When tasked with paying off large amounts of unsecured debt, specifically credit cards, many people turn to debt consolidation. While this can be a great way to save money and speed up your debt payoff, there are several important things you should know before you do so. From what it helps you accomplish, to the different types of debt consolidation options, to the fees, here are five things you should know about consolidating your debt.
The term “debt consolidation” gets thrown around very loosely, and most people are not sure exactly what it means or entails. If you consolidate your debt, it does NOT mean you are out of the woods with regard to your debt. Your debt doesn’t magically disappear. All it means is that you convert several different loans into one single loan with one monthly payment. For example, let’s say a person has five different credit cards they are paying on each month. With a debt consolidation loan, you would pay off those five credit cards, and then pay on the one loan you just obtained. Most debt consolidation plans take 2-5 years to complete. It is only after you make all of your payments in the given term when you can officially consider yourself “debt-free”. When paying off your credit cards using a debt consolidation loan, it is imperative to refrain from using those same credit cards while you are paying back the loan. Some people will pay their cards off and proceed to charge them back up again. Then, not only do they have a substantial loan to pay off, but they also have newly charged credit cards to pay as well. This can cause a serious financial hardship, so be responsible, pay your cards off, and don’t use them again.
Most people look to consolidate their debt because their monthly payments have become somewhat of a stretch. A rule of thumb is that on average, your credit card minimum payments will equal 2-3% of your total debt. So, on $20k in credit card balances, you can expect to pay $500 per month in just minimum payments. With the average credit card interest rate being about 19%, it can be prudent to pay your credit cards off and pay a new loan with a significantly lower interest rate. Paying the minimums will get you nowhere when it comes to getting out of debt. Debt consolidation can help lower the minimums, lower your interest rate, and have you debt-free in five years or less. If you have good credit and have the opportunity to lower your interest rate from 19% to 7%, this is a wise decision. Not only will you save a few hundred dollars on a monthly basis, but more importantly, it gives you a concrete finish line as to when you know you will be debt-free. By law, credit card companies now have to indicate on your credit card statement how long it will take you to pay off your balance if you pay the minimum. If you happen to have a large balance and have ever looked at this section of your credit card statement, you know that it can be terrifying. If you pay just the minimum, it will take you well over 10 years to clear the balance, sometimes closer to 20. In addition, you will end up paying double, sometimes triple the principal balance. This is why debt consolidation can be a life-saver, not only do you save money, but you can be debt-free in four years as opposed to twenty years.
When it comes to consolidating your debt, If you don’t have an excellent credit score, it can hinder your ability to lock yourself in at a favorable interest rate. In addition to a debt consolidation loan, there are options such as credit counseling and debt settlement that can help you accomplish some of the same goals. With credit counseling, you are put on a debt management plan with the credit cards you wish to pay off. The agency will charge a relatively low monthly fee, and the goal is to have the debt paid off in around four years. While it will indicate on your credit report that you are enrolled in a debt management plan through a credit counseling agency, there are no long term negative impacts to your credit score. On the other hand, with debt settlement, you enter into an agreement with a company who will attempt to negotiate the balances on your debt so you can pay back a fraction of what you owe. During the program, you halt payments to your creditors, and they are forced to mark the accounts as past due. After roughly six months, the company you are working with negotiates settlements on your behalf so you can be debt-free in 36-48 months. Debt settlement is more geared toward people who simply cannot continue making their payments or else they may need to file bankruptcy. This option will have a negative impact on your credit score, so be sure to know the pros and cons before you proceed.
No company is going to lend you money or work on your behalf for free, so it’s good to know the fees involved with consolidating your debt. For a debt consolidation loan, in addition to the interest rate, you will also pay a loan origination fee, which could be anywhere from 3-5% of the loan amount. With a debt management plan offered by a credit counseling agency, you can expect to pay a $50 initial setup fee along with a $20-$50 ongoing monthly fee. With debt settlement, the fee is typically 15-25% of the original debt amount, or the amount of the settlements. If a company does NOT charge a fee or offers some type of money back guarantee, you should be wary of doing business with them. After all, every company on Earth is in the business of making money. While you may balk at the thought of paying any of these fees, just know that it is much better to pay a small fee to consolidate your debt than to continue to make minimum payments and pay 19% interest on your current credit cards. Whether you consolidate your credit card debt through a loan, credit counseling, or debt settlement, just be sure you’re aware of the fees you will be paying. The last thing you want to do is get blindsided by fees that you didn’t know about.
In the end, maintaining a debt-free life comes down to living within your means. Many people obtain a debt consolidation loan, and then manage to rack up their credit card balances yet again. This is a recipe for disaster, as you now have a loan as well as credit cards that you must pay. If you do consolidate your debt, toss away your credit cards. Put them in a shoebox under your bed, or cut them up. The only way to remain debt-free is to refrain from using the cards that got you into this situation in the first place. If you haven’t already, you should begin to keep a monthly spreadsheet of your income and expenses. This is a simple, easy way to know if you are overextending yourself. If your monthly expenses exceed your monthly income, you know that you need to change your lifestyle so you are in the green each month. There are only two ways to increase your monthly cash flow, increasing your income, or decreasing your expenses. If you can manage to do both at the same time, you will be that much better off. In today’s gig economy, there are a plethora of ways to gain additional income through side gigs and part-time jobs. Decreasing your income is probably easier and more practical, as you can cut out many things you don’t necessarily need from your budget, such as cable, your morning cup of coffee from Starbucks, or eating out every weekend. The bottom line is that debt consolidation is simply a vehicle to get to where you want to go, which is a debt-free life. After that, it’s up to you to live a financially responsible, disciplined life and avoid the same pitfalls that previously put you in a difficult financial situation.
Learn how credit counseling can help you become debt-free.
Learn the most common causes why people fall into bankruptcy.
Learn when using a personal loan to pay off credit cards is a good idea.
Learn the difference between secured and unsecured debt as it pertains to bankruptcy.
Learn how to negotiate credit card debt on your own.
Learn the difference between fixed and variable interest rates
Read DebtMD's guide before consolidating your debt.
A quick legal lesson on your rights if you find yourself in credit card debt
Learn more about debt consolidation loans, credit counseling, and debt settlement.
Having a good credit score can help you in many facets of life. Learn how to boost your score here.
People make mistakes with their money. DebtMD is here to show you what not to do when paying off debt.
Avoid these four mistakes to stay clear of high interest credit card debt.
Start the road to debt-free living, learn habits and tools to help you become debt free at a faster rate. DebtMD is committed to helping you reach your debt-free living goals. Start your journey toward living debt free.
Choosing the right debt relief company could be one of the most important financial decisions you make. Take a step toward becoming debt free, find the debt felief company fit for your type and amount of debt.
Subscribe to our newsletter today to receive expert advice, actionable tips, and the latest news to help you navigate the complex world of personal finance. Our newsletter is designed to help you keep your financial health in check.