When Should You Consolidate Debt

With the recent economic recession, it seems that everyone’s eyes have suddenly turned to their financial matters. When you consider the debt profile of the average U.S. household, it’s not hard to see why. Our average household credit card debt is over $15 thousand dollars, the average student loan debt is over $33 thousand and the average mortgage debt is nearly $155 thousand dollars. With many people joining the ranks of the unemployed or under-employed, debt consolidation can seem like a good idea. However, there are many different ways to consolidate debt and some of them may leave the consumer in a worse financial position than when they started.

Who Should Consolidate

There are several situations that might make debt consolidation a good option. The first is people who are carrying many high-interest lines of credit. This could include credit cards, pay day loans, title loans or furniture loans. The second group is people who are having difficulty making their minimum monthly payments on time every month. There is also a group of people who want to pay off their debt in a short period of time – typically less than five years. Finally, there are homeowners who also have several sources of unsecured debt such as personal loans or student loans.

Ways to Consolidate Debt

First we should distinguish between debt consolidation and debt management. Debt management refers to the process of keeping the original lines of credit intact, but negotiating the terms in order to lower payments. The terms that are negotiated could be lowering the interest rate or lengthening the repayment time. While debt management can be done by an individual, there are also companies that charge for the service. In exchange for their fee, these companies usually collect a monthly payment from you, negotiate with your debtors and distribute payments to them on your behalf.

Debt consolidation is the term used when several smaller debts are paid off using another – larger – debt. The original debts no longer exist. There are many different ways to do this, each with their own pros and cons.

  • Debt consolidation loan – These are usually issued from a bank or credit union with whom you have other accounts. The lender issues a new loan, presumably with a lower interest rate than the existing debt. The loan is used to discharge the other debts – usually credit cards, either by the lender or the borrower. This can be an advantage to those who want to pay off their original debts without damaging their credit rating – as can be the case with filing bankruptcy. However, if you are not disciplined and continue to use the credit cards that were paid off, the result can be accruing the original amount of debt plus the cost of the debt consolidation loan.
  • Balance transfers – Another way to consolidate debt is by transferring many smaller credit card balances to one new card. This is useful when a credit card offers an introductory interest rate that is very low or even zero. Typically people take advantage of this if they are confident that they can pay off the debts before the end of the introductory period – usually 12 to 18 months. However, if you can’t pay it back in time, the resulting interest charges can be worse than they originally were. Also, if you continue to use the original cards, you could essentially double your debt in a very short period of time.
  • Second Mortgages – An option for homeowner that uses their home as collateral for the loan. You take a lump sum of money and then pay it back in monthly installments just as you would for a first mortgage. Some people choose to simply refinance their home for an amount higher than what they currently owe. Then they take the extra in cash in order to avoid having two payments. However there can be steep fees for doing that, so you’ll want to weigh that option carefully.
  • Home equity loans – Home equity loans are slightly different. Essentially, this is a revolving line of credit that is equivalent to the amount of equity you have in your home. You may choose to use the entire loan amount at once or space it out based on your specific needs. You then make a monthly payment just as you would for a personal loan, although the interest rate is usually less because this debt is secured with the equity in your home. This can be a good option for people who want to conduct their own negotiations with other lenders and make payments as those negotiations are completed. You then only pay interest on the amount that is borrowed.

Debt Consolidation Services

There are numerous debt consolidation companies that can assist you with putting a plan together for your specific debt situation, as well as help you choose the right option for your consolidation.  A few of the larger companies that handle most types of debt consolidation are Lending Tree,  Lending Club and Prosper Debt Consolidation.

There are many factors when considering consolidating and paying off your debt. You could choose to work directly with your financial institution and other lenders to negotiate terms and payments. Alternatively, you could hire a company to do the negotiating and make the payments. That is certainly easier, but can also carry hefty fees. There are also many disreputable companies that do very little on the behalf of the consumer. The service you require and the type of debt consolidation that you choose will be based on your unique circumstances.