Is Debt Consolidation A Good Idea?

If you have lots of debt, consolidation may save you time and money. Depending on your financial situation, there may be a solution that's right for you.

When you're struggling with lots of debt, debt consolidation may be an attractive solution. This term refers to combining your debts into one, and making one monthly payment to one creditor instead of making multiple payments to many creditors. You might even get out of debt faster and save money along the way. Debt consolidation comes in several forms, including credit counseling, balance transfers, and debt consolidation loans, so review your options carefully before making a decision.

Credit Counseling
When you're experiencing financial distress, these companies, also referred to as debt management companies, work with your creditors to restructure your unsecured debt. Through a debt relief plan, you make one monthly payment to them, and they pay your creditors. Companies that offer credit counseling do not loan you money. Instead, they negotiate with your current creditors to get you debt relief. Debt relief plans offer many benefits that may help you get a handle on your unsecured debts, such as:

• Lowered monthly payments
• Reduced or eliminated interest rates
• Eliminated late fees
• Accounts brought current (re-aging your account)

Balance Transfers
Transferring debt from a higher interest rate credit card to one with a lower rate can save you money. If you have a credit card with a low interest rate, you might consider transferring the balance from a high-rate credit card to the lower rate one. Or, you might apply for a new credit card with a lower interest rate. Be careful about introductory rates, also called teaser rates. Make sure you know what rate will be in effect after the first couple of months. If it's too high, this option may not be your best choice.

More About Teaser Interest Rates
Read the small print about credit card teaser rates. Teaser rates are often used to entice you to transfer a balance. Be sure to consider the following before you fill out the application:

• Introductory rates typically last a short period of time
  • While some may last up to a year, it's not uncommon for the low introductory rate to expire after three or six months. After the introductory period is over, the interest rate will increase, sometimes to a very high rate.
• The credit limit may not be high enough
  • Companies that offer balance transfers may not give you enough credit to transfer all of your debt. You'll be paying part of your debt at the original higher interest rate and part of it at the lower introductory rate.
• There may be a balance transfer fee
  • Be sure to find out if there is a balance transfer fee and how much it is.

Debt Consolidation Loan
You can apply for a debt consolidation loan at most financial institutions, like banks, credit unions, and finance companies. There are two types of loans:

• Unsecured - no collateral is required
• Secured - collateral is required

Unsecured loans are commonly referred to as personal or signature loans. Examples of a secured loan include a home equity loan or a second mortgage since your home is used as collateral.

Is a Debt Consolidation Loan for You?
When you consolidate your existing debt and pay it off with a debt consolidation loan, you are trading several debts for a single debt. Even though you still have the same amount of debt, you may find this beneficial if you:

• Get a loan with a lower interest rate than the rate(s) you are paying on your existing debts
  • This could save you money during the life of the loan depending on the term and amount of monthly payment. Don't forget to do your homework when investigating interest rates and monthly payments. A small difference can impact you greatly. For example:

                                                    Credit Card               Loan
Balance                                          $5,000.00              $5,000.00
Minimum Monthly Payment              $100.00                $140.00
Annual Percentage Rate (APR)         18%                     15%

Payoff Timeframe                   39 Years and 4 Months    4 Years

Total Amount Paid                         $18,396.67            $6,664.59

Total Interest Paid                         $13,393.67           $11,664.59

In this example, switching from a revolving credit card debt with 18% interest to an installment loan with 15% interest, and only increasing your monthly payment by $40, saves you over $12,000 in interest payments.

• Close your credit card accounts
  • Paying off multiple credit cards with a debt consolidation loan may be a good idea, but be careful about racking up more debt on the open accounts. Think about keeping one account open for an emergency and closing the others. Not only will that ensure you're not tempted to charge additional items, it'll also look good to future lenders who review your credit report.

Be Careful with Finance Companies
If you're having difficulty getting a loan from a bank or a credit union because you have too much debt or a negative credit history, you may be able to get a loan from a finance company. Be careful if you decide to use finance companies. While finance companies typically make it easier for you to get a loan, there are things you should know, including:

• Interest rates are often high
  • Higher interest rates typically mean a higher amount paid over the course of the loan.
• Loan term may be lengthy
  • The longer length of the loan results in lower monthly payments, but it causes you to pay more interest.
• Other fees may be present
  • It's not uncommon for finance companies to charge application or processing fees.
• Future creditors may not look favorably on your credit profile
  • Even if your credit rating is good, potential creditors may perceive you as a bad risk if they see a finance company among your listed creditors. Since most people use finance companies if they don't qualify for a loan from a bank or a credit union, creditors may think you've had financial problems in the past.

If you're thinking about consolidating your debt, consider the pros and cons for your situation. Remember to shop carefully and compare costs. The U.S. Federal Trade Commission has several articles for consumers in debt, including Knee Deep in Debt and For People on Debt Management Plans: A Must-Do List.

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