Consolidating Debt

If you start falling seriously behind on your bills, simple prioritization and negotiation may not be enough to help you catch up on your debt.  Even in this situation, you still have some options available to keep your finances under control.  One of the most straight-forward options is debt consolidation.

When to Consider Debt Consolidation

Most adults have at least half a dozen creditors, such as credit card companies, banks for a mortgage, car loan providers, student loan providers, and basic utility companies. If a unexpected event occurs, such as losing your job, you may start falling behind on payments for several creditors all at once.

Prioritizing your bills and negotiating with your creditors can get most people through tight money situations for a month or two, but it can only work for short periods of time.  After a couple of months, even the savviest negotiators will find themselves getting stuck with mounting late fees, finance charges, and angry calls from creditors. Each late payment also affects your credit score, which will hurt your chances for getting other lines of credit in the future.

What It Means to Consolidate Debt

This is where debt consolidation comes in. Consolidating your debt means taking out one big loan and using that money to pay off all outstanding balances from your previous loans.

While taking out a new loan may not seem like such a good solution, there are several reasons to consider a debt consolidation loan when you find yourself in hot water.

Preserves Your Credit Rating

Every time you make a late payment on your credit card or on another loan, your credit rating will take a hit. Miss enough payments and you will have a very hard time securing any loans, even years later.

On the other hand, if you consolidate your debt and pay off your consolidation loan quickly, your credit rating can actually improve. Paying off all the outstanding balances means no more negative reports on your credit history. Debt consolidation acts like any other loan.  Making payments on-time will boost your credit rating.

Keeps all your creditors happy

Remember: the most important concern for any of your creditors is that they get paid, and the sooner the better. Consolidating your debts quickly and getting all outstanding balances paid off builds goodwill with your creditors. This means they will usually be more flexible in the future if you hit another rough patch because they know you will come through.

Lowers Your Payments

Once all your outstanding balances are paid off, finance charges and late fees are gone too. This means the amount due each month is just a single payment towards the principal and interest, the same as for any other loan. The interest rate on consolidated loans is almost always lower than the late fees and finance charges you will get from each of the individual outstanding balances.

What this means for you is that a consolidated loan will keep your credit healthy and growing, and it will lower the number of monthly payments required to pay off the same principal in debt.

How to Consolidate Debt

Consolidating debt means taking out a loan to pay off other outstanding balances. Like all loans, there are two main types to consider:

Unsecured Loans

Getting an unsecured debt consolidation loan is very rare. Most creditors are very wary of people who need debt consolidation loans because it means they have already let their debts get out of control.

One unsecured loan type to consider is simply using your credit card to pay off all other balances.  This will require you having a sufficient credit limit on your card. If you already pay most of your bills using your credit card, you are consolidating your debts without even realizing it. Many people prefer this simply to keep all their payments in one place, making them easier to track.

The biggest downside of using credit cards or other unsecured loans to consolidate your debt is the finance charges. Unsecured loans almost always charge higher interest rates. This means you might not be saving much money by consolidating everything on your credit card rather than just making minimum payments.

You also cannot use your credit card to pay off other credit card debt. If credit card debt is one of your problems to begin with, you probably will not be looking at unsecured loans for consolidation.

Secured Loans

Most types of debt consolidation loans involve a secured loan, usually a home equity loan, also called second mortgage. This means you will use the equity built up from your home to take out a new loan. The amount of debt you can consolidate is dictated by how much equity you have to use as collateral. If your debts are greater than the equity you have built up in your home, you are considered insolvent.

If you are a renter, you won’t have a home equity loan as an option.  However, there are some types of secured loans that use your car or other property as collateral. Unfortunately, these usually fall under “Payday Loan” or “Pawn Shop” type lenders, which can charge excessively high finance charges. Taking these types of loans is more likely to drive you farther into debt than to help pull you out. If you are not able to find any other type of consolidation loans, you should investigate credit counseling services.

Risks of Consolidating Debt

Debt consolidation is not a “get out of debt free” card. You are simply using existing credit lines and equity to pay off a temporary hardship and preserve your credit rating.

Risks with Unsecured Loans

If you simply transfer other outstanding debts onto your credit card, you now must grapple with your new credit card debt. Credit cards typically charge fairly high interest rates compared to secured loans, which means the interest you pay will still be very high.  The interest charge itself could be nearly as much as you would be paying in late fees, but you would not be hurting your credit rating.

If you can only afford the minimum payments on your credit card, you are stretched dangerously thin.  Any other financial emergency could force you into default.

Risks with Secured Loans

Consolidating your debt with a secured loan is cheaper than using your credit card or an unsecured loan. This makes this type of loan a more attractive option, but it comes with its own serious drawbacks.

First, you are wiping out your equity. This means all the value you have been building up in your mortgage (or any other property used as collateral) is gone.  You will need to completely pay off the consolidation loan to get it back.

Second, your finances are still stretched very thin. Missing your payment on a consolidated secured loan is the same as missing a payment on your primary mortgage.  It could put your whole house into default and trigger foreclosure proceedings.

Taking Action

If you are in a position where you cannot juggle your bills or negotiate a 1-2 month extension with some creditors, you need to take action quickly in order to get out of debt and keep your finances healthy.

Consolidating your debt is often one important part of that process, but it is not a decision to make without consulting experts.  If you are considering consolidating your debt, speak first with a not-for-profit credit counseling agency to fully explore your options. Debt consolidation is usually one action taken as part of a larger personal finance plan, not an action to be taken on its own.

Any time you are working with debt, the clock is ticking. It is always better to ask for help sooner rather than just panicking later.

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Challenge Questions

  1. Using examples, what does it mean to consolidate debt?
  2. What are the advantages of consolidating debt?
  3. Are there any disadvantages to consolidating debt?
  4. What is the difference between a secured and unsecured loan?
  5. What are the current loan rate percentages being offered in the market place today for a loan of $10,000 over 3 years?

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