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What is 'Debt Consolidation'

Debt consolidation means taking out a new loan to pay off a number of liabilities and consumer debts, generally unsecured ones. In effect, multiple debts are combined into a single, larger piece of debt, usually with more favorable pay-off terms: a lower interest rate, lower monthly payment or both. Consumers can use debt consolidation as a tool to deal with student loan debt, credit card debt and other types of debt.

Methods of Debt Consolidation

There are several ways consumers can lump debts into a single payment. One is to consolidate all their credit card payments onto one new credit card – which can be a good idea if the card charges little or no interest for a period of time – or utilize an existing credit card's balance transfer feature (especially if it's offering a special promotion on the transaction). Home equity loans or home equity lines of credit are another form of consolidation sought by some people, as the interest on this type of loan is deductible for borrowers taxpayers who itemize their deductions. There are also several consolidation options available from the federal government for those with student loans.

BREAKING DOWN 'Debt Consolidation'

Theoretically, any use of one form of financing to pay off other debts is practicing debt consolidation.  However, there are specific instruments called debt consolidation loans, offered by creditors as part of a plan to borrowers who have difficulty managing the number or size of their outstanding debts. Creditors are willing to do this for several reasons – one of them being that it maximizes the likelihood of collecting from a debtor. These loans are usually offered by financial institutions, such as banks and credit unions; there are also specialized debt-consolidation service companies.

There are two broad types of debt consolidation loans: secured and unsecured. Secured loans are backed by an asset of the borrower’s, such as a house or a car, that works as collateral for the loan. More traditional, unsecured debt consolidation loans, which are not backed by assets, can be more difficult to obtain. They also tend to have higher interest rates and lower qualifying amounts. Even so, the interest rates are still typically less than the rates on credit cards. Also, the interest rate is fixed.

“Typically, the loan has to be paid off in three to five years,” says Harrine Freeman, CEO and owner of H.E. Freeman Enterprises, a credit repair and credit-counseling service in Bethesda, Md., and author of “How to Get Out of Debt.”

These types of loans don’t erase the debt; they simply transfer all your debts to a different lender or type of loan. (In circumstances where you need actual debt relief or don't qualify for loans, it may be best to look into a debt settlement rather than, or in conjunction with, a debt consolidation. Debt settlement aims to reduce your obligations rather than just reducing the number of creditors. Individuals usually work with a debt-relief organization or credit-counseling service. These organizations do not make actual loans; instead, they try to renegotiate the borrower’s current debts with creditors.)

Advantages of Debt Consolidation Loans

Freeman says that debt consolidation loans are most helpful for those who have multiple debts, owe $10,000 or more, are receiving frequent calls or letters from collection agencies, have accounts with high interest rates or monthly payments, are having difficulty making payments or are unable to negotiate lower interest rates on loans. Once in place, a debt consolidation plan will stop the collection agencies from calling (assuming the loans they're calling about have been paid off).

There may be a tax break, too. The Internal Revenue Service (IRS) does not allow you to deduct interest on any unsecured debt consolidation loans. If your consolidation loan is secured with an asset, however, you may qualify for a tax deduction. Debt consolidation loan interest payments are most often tax deductible when home equity is involved.

A consolidation loan may also be kind to your credit score down the road. “If the principal is paid down faster [than it would have been without the loan], the balance is paid off sooner, which helps to boost your credit score,” says Freeman.

How Debt Consolidation Works

For example, say an individual with three credit cards and a total of $20,000 owing at a 22.99% annual rate compounded monthly needs to pay $1047.37 a month for 24 months to bring the balances to zero. This works out to $5136.88 being paid in interest alone. If the same individual were to consolidate those credit cards into a lower-interest loan at an 11% annual rate compounded monthly, he or she would need to pay $932.16 a month for 24 months to bring the balance to zero. This works out to $2,371.84 being paid in interest. The monthly savings is $115.21, and over the life of the loan the amount of savings is $2,765.04.

Even if the monthly payment stays the same, you can still come out ahead by streamlining your loans. Say that you currently have three credit cards that charge a 28% APR; they are maxed out at $5,000 each and you're spending $250 a month on each card's minimum payment. If you were to pay off each credit card separately, you would be spending $750 per month for 28 months and you would end up paying a total of around $5,441.73 in interest. However, if you transfer the balances of those three cards into one consolidated loan at a more reasonable 12% interest rate and you continue to repay the loan with the same $750 a month, you'll pay roughly one-third of the interest ($1,820.22), and you will be able to retire your loan five months earlier. This amounts to a total savings of $7,371.52 ($3,750 for payments and $3,621.52 in interest).

 

Loan Details Credit Cards (3) Consolidation Loan
Interest % 28% 12%
Payments $750 $750
Term 28 months 23 months
Bills Paid/Month 3 1
Principal $15,000 ($5,000 * 3) $15,000
Interest $5,441.73($1,813.91*3) $1,820.22($606.74*3)
Total $20,441.73 $16,820.22

Of course, borrowers must have the income and credit worthiness necessary to allow a new lender to offer them at a lower rate. Although each lender will probably require different documentation depending on your history, the most commonly required pieces of information include a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.

