Is Debt Consolidation Right for Me?
It’s easy to reach for the plastic to pay for something, but that ease brings with it the risk of credit card balances quickly spiraling out of control. And when credit card debt is combined with payments for other debts, such as home, auto and student loans, it can become difficult to meet your credit obligations every month.
To break the cycle, many Americans turn to debt consolidation. For some, combining their debts into one monthly payment to one creditor is the perfect solution. For others, the inability to meet their consolidated obligation just extends the cycle further.
Before you make a decision, let’s take a quick look at the three primary types of debt consolidation and the pros and cons of each approach.
Home Equity Loans
If you own a home, you may be able to take out a loan or line of credit. The amount is typically based on the equity the property has accrued since you purchased it. This can be a way to get a very large amount of money in one big chunk, allowing you to pay off multiple debts — including your credit card bill —that carry high interest rates and high monthly payments.
But there are a few caveats. First, if the debts you are covering are credit cards and other “unsecured” forms of credit, the interest rates are higher because you can’t lose anything except your credit rating by not paying them. You will get calls from debt collectors and your credit score will nosedive, but you aren’t going to find yourself out on the street.
Home equity loans have a lower interest rate because you are using your home as collateral. If you fail to pay every month, on time, in full, the bank can seize and auction your home to cover the debt. If you have a firm plan in place to make your payment every month, without fail, a home equity loan can be a solution to the problem. But if you have any doubts about your ability to stick to the payment plan — be they fears about your job situation, spending habits or worries about emergency or unforeseen expenses, this might not be the way to go.
Many offers for new credit cards include the option to transfer balances and pay them down at zero percent interest, typically for an “introductory” period of one year. If you have a high-balance, high-interest credit card bill, these offers can be irresistible. They might even represent the opportunity you needed to make more than the minimum payment each month, allowing you to pay down the principal balance as well as the interest.
But there is a catch.
First, the fine print often states that, if you miss even a single payment, the introductory interest rate can suddenly skyrocket. Depending on the card and the offer, that interest rate could be even higher than the rate on your old card.
Second, the real benefit depends entirely on how much of the balance you can pay off during the zero percent interest period. If you’re only making minimum payments, then you aren’t going to put much of a dent in it, and as soon as the introductory period is over, you’re right back where you started. If you plan to take this route, to be successful, you’ll need to really commit to paying down the balance as much as possible while you have no interest to worry about.
Debt Consolidation Providers
Debt consolidators attack your situation in one of two ways: Either they will negotiate with your creditors for a lower payment and interest rate or buy the debt from them and collect the balance from you. Either way, you are making one payment to one creditor at a fixed rate.
If you are overwhelmed with multiple payments or high interest rates, this could be a good option. But, again, there are a few cons.
First, you have to make sure you are working with a reputable company. There are plenty of debt consolidators who are in business to prey on the financially vulnerable, so make sure you do your homework ahead of time. There are some great nonprofit resources out there that will point you in the direction of nationally recognized organizations that can help.
Second, in many cases, the lower interest rate isn’t the only factor that lowers your monthly payment. To create a manageable payment, your debt consolidator may have to extend the term. So a debt that would have taken three years to pay off could now take five, for example. While that might seem like a great thing — after all, it’s less money coming out of your limited budget each month — it also means you will be paying more in the long term. Depending on your balance and interest rates, that could be hundreds or thousands of additional dollars.
In the end, debt consolidation is just one potential tool that can be used to get out of sticky financial situations. In a vacuum, none of these options will really solve the underlying problems. But when used thoughtfully, and with a concrete plan in place to reduce spending and ensure no new debt is created, each has the potential to offer hope for a more secure financial future.