Debt Consolidation

Debt Consolidation
Debt Consolidation is a method for paying down debt. It involves combining many smaller debts into one larger debt — oftentimes by taking out a new loan or opening a new credit card. The new debt usually comes with more favorable terms than the old debts, and can save people money over time. It is most commonly used with consumer debt, but other forms of debt — such as student debt — can be consolidated as well.[1]

How does Debt Consolidation Work?

There are several different ways that debt can be consolidated, but there are a few things that all these methods have in common. All methods for consolidating debt involve combining many smaller debts into one large debt; this simplifies the number of payments a person owes. All methods look to secure more favorable terms on that new debt: this allows people to save money. Lastly, all debt consolidation methods rely on a person continuing to make their payments; consolidation is not a one-stop solution for debt repayment.

What Are Different Methods for Debt Consolidation?

The most common method is to take out a debt consolidation loan, which allows people to pay off their other loans and credit cards. They then continue making payments on the debt consolidation loan until it is paid off. People can also consolidate their debt by taking out a home equity loan, which have substantially lower interest rates but come with increased risks.

Another common method for debt consolidation is transferring credit card balances onto a new card that comes with an introductory offer. While credit cards generally have higher interest rates than personal loans, an introductory offer such as 0% interest for 18 months can make them far more affordable in the short term. This method is best for people who have a plan and the means to pay down their debt quickly.

Finally, there are two methods for consolidating debt that involve working with third-party organizations. Credit Counselors are not-for-profit companies that can help people consolidate their debt through a Debt Management Plan (DMP); they can negotiate with a person’s creditors to secure more favorable terms. Debt Settlement Agencies are for-profit companies that negotiate with a person’s creditors to lower the total amount owed. Both types of companies come with many risks, and not all of them are on the up and up.

How does a Debt Consolidation Loan Work?

With a debt consolidation loan, you use it to pay off your other debts, and then you make monthly payments on the new loan. They are installment loans and they vary in length, but the typical repayment term for loans like these is 3-5 years.[2] They can be found through banks, credit unions and installment loan lenders.

When taking out a debt consolidation loan, the idea is to find a loan with more favorable terms than your current loans. Generally, this means finding a loan that has a lower Annual Percentage Rate (APR). The APR measures how much a loan will cost you over the course of one year. It is expressed as a percentage of the total amount owed. Since the APR includes the interest rate as well as additional fees, it is a better measure of cost than the simple interest rate. The lower the APR, the less a loan will cost.

However, it’s important to look at the repayment term in addition to the APR, because the longer a loan is outstanding, the more fees and interest it will accrue. A loan with a lower APR but a longer repayment term could end up costing you more money over time.

This doesn’t mean that longer terms are without their benefits; a loan with a longer term is going to come with lower monthly payments, which could really help someone who’s struggling to afford their monthly bills. For them, spending more money over time might be worth the temporary relief.

When shopping for a debt consolidation loan, it’s important check the rate that’s being offered. Some loans come with introductory “teaser rates” that only apply for a certain period of time, after which they go up. You should also be sure you understand all the fees that accompany the loan.

Taking out a debt consolidation loan can temporarily hurt your credit score. Some might see the loan as evidence that a person has taken out more debt than they can handle. Plus, closing credit card accounts after they’re been paid off can also negatively impact your credit score by hurting your debt-to-credit-utilization ratio, which measures how much of your available credit you actually use. Keeping those accounts open could help your credit score, just so long as you don’t use them.

How does Consolidating Debt with a Home Equity Loan Work?

This method basically works the same as a standard debt consolidation loan; the only difference is you’re securing the loan with the value of your home. Because of this, Home Equity Loans are also known as “second mortgages.” Unlike other mortgages, they cannot be used to purchase a home; they can only be taken out on a home that a person already owns. They are also available as lines of credit.

Home equity loans are secured loans, meaning that the borrower has put up a valuable piece of property to serve as collateral. If the borrower defaults on the loan, the lender gets to claim the collateral to recoup their losses.

The involvement of collateral means less risk for the lender, so the interest rates for secured loans are much lower than the rates on traditional unsecured personal loans. Interest rates for personal loans are generally between 10-36%,[3] whereas the rates for home equity loans are usually somewhere around 5%.[4] Payments on interest are also tax deductible.

It is these low rates that can make home equity loans a very effective method for consolidating consumer debt. Some people even use them to consolidate student debt.[5] However, these low rates also come with one very big risk: fail to pay off the loan and you forfeit your home. That’s the downside to secured loans.

This method for debt consolidation will only be available to people who own a home or have at least paid down a substantial part of their first mortgage. It is the method that comes with the biggest potential savings, but it also comes with the biggest risks.

How does a Credit Card Balance Transfer Work?

In order to attract new customers, many credit card companies offer deals like 0% interest for a certain period of time or low-to-no-cost balance transfers. During these introductory offers, the cost of borrowing can be effectively zero. This means that consolidating debt onto a credit card with an introductory offer can be very cost effective — at least for a little while.

