What is Debt Consolidation and How Does it Work

Debt Consolidation

Debt consolidation is an approach used by credit-card users who have run up their debts to an unmanageable amount. In fact, you probably would not hear about this method for overcoming debt if it wasn’t for credit cards and their misuse. While credit cards are ideal for anyone who needs to make purchases for daily necessities, people get into trouble with spending when the cards are used more freely.

Whether you are just about ready to file bankruptcy or wishing to better manage your budget, you cannot help but notice the claims that are touted for consolidating debt. In order to determine if this kind of budgeting tool is right for you, you need to better understand the various debt consolidation options and the benefits and drawbacks of each.

What is Debt Consolidation

In basic terms, debt consolidation is a method where you use a single loan or method of repayment to pay off your credit card debts or smaller loans with one monthly payment. Therefore, you only need to pay one amount monthly instead of several payments at a time. Consolidation is therefore designed to make paying bills an easier process. The objective of this approach is to reduce the interest on what you owe on your outstanding loans and pay off your debt much more easily and quickly.

Why People Use Debt Consolidation

Usually, consumers resort to debt consolidation, whether it is through an unsecured or secured loan, or through a credit counseling or debt management program, to reduce their debt into one manageable monthly payment. When they use this approach, they get rid of the feeling of drowning in debt and begin swimming above water again.

Don’t confuse debt consolidation with debt settlement practices. When you use debt consolidation through a means of financing, your debt is realized without negative consequences to your credit score. Consolidating your debt, usually your credit card debt, can be done through a secured loan or unsecured financing.

Debt Consolidation through Secured and Unsecured Funding Options

When you apply for a secured loan, such as a car loan or mortgage, you make a pledge that certain assets, such as your car or home, can be used to secure the loan’s repayment should you default. For instance, when you obtain a mortgage loan, your home serves as the collateral or security for repayment. If you fall behind on the financing, the holder of the mortgage can foreclose on your property to satisfy the terms of the loan agreement.

Unsecured loans, on the other hand, are based only on a promise to pay off a debt and are not attached to any kind of property or collateral that can be repossessed or foreclosed to pay off the loan. Credit cards are good example of unsecured loans. These loans for people with bad credit come with a higher interest rate as they carry more of a lending risk.

Consolidating Debts with Secured Sources of Funding

In order to consolidate debt with a secured loan, you can choose from a variety of options. For example, you can refinance your home, obtain a home equity line of credit or take out a second mortgage for consolidation purposes. You can also take out a car title loan using your auto as the collateral.

A 401K loan, too, can be used to consolidate credit card debt. The retirement fund is used as the collateral. In some cases, people will take out a loan against the cash value of their life insurance policy. In addition, some financing companies will loan out money against lottery winnings, lawsuit claims or annuities.

How Debt Consolidation Can Hurt You

If you consolidate your debts by taking out a secured loan, the interest on the loan will generally be lower. This is because the loan is taken out with the promise that a piece of collateral, such as a home or car, will be used for repayment if the loan cannot be repaid. Therefore, if you cannot pay off the loan, as promised, you could lose your car, home, retirement savings, life insurance or other security.

The term of a secured loan can also be longer than the terms of your debt obligations. As a result, the total interest paid for a consolidation loan could actually be greater than the interest paid on the individual debts. Even if the monthly payment on the consolidation is lower, the length of time that the loan is taken out could elevate the total amount paid.

While debt consolidation using an unsecured loan used to occur quite often, the financing is not as easy to obtain today. Typically, an unsecured loan amount requires that the borrower possess a good credit score. Usually, transferring high-interest amounts to a low interest introductory rate on a credit card can reduce the interest you pay on your other cards and therefore lower your payment amount. This is an example of an unsecured loan that is commonly used for consolidating debt.

The biggest advantage of unsecured debt consolidation financing is that no collateral or property is at risk to be taken. While the interest rate is usually higher than it is for a secured loan, it can be less if several high-interest balances are transferred to a card with a lower interest rate. As a result, your risk is reduced and your interest is also lowered along with your payment.

The Drawbacks of Taking Out an Unsecured Loan for Reducing Debt

However, an unsecured debt consolidation can be hard to manage if you don’t have a sterling credit score. Needless to say, if you need to consolidate your debt in the first place, you probably don’t have great credit anyway. If the payment is financed through a financial institution, then the interest that is charged probably would not justify your reason for getting an unsecured loan in the first place.

Plus, making use of balance transfer on low-interest or no-interest credit cards can be complicated. Usually, there is a transfer fee that will negate some of the savings. There are also other rules that may reduce the benefits. If you use the credit card for a purchase, the resulting charges may generate interest while the transferred amounts are applied to the no-interest rate.

Also, a low-interest or no-interest offer is usually limited. If you cannot pay off the debt consolidation in the designated time, you could end up paying a higher interest rate once the time period is over.

Given this information, you may not want to apply for a secured loan or an unsecured loan to consolidate your debt. You may find that you will fall into a debt situation that is just as unmanageable or is worse, especially if you stand to lose your car or house or have to pay even a greater interest rate.

How Debt Consolidation Can Help You

If you feel squeamish about using the above methods, then you can always opt to join a debt consolidation program. This type of program will not obligate you to another loan term and can, in the long run, help you pay offer your creditors and debt as well as lower your overall interest rate.

When you have fallen into debt with several creditors, there are just too many accounts to keep track of the stack of bills on your desk at the end of a month. You also can get tired or receiving the steady calls to your home from creditors who wish to be paid. In circumstances like these, using a debt consolidation program that eliminates borrowing can be a solution that you can meet.