Finding a Debt Consolidation Loan

If you have a good payment history with a bank, credit union or credit card company, asking that institution about a debt consolidation loan should be your first step. “If you can get your bank to approve a loan, that’s great," says Tim Gagnon, assistant academic specialist of accounting at the D'Amore McKim School of Business at Northeastern University. "But your bank may not be looking to keep you as a client and your credit scores may not be high enough to meet their lending requirements.”

If you’re turned down by your bank or credit union, Gagnon suggests exploring private mortgage companies or lenders. “They tend to be less rigid on scores and ratios."

How To Consolidate Debts

Once you get your debt-consolidation vehicle in place, how to decide which bill to tackle first? This may be decided by your lender, who may choose the order in which creditors are repaid.

If not, you should start by paying off your highest-interest debt first. However, if you have a lower-interest loan that is causing you more emotional and mental stress than the higher interest ones (like a personal loan that has stretched family relations), you may want to start with that one instead.

Once you pay off one debt, move the payments to the next set in a waterfall payment process until all of your bills are paid off.

Potential Pitfalls

There are several pitfalls consumers should consider when consolidating debt.

Extending the Loan Term: Your monthly payment and interest rate might be lower, thanks to the new loan. But pay attention to the payment schedule: If it is substantially longer that that of your previous debts, you might be paying more in the long run. Most debt consolidation lenders make their money by stretching out the term of the loan past at least the average, if not the longest term, of the borrower’s previous debt. This allows the lender to make a tidy profit even if it charges a lower interest rate.

Example: John has $19,000 of credit card debt, a $12,000 car loan and $5,500 remaining on a school loan. His total monthly payments come to $1,175. A debt-consolidation lender offers to roll his loans into a single note that charges a lower rate of interest and reduces his monthly payment to $850. He gratefully accepts and saves $325 per month. However, the longest term of John’s previous loans was five years, and the new loan has a term of 90 months (seven and a half years). He will end up paying a total $6,375, whereas with the old debts, the maximum he would've paid would have been $5,875.

That’s why doing your homework is important. Call your credit card issuer(s) to find out how long it would take to pay off the debt on each of your cards at its current interest rate. Then compare that to the length and cost of the consolidation loan you're considering.

Hurting the Credit Score: By rolling over your existing loans into a brand new loan, you are likely to see a modest negative impact on your credit score at first. Credit scores favor longer-standing debts with longer, more consistent payment histories. Replacing debts before the original contract would have called for is viewed negatively. You are also listed as having assumed a larger, newer debt, which increases your risk factor. And, of course, just as with any other type of credit account, a missed payment on a debt consolidation loan goes on your credit report.

In addition, closing out the old credit accounts (once they're paid off) and opening a single new one may reduce the total amount of credit available to you, raising your debt-to-credit utilization ratio. This can also ding your credit score, as lenders may see you with an increased ratio as less financially stable. However, if you consolidate credit card debt and end up improving your credit utilization rate – that is, the amount of potential credit you have that you're actually using – as a result, your score could rise later on.

Example: Sally rolls $16,000 of credit card debt into a new loan. She cuts up her credit cards, but leaves the accounts open. If she has no other debt, she has effectively cut her debt-to credit ratio in half, as she now has $16,000 of unused credit available on her credit card accounts, plus her $16,000 consolidation loan. If she were to close her old accounts, however, she would be using 100% of the credit she has available from her new loan, which would adversely affect her score.
 
Jeopardizing assets: It is significantly easier to obtain a secured consolidation loan than an unsecured one, which means that you may end up consolidating several unsecured debts (like credit card balance)  into a larger secured debt. You may be pledging your property as collateral against much larger amounts than you had previously. For example, using a home equity loan or line of credit put your home at risk if you fail to make the required payments.

Losing special terms or benefits: Student loans have special provisions  (such as interest rate discounts and rebates) that will disappear if you consolidate them with other debts. Those who default on consolidated school loans will usually have their tax refunds garnished and may even have their wages attached, for example.

Paying a lot of money to a debt-consolidation service: These groups often charge hefty initial and monthly fees. And you may not need them. You can consolidate your debt yourself for free with a new personal loan from a bank, or low-interest credit card, for example.

The Bottom Line

Replacing several multiple-rate loans with one, fixed-rate monthly payment certainly simplifies life. Don't consolidate just for convenience, however. Unless you're absolutely overwhelmed by multiple payment dates, the ease of a single monthly payment alone is not a sufficient reason to consolidate debt, given the pitfalls.

And remember: consolidating debt alone does not get you out of debt; improving spending and saving habits does. If you do combine your debts, resist the temptation to run up balances on your credit cards again; otherwise you'll be saddled repaying them and the new, consolidated loan.  Consolidation is a tool to help you get out of the debt-laden doghouse, not to get you a nicer, more expensive doghouse.

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