truth is that you can use any type of personal loan to pay off other amounts owed and, in doing so, consolidate your debt. You just need to get approved for a big enough loan with a low enough rate and the right repayment period to make the transaction worthwhile.
Home Equity: Homeowners can take out a second mortgage, a home equity loan, or a home equity line of credit (HELOC). This basically entails using the equity you have amassed in your home as collateral for money that can be used to pay off other debts.
Home equity debt consolidation is often cheaper than taking out a personal loan, but it also has the significant downside of getting your home foreclosed if things do not go as planned.
Credit Card Balance Transfer: Unbeknownst to many consumers, you can actually transfer most types of debt to a credit card. In fact, 63% of the major credit card companies accept balance transfers from credit cards, store cards, auto loans, student loans, mortgages, HELOCs, small business loans, AND payday loans, according to WalletHub’s 2013 Credit Card Balance Transfer Study.
Actually, balance transfers are pretty much synonymous with debt consolidation. The issuer of the credit card to which you are transferring a balance will pay off what you owe the original lender, thereby taking ownership of your debt. You will then be responsible for paying the credit card issuer back. Such a transaction can be financially advantageous if you get your hands on a 0% balance transfer credit card and then pay off what you owe before regular interest rates kick in (usually within 6-18 months).
Debt Consolidation Companies
“Debt consolidation company” is an umbrella term that encompasses various types of organizations, from the often-shady debt “repair” companies to non-profit credit counseling organizations, banks, and credit unions. Consumers who choose to pursue debt consolidation should therefore be extremely discerning when it comes to deciding which company, if any, to do business with.
Each type of debt consolidation company obviously performs a different type of service and charges different rates and fees. Some are also more necessary than others.
Debt Repair/Relief Companies: These are the institutions that advertise on TV and radio, making wild promises about debt forgiveness or their ability to bring your payments down to just a few bucks per month. In reality, they’re big on cost and fall short when it comes to helping their customers.
“‘Shady’ is a good word” to describe such companies, says Scott Maurer, a consumer law professor at Santa Clara University. “I am convinced that the vast majority of players in this market take consumers’ money and provide no benefit to them,” Maurer told WalletHub. “In fact, most do far more harm than good.”
Credit Counseling Organizations: Certain non-profit organizations are committed to helping indebted consumers improve their finances. More than anything else, they provide guidance and support, educating people about their options as well as potential pitfalls. Some may even represent you in negotiations with lenders.
Banks & Credit Unions: Banks and credit unions qualify as debt consolidation companies because they offer the loans and balance transfer credit cards that indebted consumers often use to consolidate balances.
Pros & Cons of Debt Consolidation
The main benefit you extract from debt consolidation depends on how you approach the interest rate and repayment period.
Lower Interest Rate: A lower interest rate means more money paying down the principal each month. If you also keep your monthly payment the same, you’ll pay down your debt faster and save money in the process.
Extend Repayment Term: The longer you leave your debt vulnerable to interest, the more expensive it’s going to be. So, in this situation, you’ll probably spend more in the long-run than you would have under the original terms of your agreement, but you’ll save – both in terms of cash and credit standing – relative to what would happen if you default.
Lower Interest Rate & Extend Payment Term: When you extend your repayment term via debt consolidation but also get a lower interest rate, whether or not you’re better off depends on how long and how much. You’ll need to crunch the numbers to make sure you’re actually benefitting.
At the end of the day, it’s not all about dollars and cents. There are various other, far less tangible benefits and drawbacks that accompany debt consolidation as well.
|One Monthly Bill:||Having one bill and one due date to focus on makes it easier to plan and avoid missed payments.||Treats Symptom, Not Problem:||Debt consolidation may enable you to stay afloat for longer, but if you don’t address the underlying causes of your payment problems, you’ll only prolong inevitable delinquency, default, and even bankruptcy.Studies actually show that a lot of people use debt consolidation as an excuse to get into even more debt, not out of it.|
|Line of Sight:||Knowing exactly what you have to do to be free of debt, not to mention when that will be, will likely cut down on your stress significantly.||It’s Mentally Tough to Swallow:||A few small-to-moderate balances probably won’t seem as daunting as one large one.“People may be motivated to pay off small debts,” Professor Rick says. “However, chipping away at one large balance may be less motivating. Dollars that would have been devoted to debt repayment may be allocated elsewhere if the motivation is missing.”|
Debt Consolidation Alternatives
Debt consolidation is far from your only option if you’re struggling to make ends meet. And it’s important to consider ALL of your options carefully before deciding how to proceed because when you’re having debt problems, there is no perfect remedy. Every plan of any substance will have downsides. You just have to focus on minimizing risk, maximizing return, and staying disciplined until the job is done.