How the Debt Consolidation Process Works

A debt management agency, unlike a loan, will reduce the interest you are paying by negotiating with your creditors. If you choose to take out a loan, your creditors may be paid off but the new loan remains open nonetheless. When this happens, you may run up new debt on your cards on top of the consolidated loan amount. Many times, a consolidated loan—secured or unsecured—merely shifts the debt but really does not address the underlying debt problem.

Therefore, a debt management agency can offer a way to consolidate your credit card bills or unsecured personal debts without the need to borrow more money. An arrangement is worked out between the agency and the creditor where one consolidated payment is made by the consumer to the agency monthly.

Not only is the method more manageable, it offers other advantages too. Frequently, creditors who participate in a debt consolidation program will reduce your rate of interest and waive any outstanding fees, such as over-the-limit charges or late fees. Also, all or the majority of the credit accounts are closed to further spending. Therefore, you can make good progress in reducing and eliminating your debt. This type of program also includes financial counseling, directed toward enhancing your credit management ability so future debts can be prevented.

How a Debt Consolidation Can Affect Your Credit Score

However, when you follow a debt management plan and consolidate your debts through an agency, you need to be aware that it can affect your credit score – in this case, it can have a negative impact. That is because the accounts that are accepted into the agency’s debt management program are closed. These previously active trade lines will be updated on the credit report to show each account has been closed – all which negatively affects your rating.

Also, while you are enrolled in a debt consolidation program that includes credit counseling, it is typically difficult to obtain a loan or financing for the first one to two years. That is because most of your creditors will inform the reporting bureaus that your account has been included in a structured repayment plan. If you have had several credit bills outstanding, this information will appear several times on your report.

The overall enrolment time for a debt management program with a credit counseling agency is about 5 years. This can result in being locked out of the use of new credit cards during this time. However, you can, in some instances, obtain a loan on a home or car or qualify for a student loan after about 18 months of making your payment on-time under a debt management plan. If you complete the program, and any other payments are kept up-to-date (such as a car loan or mortgage), you should find that your credit score, by that time, is in good shape.

While you will eliminate most of your unsecured debt after you complete a credit counseling and debt management program, you will remove any unsecured credit history too, thereby showing that you have no recent credit history under this category. Because your recent or most current activity is one of the most essential parts of a credit report, you will need to rebuild your credit by making timely payments on any new unsecured credit you obtain.

How to Avoid Scams When Seeking to Consolidate Debt

With that being said, you still need to be careful, too, about not getting involved with a scam when seeking debt consolidations help. Unfortunately, some people who tout debt consolidation or debt settlement services are not in the business of helping anyone but themselves.

While getting out of debt sounds great, many people are not aware of some of the pitfalls that may arise from utilizing some so-called debt management service plans. Debt settlement, debt consolidation or debt counseling may also sound very much alike, but, in essence, they can present very different results.

How Debt Settlement Differs from Debt Consolidation

Debt settlement entails negotiating down the amount of debt a person owes while debt consolidation involves combining several liabilities or loan payments into one financed monthly amount to reduce a consumer’s debts. Debt counseling, as it sounds, is given to individuals for a charge that normally results in creating a debt management plan to help repay several debts.

Among the three aforementioned methods, companies that advertise debt settlement programs can pose the biggest risk to one’s finances. The Federal Trade Commission or FTC alerts people that fraudulent methods in the debt settlement field continue to grow. These companies operate by encouraging the debtor to sign a contract agreeing to send the business a payment each month – usually for five years. During that period, the person is directed to stop paying his creditors. Some of the companies send out “cease and desist” letters to creditors, informing them to stop contacting families about their obligations.

In turn, the settlement company collects fees for the service upfront, with most of the charges costing thousands of dollars. One of the fees that is imposed sets up an account with a negotiator for the debt. Other charges include a monthly servicing fee and one final fee for the settlement.

Once these charges are assessed and paid, the debtor’s monthly payments are accumulated in a single account to pay each of the consumer’s creditors a future settlement amount. Most of the debt settlement companies will not proceed with negotiations until a certain amount of money has been collected and received.

This type of arrangement can damage a person’s credit because the settlement agreement necessitates that the consumer halt any payments on a bill, thereby resulting in missed and late payments – information that is reported as negative info to the credit reporting agencies.

Establishing a so-called debt settlement plan can also prevent any protection from lawsuits brought about by creditors. Creditors often sue a consumer once they have been contacted by a debt settlement company. Wages can even be garnished when the debt settlement company is fronting a scam.

How a Settlement Can Impact the Tax You Owe

When consumers stop paying their creditors through a settlement program, the interest and fees of the credit accounts also continue to mount, thereby causing the original owed amount to double, sometimes, triple over time. Also, the IRS requires that consumers report any forgiven amount of money over $500 be reported as taxable income. Therefore, using a debt settlement service can affect your tax status too.

Don’t Give a Service Your Money Upfront

Debt settlement companies that scam customers usually make false claims about how they can help someone reduce a consumer’s debt. Be wary of anyone who wants to charge you upfront for a debt settlement program as many scam businesses will take the consumer’s money without performing any of the promised services.

Make a Call to the BBB

A debt consolidation agency or program that features credit counseling is usually a better alternative to consolidating and reducing debt. Before entering into any kind of financial assistance program though, check out the company’s credentials. Inquire about the company through the Better Business Bureau or contact the Attorney General’s Office in the state where the debt settlement or debt consolidation company is based.

One Final Note

The above information gives you full details about how consolidation works when paying off debts through secured and unsecured lending sources and via debt consolidation agencies. If you find a debt consolidation program that is supported by debt counseling services, this approach is often the best way of eliminating credit card debt once and for all. To pay a number of loans back with another loan can cause you to sink deeper into debt. Give yourself a chance by directing your focus on getting rid of your debt and making your payments on a consistent and timely basis.