This method only applies to credit card debt and should only really be employed when the new card comes with an introductory offer. Transferring debt to a card with no offer but with a lower interest rate certainly has its benefits, but you would be better off applying for a debt consolidation loan in cases like that. The interest rates on loans are generally lower than the rates on credit cards.

This method is best when paired with a specific plan to pay off debt. A person who can afford to pay an extra $1,000 a month towards their debt could really take advantage of 0% interest for 18 months. For people who do not have a plan for debt repayment or who are operating on a tight budget, this option might save them a little bit of money, but once that introductory offer expires they’ll be back where they started.

With an introductory offer, it’s important that you make your payments on time. Missing a payment or paying it late could lead to the introductory terms being revoked. Additionally, Many 0% interest balance transfers still come with a balance transfer fee, which is usually a percentage of the amount transferred.[6] This added cost could hurt your ability to save money on the transfer.

How does Consolidation through Credit Counseling Work?

Credit counseling agencies are non-profit organizations that help people in need to better understand and handle their personal finances. Many charge fees for their services, but some offer them for free.[7]

Not all credit counselors are legitimate, so it’s a good idea to do your research before working with one. To find a credit counselor in your area, check out this list of  HUD-approved credit counseling agencies. You can also contact your state Attorney General’s office or your local consumer protection agency.

Credit counselors help people consolidate their debt through a process called a Debt Management Plan (DMP), but they do not offer a DMP to everyone who comes to them. First, they work with people to create a budget and form better financial practices. If that is not enough to take care of their financial issues, then the counselor may recommend a DMP.

With a DMP, the counselor contacts your creditors and negotiates more favorable terms on your debts. This might mean a lower interest rate or it could mean a longer payment term, both of which will reduce how much you pay each month. Counselors do not negotiate a reduction in the balances owed.

Once the DMP has been agreed to by all parties, you make a single monthly payment directly to the credit counseling agency. The credit counselor then uses those funds to pay off your debt. DMPs last until all your debt is paid off, which usually takes several years. While the DMP is in effect, you are not allowed to open any new credit accounts — that means no new loans or credit cards.

If you’re using a DMP, it’s important that you keep paying all your creditors until they have officially agreed to the terms of the plan. Not paying them will likely result in late fees and other penalties. If a credit counselor tells you to stop paying your debts before the DMP is in place, that’s probably a sign that you shouldn’t be working with them.

How does Consolidation through Debt Settlement Work?

Unlike credit counseling agencies, debt settlement companies are for-profit businesses. Whereas credit counseling agencies sometimes offer their services for free, debt settlement companies always charge.

A debt settlement company negotiates with your creditors to reduce the balances owed into something that can be paid off in one lump sum.[8] Under the agreement, you then set aside money every month — sometimes into a separate account — that can eventually be used to pay that debt off.

There are many risks to using a debt settlement company. Debt settlement companies do not have pre-existing agreements with lenders, which means that they might not be able to successfully negotiate a lower balance. This is different from credit counseling agencies, which often have up-front agreements with lenders. This could lead to late fees and penalties, and it could even to lead to your creditors suing you for repayment. Failing to make payments on your debt could also negatively impact your credit score.

Also, many lenders and credit card companies have pre-set settlement amounts, which means that the debt settlement company can’t actually secure you a better deal. You might be better off contacting your creditors and negotiating with them directly.

Before working with a debt settlement company you should contact your state Attorney General’s office or your local consumer protection agency to see if there have been any customer complaints or actions filed against them. And always be wary of debt settlement companies that charge up-front fees, tell you to stop making payments or communicating with your creditors, or make guarantees about what they can deliver.

References:

  1. Jayakumar, Amrita. “Should I Consolidate Debt?” March 14, 2016. NerdWallet.com Accessed May 17, 2016.
  2. Roberts-Grey, Gina. “Strategies for Debt Consolidation Loans.” Investopedia.com Accessed May 18, 2016.
  3. “Calculate Payments on a Personal Loan.” Accessed May 17, 2016. NerdWallet.com Accessed May 17, 2016.
  4. Latham, Saundra. “Best Home Equity Loan Rates for 2016.” TheSimpleDollar.com Accessed May 16, 2016.
  5. Cussen, Mark P. “Using Home Equity Loans For Debt Consolidation.” Investopedia.com Accessed May 16, 2016.
  6. “My card issuer offered me the opportunity to transfer a balance at a zero percent interest rate for 12 months. I did a balance transfer and they charged me a 5 percent fee. Can they do that?” ConsumerFinance.gov Accessed May 17, 2016.
  7. “Choosing a Credit Counselor.”Consumer.FTC.gov Accessed May 17, 2016.
  8. “Coping with Debt.” Consumer.FTC.gov Accessed May 16, 2016.