Is Debt consolidation a good idea? Here are the basics.

If you’re in debt, you may have asked yourself: “Is debt consolidation a good idea?” In this post we’ll help you answer that question by explaining how a debt consolidation loan works, what the alternatives are, and describing when debt consolidation can help you and when it will not.

After all, being in debt is no fun. You need all the information in order to make the best decision, so that you can turn your finances around as quickly and painlessly as possible.

Debt Consolidation Basics

So what is a debt consolidation loan? It’s a loan that allows you to pay off your current debts with a new loan that has different terms (usually from a different lender) than your current loans or credit cards.

The reason this can be helpful to people with a lot of debt is that it can solve three of the worst problems you face:

1) High interest rates
Some types of debt (particularly credit cards) can have extremely high interest rates – up to 25% or more. If you’re in that kind of situation, there’s a good chance your debt will grow faster than you can pay it off. Which is why a consolidation loan can often prove to be a better option: it may allow you to get a lower interest rate, which would save you money over the long-run.

2) High monthly payments
People with lots of debt also frequently struggle with high minimum payments – which are sometimes more than they can pay each month. That can lead to a domino effect where you miss payments, your interest rates get raised, and then you can’t stay above water. A consolidation loan can sometimes lower your monthly payment, and that can give you enough breathing room to get back on track.

3) Confusion because of too many bills
Another common obstacle to getting out of debt is when the sheer number of bills you receive makes it hard to even keep track of which payment is due on which date. Consolidation can help with this problem by reducing the number of bills you get down to a single one. That can make it easier to focus on getting out of debt.

So is debt consolidation a good idea? It depends on your situation. We’ll explain below. While there are some real benefits to debt consolidation, it’s extremely important that you do your homework and understand there’s a wide range of options when it comes to debt consolidation loans – some are good, some are bad, and some are downright predatory.

Different Kinds of Debt Consolidation

The term debt consolidation encompasses a wide range of options. So how do you find the right one for you? Below, we’ll describe the various different ways you can consolidate your debt and explain the advantages and disadvantages of each particular option:

Debt Consolidation Company

There are many debt consolidation companies out there. As you would expect, they allow you to pay off all your debts by taking one loan from them, so that you will no longer owe any money to your previous creditors. Instead, you will owe the debt consolidation company an amount equal to the total sum of all your debts. And you will pay a monthly payment to them, which will go toward paying the principal of the loan as well as interest and fees. If you can get a low interest rate, this may be a good option.

However, you must be cautious when dealing with debt consolidation companies. Once you have agreed to the debt consolidation plan, you can’t go back, so it’s important to understand the potential consequences first. The fees and interest rates can end up being very high – especially if you have fair or poor credit. Since most people struggling with debt do not have excellent credit scores, they’ll have to pay high interest rates and fees which will burn a large percentage of their total cash flow each month. .

Furthermore, even if you get what seems like a good interest rate, there is still a significant risk involved in dealing with a debt consolidation company.  Your repayment plan might be much longer, which could cause you to pay more interest over the life of the loan even with a lower interest rate than what you had before. And if you miss a payment (or are late) you could face costly penalties and your interest rate could be increased. You also must be careful not to continue using more credit (with credit cards) after entering the debt consolidation program. Otherwise, you’ll end up with the same amount of debt – or more.

Home Equity Loan (or HELOC)

A home equity loan, or Home Equity Line of Credit (HELOC), allows you to borrow money against the value of your home. The size of these loans varies, but they can often be up to 75-80% of your home’s value. While home equity loans usually have fixed terms, meaning the amount of the loan, the interest rate, and the timetable for paying back the loan are all fixed, HELOCs on the other hand allow you to apply for a credit limit that you can draw upon at your convenience – but with no guarantee that your interest rates will stay the same.

While a home equity loan or HELOC can usually provide a lower interest rates than other loan types, there’s a catch. To understand why, consider the difference between your mortgage and your credit card. The mortgage is a “secured debt” and the credit card is “unsecured debt.” That means if you stop paying your credit card bill, the lender cannot automatically take any property (or collateral) from you as a penalty. On the other hand, when it comes to your mortgage, your house serves as collateral, so that if you were to stop paying your mortgage, the bank could take your house.

