If you’re trying to lower your monthly payments or get out of debt, you may be looking at this option; but how does debt consolidation work? Simply, debt consolidation is taking out a loan at a lower interest rate, paying all of your debts, and making one lower payment on the loan every month. There are benefits and drawbacks and your situation will dictate whether debt consolidation is the right choice for you.
Forms of Debt Consolidation
There are a few different ways of how debt consolidation works:
- Debt consolidation companies or debt management programs. These companies negotiate with creditors to lower your rates and payments and lump all your payments together so you pay one amount and then disperse the payments to different creditors. Alternatively, they may offer you a loan to pay back all the debts and then you just pay them one monthly payment. There may be a monthly fee for the former method. Sometimes it helps to be accountable to someone when you’re paying back debt.
- You can get a loan yourself and pay back the debts and then make the monthly payments on the loan. If you are very diligent about making the payments every month, you might try this method of consolidation.
- Transfer everything to a zero interest credit card. These rates are usually introductory, so you have to pay it off before the rate goes up! This method only works if you have a plan to pay it off before the rate hike, otherwise you might end up paying the interest on the debt again.
The Downside of Debt Consolidation
Most financial experts caution against using consolidation to pay off your debts. They list a myriad of reasons; most common being that you’ll see the zero balances and run your credit cards up again. Then you’ll have 2 debts! Also, related to this problem is the fact that you never face the problem of your overspending. If you just treat the symptom of overspending by taking a loan to pay the debt, you don’t use your “blood, sweat, and tears,” therefore you can’t understand the gravity of the situation you got yourself into. If you don’t suffer the pain of paying your debts yourself, you will never be cured of the disease of overspending. Of course, some debts are the result of emergencies, and overspending cannot be blamed.
Another reason is because although the interest rate is lower and the payments are lower, the term of repayment may be longer. You might end up paying more money in the long-run—sometimes thousands.
The Benefit of Consolidating Debt
The most common argument for debt consolidation is simple. It costs more to finance money over a longer period of time; the lower monthly payments give people some breathing room. If you’re in a bind and you can’t keep up with your bills, it may be worth it to pay a little more over time.
Make Sure You Have a Clear Understanding of How Debt Consolidation Works
Debt consolidation fails about ¾ of the time, which means it succeeds ¼ of the time. These aren’t very encouraging statistics, but if you understand exactly what you’re getting into, you might succeed.
First and foremost, do not use your old credit cards, just because the balances are zero does not mean the debt is gone. You just owe the money to someone else. DO NOT USE YOUR OLD CREDIT CARDS!
Second, always make the consolidation payment on time. Failing to meet your obligation may undo the terms of the consolidation and you may end up back where you started or worse! Check with the exact terms of your agreement to find out the default penalties.
If you choose to go with a debt consolidation or debt management program, research them thoroughly. If a friend or family member used a particular company ask them about their experience.
Just remember, debt consolidation has a big downside and if you don’t take it seriously, the odds of success are not in your favor. If you need to use this option because you have no other choice, then approaching it knowing the possible pitfalls and the negatives gives you a good chance of success. Make sure you have no problem understanding debt consolidation.