How Does a Debt Consolidation Program Work?

Key Takeaways
  • Debt consolidation might include a debt management repayment plan, credit card balance transfer, personal loan, or equity line of credit.
  • The main strategy in any debt consolidation strategy involves replacing one debt with another debt, usually with a lower interest rate or monthly payment.
  • Debt consolidation may not save you much money. In many cases, you still pay a high rate of interest and must repay 100% of the existing balances plus interest and fees.

Another month begins, and your debt balances are going nowhere. Making minimum payments has not made a noticeable impact. You still don’t have enough at the end of the month for unexpected expenses or enough cash to set aside funds for future needs.

Something has to give.

You do not have enough income to increase your monthly payments. Perhaps consolidating debt will solve your financial problems. Let’s take a look at the options.

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The Avenues Available to Consolidate Debt?

Debt Consolidation first appears to be an attractive option because you roll multiple debts into a single payment simplifying the process and saving you money. Here is a look at the different choices and their impact on your credit and finances.

Credit Counseling agencies recommend debt management plans or DMPs. You make one monthly payment to the program, and the agency pays your creditors based on an approved schedule.

Upon entering the program, you must close enrolled accounts. The agency will attempt to lower interest rates. However, in most cases, rates remain in the double digits. You agree to a five-year repayment schedule that requires you to repay the full balance and could result in a higher monthly payment.

Personal Loans are an option if you have excellent credit and high enough income to qualify for additional debt. Crowdfunding sources like Lending Tree are popular options. In many cases, the approved loan will come with a high rate of interest. Loans typically require repayment within five years, which could raise your monthly costs. It is not always necessary to close paid accounts.

Credit Card Balance Transfer also requires excellent credit and enough income to qualify for more debt. Balance transfer offers include a low introductory rate for 12 to 18 months and a 3 to 5% balance transfer fee. You might be able to transfer a few thousand dollars to the new lower rate. However, the long-term interest charged at the end of the promotional period could be as high as the existing debt, limiting its usefulness.

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HELOC (home equity line of credit) will convert unsecured debts into a secured loan using your home as collateral. Home loans include high upfront fees and loan qualifying parameters that may limit its availability. If you qualify, you could lower your rate significantly and make payments over 20 or 30 years. The biggest danger is that you add the risk of losing your home if you struggle to make payments.

Final Thoughts

Debt consolidation may appear to be a good option at the onset, but in almost every case, it could lead to a worse financial situation than you currently face.

All consolidation programs require debt repayment in full. It is challenging to secure lower rates with high existing debt levels because you have a lower credit score due to excessive credit utilization. Adding new debt to an already overburdened budget can further complicate your financial circumstances. Lastly, converting unsecured debt to secured debt gives creditors additional means to collect on the debt, including foreclosing on your home.

Instead of seeking debt consolidation, the better option could be to settle debts for less than the full balance owed. If you face financial hardship due to the pandemic, creditors might be willing to work out a payment arrangement that will eliminate your unsecured debts at a significant discount.

  • What impact does debt consolidation have on my credit score?

    Transferring existing debts into a new loan does not affect the amount of debt you have; it just moves it to another account. Your credit will get better as you make on-time payments and lower debt balances.

  • Is it a good idea to consolidate debt?

    The goal of debt consolidation is to streamline the process of moving multiple accounts to a single payment. In some cases, it will also result in lower interest rates. If you have the discipline to pay off the new debt without using your available credit, you could save money in interest charges. However, incurring new debt could leave you worse off than before the consolidation.

  • What debts can I include in debt consolidation?

    Most debt consolidation involves unsecured debts such as credit card bills, payday loans, personal loans, or medical debts.

  • Is debt consolidation risky?

    Converting unsecured debt to secured debt could put collateral, such as your home, at risk of foreclosure. Converting debt to another unsecured loan might provide few or no benefits if the interest rate is not lower. When you roll debt into a new loan, you also run the risk of accumulating even more debt, leaving you in a worse financial situation than you started.