Debt Consolidation

A Tale Of Two Options

Are you considering debt consolidation in order to get yourself out of debt?

If so, are you considering taking out a new loan to consolidate your debts or are you thinking of entering a debt management/consolidation program?

Not sure?

Not even sure what I'm talking about?

Don't worry, if you are like most people, you probably didn't even know that the term debt consolidation is often used to refer to two completely different debt reduction options.

One option involves consolidating your debts with a new, lower interest rate loan.

The other involves working with a credit counselor to lower the interest rates on your unsecured debt, consolidate your current payments (not your actual debts) and devise a formal debt repayment plan.

If you think the second type of debt consoliodation might be right for you (or if you just need some good, unbiased debt advice), you may want to consider getting a free, no obligation debt analysis from a trained debt counselor. They will walk you through an evaluation of your financial situation, discuss the options that they as a professional counselor would recommend, and then match you up with the appropriate debt solution if you wish. Speak to a counselor today for free.

If you want to get a complete overview of all of your potential your debt relief options, have a look at my article on options for getting out of debt.

OK, now let's take a closer look at these two options, including their differences and exactly how to use each of them (if it's appropriate for your situation) to get out of debt.

Debt Consolidation/Debt Management Plans

The term debt consolidation is used more and more these days to describe what is really a debt management plan or DMP for short. In this context the word "consolidation" does not refer to the lumping together of your actual debts, but rather the lumping together of your debt payments.

Let me explain.

A debt management plan is typically administered by a credit counseling or debt consolidation company. There are some good online debt consolidating companies around that are reputable and convenient to work with. So if you are struggling to manage you finances/money and hence struggling to make your debt payments each month, then working with a debt/credit counselor could be exactly what you need to get yourself turned in the right direction.

Not sure where to find a reputable debt consolidation company? Not even sure that this is what you need? Then your first step should be to speak with an independent debt counselor who will review your financial situation (more on this below) and then, and only then, recommend a trustworthy debt consolidation company if they feel this is the right direction for you. Here is a debt counselor that I recommend. You can speak to them on the phone for free today during business hours.

What To Expect

When you first meet with your counselor for a debt consolidation review (this can be in person or over the telephone) they will go over all of your finances with you and help you prepare a thorough monthly budget and overall debt plan. Sometimes this alone is sufficient to get you back on track. But if your counselor thinks it would help you, they will recommend that you enter a debt consolidation or "debt management" program in addition to, or in conjunction with the counseling.

The goal of most debt management plans is to get you out of debt in 5 years or less. Once you enter the plan your credit counselor will begin negotiating with your unsecured creditors to seek concessions on your debt.

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They will try and get your interest rates reduced, eliminate late fees and penalties, and, if necessary, negotiate a monthly payment amount that fits your budget.

Once these concessions are in place, and new payment amounts have been negotiated on your accounts, you will make one payment each month to the credit counseling agency who will in turn pay each of your creditors who are participating in the plan. As I alluded to above, it is this "consolidating" of your monthly payments that leads to the term debt consolidation being used.

Curious as to how much you can save by enrolling in a debt consolidation program? Get a free savings estimate here.

A Debt Consolidation Loan

I don't have any statistics to back this up, but my guess would be that when most people think about consolidating debts they envision getting a new loan and using the proceeds to pay off all of their other existing debts/loans. In other words, the existing loans are grouped into one "big" new loan.

What are the benefits when you consolidate debts using a new loan?

There are three main reasons why you might choose to consolidate your debts using a new loan.

The first reason (and it's not much of a reason), is to make life easier by only having one loan payment each month, instead of the 3,4,5 or more you have now. This may help you avoid missing a payment but that is about it.

The second reason is a blessing and a curse. Consolidation loans will often allow you to stretch out the payment terms of your loans, thus making your monthly payments lower and more manageable (even if the interest rate is not lowered). This is the "blessing".

The "curse" is the fact that by stretching out the time it takes you to pay back your debts, you will likely end up paying a significant amount more in interest charges over the life of the loan. (This can still be the case even if the interest rate is lowered.)

The main benefit of course, arises if the interest rate on the new loan is lower than the interest rates you are currently paying (or at least it had better be or you shouldn't be taking out the loan). The lower the interest rate, the less you pay in interest charges and, in theory, the faster you can pay off the debt (because more of the monthly payment goes towards actually paying down the debt, not towards interest charges).

Consider This Debt Consolidation Loan Example

Let's say you have $20,000 in credit card debt at 22% interest and a minimum payment amount equal to 2% of the outstanding balance.

Scenario #1: If you just made the minimum payments on these credit cards each month going forward, it would take you 161 years and cost you $210,736 in interest charges before you would be debt free. Now, I don't know about you, but I won't be around in 161 years.

Scenario #2: Your minimum payment next month will be $400 ($20,000 X 2%). If you continued to pay $400 every month going forward (the required minimum payment will actually decline over time) you would have those credit cards paid off in 11 years and pay $34,713 in interest charges. Better, but not great.

(Not sure what the difference is between Scenario #1 and Scenario #2? Click here for a further explanation.)

Scenario #3: You get a new debt consolidation loan for $20,000 at 7% interest, secured by the equity in your home. You then use the proceeds to pay off your credit card balances. But remember,

you haven't paid off anything.

All you have done is "shift" your debts from one place to another. You still have to work hard to make sure you pay off the debt.

Let's look a little closer at the numbers for Scenario #3.

If you paid $400 each month towards your new loan, it would now take you only 5 years and $3,716 in interest charges to pay off that $20,000. Therefore, by using a debt consolidation loan, you will save yourself about $31,000 in interest charges and be out of debt 6 years earlier, compared to leaving the balances on your credit cards, and paying the same $400 each month.

Where Can You Get Debt Consolidation Loans?

Loans to consolidate debts can come from many sources. For example, if you own a home and have equity in it, you could consider borrowing against this equity to consolidate your debts (as in our example above). This could be in the form of a home equity line of credit, a second mortgage or a cash out refinance. An added benefit to using your home as security for a new loan is that the interest that you pay on that loan may be tax deductible.

Other sources to consider are personal loans from banks, peer-to-peer lending (my personal favorite), borrowing against your retirement funds, borrowing from family or friends, or transferring your credit card balances to new, lower interest or 0% interest credit cards.

Which Type Of Debt Consolidation Plan Is Best For You?

Before I answer that question, let me start by saying this...

No matter what debt reduction plan you choose, the success of that plan depends on you. More specifically, it depends on your ability to manage your money, prepare a detailed budget (that includes paying down your debts and incorporates savings goals) and stick to that budget.

Now, which debt relief plan is best for you? Is debt consolidation bad (or good) for your financial situation? Well, unfortunately, without knowing your situation I can't answer that question. But, I can tell you how to figure it out.

The first thing you can do is to learn exactly what options are available to you (and debt consolidation is just one of those options) and then educate yourself as much as you can about each of those options. Once you have at least a basic understanding of these, the next step would be to contact a credit counseling company. Not only will they provide you with a free quote on what it would cost to consolidate your debts, they will help you zero in on the best debt elimination option and get you on the right path.

Ideally you want to speak to a company that offers a wide variety of options so that they can offer you unbiased advice and recommend a course of action that truly suits your situation. For example, If bankruptcy is truly your best option, then there is no sense wasting time in a debt consolidation program (that is doomed to fail) just becasue that is the only solution that the company offers.

Next Step: Find out what all of your debt relief options are.

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