If you decide to consolidate your credit card debt with a home equity loan (or home equity line of credit), you’re essentially betting your house on the fact that you can pay back the loan. For some people, that’s no problem. But if you’re thinking about debt consolidation then you’ve probably already had some difficulty paying off your debts. If that’s the case, putting your house on the line may be too risky of an option for you.

Balance Transfer

You might have seen offers for “0% interest” credit card balance transfers. In theory, these can serve as a way to consolidate your debt onto one card, but be careful because the fine print on these offers sometimes exposes serious drawbacks. Here’s how it’s supposed to work: you initiate the balance transfer and pay a immediate transfer fee – usually between 2% and 5% of your total balance. For example, if you were transferring $10,000 to the new card you would pay $200 to $500. Then, you have a period of time (usually 6 months or 1 year) in which you will not accumulate interest on the balance.

During that time, you MUST continue making payments. If you miss a payment or even make a late payment, you will often lose the introductory 0% interest rate and will instead have to start paying interest immediately. Assuming that you make your payments each month during the introductory period, the usefulness of the balance transfer will depend on how much of your balance you can pay off before the interest rates kick in. To continue with the example above, let’s say you paid off $2,000 of the $10,000 balance during the introductory period. The benefit of doing so would depend on how high the interest rate was going to be after the introductory period was over (since you’d still have $8,000 on the card).

And we should mention the other risk associated with this option: it’s still a credit card! If  you’ve had trouble with overspending in the past, it might not make sense to solve your debt situation with another credit card – especially if the 0% introductory rate will tempt you to spend more.

Peer to Peer

More recently, a new option has been created that allows individuals to lend to each other. Peer-to-peer lending companies connect people who need a consolidation loan with people who can invest a small amount of money. The investor benefits by getting a good rate of return on their money, not to mention the satisfaction of helping someone get out of debt, and the borrower benefits by getting a consolidation loan for a lower interest rate than they’d get anywhere else (with loans ranging from $1,000 to $25,000).

Instead of filtering loans and investments through a massive institutional “middle man” as in a traditional bank, peer to peer loans are serviced by a peer-to-peer lending company that takes a small fee off the top and provides better than average rates to both investors and borrowers. These loans usually give you a 3-year or 5-year term to repay the loan, and more importantly, your interest rate is fixed the whole time. Why is that important? Well, with a fixed interest rate, a fixed amount, and a fixed repayment timeline, you can create a serious get-out-of-debt plan.

Is Debt Consolidation a Good Idea?

We realize there is a lot of information to consider. And each person’s financial situation is different. One of our principles at ReadyForZero is to make it easy for you to do the right thing for your long-term financial health. It’s why we always guide you to pay your highest interest debt account first (to save money and time). And it’s why we congratulate you whenever you pay off 25%, 50%, or 75% of your debt. But we want to find new ways to help and make this process easier for you.

Recently, we realized that many of you could benefit from some kind of debt consolidation loan to reduce your interest rate and help you pay off your debt faster. We researched what type of consolidation would be most helpful, and we were convinced that peer to peer loans have the potential to help the greatest number of our users. For that reason, we have been working with LendingClub to initiate a new savings platform in ReadyForZero (which we announced last week).

The way it works is that we set automatic triggers (such as your total debt load, interest rates, and paydown speed) to discern when a peer to peer loan can help you solve one of the problems mentioned at the beginning of this article:

1) High interest rates
2) High monthly payments
3) Too many bills

In the cases where a peer to peer loan can help you with one of these problems, we will present you with an opportunity to learn more and sign up for a loan with LendingClub. The entire process is automated and we never share your data with anyone.

Here’s an example of a situation where this might happen: let’s say you have three credit cards, with different balances and different interest rates:

Chase: $1,200 at 14% interest ($24 minimum per month)
Capitol One: $3,000 at 18% interest ($60 minimum)
Wells Fargo: $4,500 at 15% interest ($90 minimum)

In this scenario, you’d have three different monthly payments and if you paid $300 per month it would take you 3 years to get out of debt (costing $2,060 in interest payments).

