11/9/2012 5:15 PM ET|
When should you consolidate debt?
Lumping everything you owe into one bill can make it easier to get out from under your debts. But you need to know your options.
Does the phrase "debt consolidation" mean anything to you? For some, it brings to mind images of financial scams and disreputable companies trying to take advantage of unsuspecting consumers.
But is that really the case?
Yes and no. Debt consolidation, at its most basic level, is simply the action of grouping all your bills into one combined debt. Say you have three student loans and decide to use debt consolidation to combine them into one consolidation loan. In that case, the new loan would have a balance equal to the sum of the other loans.
Sounds pretty simple, right? Unfortunately, some companies advertise themselves as "debt consolidation providers" when in reality they actually provide debt management, which is different.
Why do they call themselves something they're not? Because they know people are out there looking for debt consolidation loans. Such companies are banking on people not recognizing the difference between debt consolidation and debt management.
The reality is that debt consolidation is a legitimate tactic for managing your debt -- but only under the right circumstances. Following is what you need to know beforehand if you're considering debt consolidation.
How debt consolidation works
The idea is pretty simple, but there are various ways to approach debt consolidation, and each one has specific advantages and disadvantages. Here are the common types of debt consolidation programs:
- Standard debt consolidation loan: This requires you to get a loan from a bank, credit union or peer-to-peer lender, which agrees to consolidate all your debts (usually credit card balances) into a single new loan. The benefit to you is that the interest rate on the consolidation loan is often lower than what you were paying on the smaller debts.
- Balance transfer offers: Technically, a credit card balance transfer is a type of debt consolidation, because it involves moving all of your credit card debt onto one new card. Often, you will see an introductory 0% interest period of 12 to 18 months on a balance transfer offer, which can help significantly if you are sure of your ability to pay off your balance during that time. If you don't pay off the entire balance before the introductory period expires, you'll trigger interest charges that can often be steep.
- Home equity loan: This option is available only to people who already have a mortgage. With such a loan, you would borrow against the value of your home to pay off your credit cards (or other debts). A home equity loan generally charges less in interest, but it comes with the added risk that if you cannot pay it back, your lender can foreclose on your home.
- Student loan consolidation: A student loan consolidation often differs from a standard consolidation loan in that you may be borrowing from the federal government. Usually, the government offers low interest rates and flexible repayment schedules. But keep in mind that student loan debt is much harder to discharge through bankruptcy than other types of debt are, and the government may be able to garnishee your wages if you default on your federal student loans.
Finding a reputable debt consolidation company
So what should you do if you'd like to pursue a standard debt consolidation loan? First, you'll need to identify a reputable debt consolidation company. Try contacting your local credit unions and banks; ask them what interest rates they can offer you. Then compare those rates to see which ones offer the most attractive deal. You can also research companies such as Lending Club that offer peer-to-peer loans. According to Gerri Detweiler, Credit.com's consumer credit expert, "true debt consolidation loans can be hard to find. The more debt you have, the harder it is to qualify for a new loan. But some lenders, especially social lending firms and credit unions, for example, offer consolidation loans at reasonable rates."
As you do your research, watch out for any company that tries to sell you something other than debt consolidation, is pushy or makes you feel uncomfortable in any way. Don't get hoodwinked by a fast-talking salesman who convinces you that he can make your debt go away quickly or whose promises sound too good to be true.
Debt consolidation and your credit scores
If you're interested in debt consolidation, it's very important to determine how it will impact your credit scores. And in order to tell whether debt consolidation hurts your credit scores, you must first decide which type of consolidation you're going to be seeking. Applying for any type of loan usually requires a hard credit check, which can lower your scores a small amount.
But more importantly, you should be aware of how your credit utilization ratio will be affected. Credit utilization refers to the percentage of your available credit that you're currently using. For example, if the combined credit limit on all your credit cards is $30,000 and you have $15,000 in credit card debt, your credit utilization is 50%. But if you get a debt consolidation loan and close all your credit card accounts, your total debt will still be $15,000, but your credit utilization will now be 100%, which can damage your credit scores.
According to Detweiler, "a debt consolidation loan shouldn't hurt your credit score. You may see a dip temporarily since you have a new account. But if you pay it on time, that should even out. If you close all the credit cards you've consolidated, you may see your scores drop -- though for some that may be safer than running the risk of charging on those cards and getting deeper in debt!"
Ultimately, debt consolidation can be a good option, but it's not something you should rush into. If you use the above to guide you in researching whether debt consolidation is right for you, you'll be prepared to make the right decision.
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I recommend that you check out a new debt consolidation calculator at http://www.bills.com/debt-consolidation-calculator/ that allows you to see the cost of your debt and then provides information and tools to see what steps you can take to reduce them. You can get information about your mortgage, auto loans, student loans, and credit card debt.
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