- Debt Management: Debt management involves negotiating a payment plan with your creditor in order to get a more manageable monthly payment, stay current on your bill, and eventually right the ship. Lenders won’t always agree to a plan that’s feasible for you, however, so make sure to only agree to things that you can keep your end of the bargain.For more information, check out WalletHub’s Debt Management Overview.
- Debt Settlement: This is the process by which a lender forgives a portion of your debt in return for you making a lump-sum payment for the remaining balance. Debt settlement can save you a lot of money, but lenders typically won’t even consider it unless you have defaulted or are close to defaulting on what you owe.For more information, check out WalletHub’s Debt Settlement Guide.
- Bankruptcy: Bankruptcy is the most serious, costly, and credit-damaging debt solution. Yes, it will provide you with debt relief (certain bills may be discharged), but you’ll also have to hire a lawyer, and a negative mark will remain on your credit reports for 10 years.For more information, check out WalletHub’s Bankruptcy Guide.
Debt Consolidation Tips & Strategies
By now you know how debt consolidation works and the various approaches that one can take toward it. Regardless of which option you choose to pursue, there are a number of steps that you can take to ensure that your efforts are not in vain and your situation will improve.
- Maximize Your Credit Standing: Whether you’re using a personal loan, a balance transfer credit card, or home equity as a consolidation tool, having the best possible credit standing will make the road to recovery a much smoother and less expensive one. Your credit standing signals to lenders how financially trustworthy you are and dictates your likelihood of approval as well as the rates you’ll pay.You can read more about maximizing your credit in WalletHub’s Credit Improvement Guide.
- Use a Debt Calculator: In order to determine if debt consolidation is feasible, let alone beneficial, you must figure out how much your monthly payment will be, how long it will take to pay off, and how much you’ll wind up paying in finance charges. A debt calculator will not only help you with that, it will also tell you whether or not you can save money with a different credit card or loan offer.
- Make a Budget: Debt consolidation will prove meaningless if you don’t adopt sustainable spending habits as well. You can’t solve old problems if new ones are continually cropping up, after all. So, rank-order your expenses (including debt payments) and eradicate anything that would cause your spending to exceed your take-home.
- Stay Disciplined: Once you settle on a plan for getting out of debt, stick to it. Avoid temptation and focus on how much easier things will be once the weight of debt is lifted off your shoulders.One of the biggest temptations will be the various credit card and loan offers that come your way once your situation improves. Lenders, understanding that you now have more disposable income, may start to inundate you with deals. Taking them up on one isn’t necessarily bad, you just have to make sure not to relapse.“It is impossible to divorce ‘overspending’ from the availability of easy borrowing, including the availability of credit cards and home equity lines of credit,” says Steven Fazzari, a professor of economics at Washington University in St. Louis. “If it’s easy to just swipe the plastic or make a transfer from the line of credit, we are more likely to succumb to the temptation to spend more than we are making. In this context, simple rules, like paying off the entire credit card bill each month, can help us avoid the temptation to spend excessively.”
- Build an Emergency Fund: A rainy-day fund makes it infinitely easier to withstand economic turmoil and unexpected expenses. Your goal should be to gradually amass about a year’s worth of take-home in such an account.As long as you’re confident in your ability to make minimum payments on what you owe, starting your emergency fund should actually take precedence over really focusing on getting out of debt. Otherwise, you’re still going to be one major unexpected expense away from winding up back at square one.
- Use the Island Approach: The Island Approach is a method that involves using separate accounts for different types of credit card transactions. By carrying your revolving balances on one credit card and using another card for normal, everyday expenses that you pay in full, you’ll reduce the amount of interest you pay and garner a better understanding of your spending and payment habits. For example, if finance charges ever make their way onto your everyday plastic, then you’ll know you’re spending beyond your means and need to cut back.