Depending on your credit score, you might be able to get a consolidation loan from lending club that would look like this:

LendingClub Loan: $8,700 at 12% interest ($174 minimum or less)

In that case, you’d have just one payment to worry about, and assuming you paid 300 per month you would get out of debt in 2 years, 11 months, and would pay $1,504 in interest (saving you $556 compared to your current path)

Thanks to readyforzero blog for this article.

What is Debt Consolidation and how does it affect your credit rating?

Debt consolidation

What does this mean?

A debt consolidation loan is a single loan (generally from a financial institution) that allows you to repay your debts to several or all of your creditors at once. You are then left with only one outstanding loan — to the financial institution. In addition to streamlining your debts into a single payment, a debt consolidation loan may also offer you an interest rate that is lower than that charged by your creditors saving you money in interest charges. This option can be especially attractive if you have outstanding debts at a relatively high rate of interest (for example, those charged on some retail store cards or credit cards). You must ask your financial institution for a loan equal to the amount of your total outstanding debts that are currently due. In most cases, the financial institution will settle all the debts for you and, in return, the only monthly payment you will have to make will be to them.

Contact several financial institutions before you choose a consolidation loan since the interest rates offered by competing financial institutions may vary.

Eligible debts

This option may be suitable for debts such as those relating to credit cards, public utilities or other consumer loans. However, not all debts can be combined into a consolidation loan — a mortgage cannot be included, for example. Your financial institution will be able to tell you which of your debts you will be able to pay off with the loan that they grant you.

Who qualifies?

In order to qualify for a consolidation loan, a consumer usually needs to have an acceptable credit rating and sufficient income to demonstrate that they will be able to manage the loan (that is to say, to demonstrate they will be able to make the monthly consolidation payment, in addition to paying for their regular monthly bills and expenses).

Hand signWarning! A blemished credit rating will likely diminish your ability to secure a consolidation loan, therefore it is best to act as soon as possible (please refer to Credit and Credit Repair for more information).

How much does it cost?

It does not cost anything to apply for a loan in order to consolidate all your debts. However, a fee may be charged to open your file. Inquire at the financial institution that you choose.

Things to do and to remember…

  • Before meeting with a financial institution’s loan officer, draw up a complete list of your current debts to determine the total amount of your outstanding debt. You don’t have to include all your debts, but it is better to tell the loan officer about them. Since the officer has to look at your credit file in order to make a decision about a consolidation loan, they will have access to all this information anyway. It is best to be completely honest.
  • If the interest rate offered by your financial institution seems too high, don’t hesitate to shop around at other financial institutions to try to negotiate a better rate. Some budget/credit counsellors suggest shopping at no more than 3 institutions because “an unusual increase in the number of inquiries can have a negative influence on your credit score”.1 For more information on this topic, please refer to the Credit and Credit Repair section.
  • Be aware that many finance companies offer consolidation loans, but generally charge a higher interest rate compared to a mainstream financial institution. Before entering into any loan agreement, it is critically important to carefully review the terms and conditions (i.e., loan period, interest rate, special terms, fees, etc.) so that you know exactly how much the loan will end up costing you.
  • In most cases, once the loan has been granted, the financial institution will pay off the outstanding debts to your creditors. In some cases, based on your ability to convince the lending institution that you are back on track, you may be able to arrange to pay your creditors yourself directly.
  • Your financial institution may close credit accounts you have with stores, businesses or credit card issuers to make sure that you don’t increase your debts while paying off the consolidation loan.
Advantages and disadvantages of consolidating your debts
Advantages Disadvantages
The interest rate charged by a financial institution for a personal loan is usually lower than the rate charged for a credit card. As a result, you will save on interest payments. Although this option may help you save on interest charges, you still have a combined debt, which represents the total of your old debts. If you are not careful, and you still have access to your accounts and credit cards, there is a chance that you will be tempted to use them, therefore go further into debt.
All your creditors will promptly be paid in full. You have the chance to maintain a good credit rating if you act quickly. Furthermore, you will only have to make a single monthly payment to your financial institution, instead of making several monthly payments to various creditors. Financial institutions may not be as flexible as your creditors. If you run into further problems, financial institutions will generally be less understanding and may refuse to accept a late payment. You must therefore make sure that this option is the best one for you.
As long as you follow the terms of your consolidation loan and make your payments on time, your credit rating should not be negatively affected.

Thanks to Innovation, Science and Economic Development Canada for this article.