Understanding Debt Consolidation

Understanding Debt Consolidation Debt consolidation is one of those financial terms that's thrown around a lot these days and it tends to get lumped in with things like debt settlement, debt management, and even bankruptcy. Although all of these things relate to the issue of debt, debt consolidation is not very similar to other forms of debt relief. For some people, it can be better.

Unlike bankruptcy, you do not need a court order to go into debt consolidation. Unlike debt management, you do not need a counselor or agent to act on your behalf. And unlike most plans of debt relief, debt consolidation done correctly will not hurt your credit score or your financial reputation.

Of course, debt consolidation is not for everyone. Financial woes have a way of being unique, and every single person or family facing mounting debts has a lot of special factors that come into play. Financial programs to help cope with debt are definitely not one-size-fits-all.

Besides that, not everyone (even those who want and need it) can qualify for debt consolidation.

Quite simply, debt consolidation is a way of rolling many debts together, taking out another loan to pay them off, and then managing the consolidated debt. In other words, you take out a big loan, use it to pay off all of your credit cards and other debts, and then pay off the big loan.

This sounds counter-intuitive. A person drowning in debt probably hates the thought of another debt! And how can adding one more colossal debt to the mixture help you?

The answer is not that you are simply getting another loan, it's really a way of re-organizing or re-structuring your debts. For example, let's say you have seven credit cards. You're maxed out on three and you owe differing amounts on the other four. Altogether, you owe $82,000 on credit cards. Add to that $22,000 in car notes and perhaps $4,000 on a revolving plan to buy furniture and your total debt is $104,000. That may sound high to some people, but it is really not all that unusual!

Now look at the interest rates on those loans. This can take some detective work, but that information should be available on your monthly statements. If it is not or you can't find it (or figure out what they're talking about), call the toll-free customer service number most such companies have and discuss the loan with them. You want to know the interest rate, which is the percentage of the total loan the company charges you for the privilege of borrowing its money.

You will probably discover that interest rates are all over the map. Department store credit cards are traditionally pretty high (22% is not unheard of). Other credit cards span a pretty broad range (16% to 20% is fairly normal). An in-store loan for furniture is likely high (22% is typical) but the car note might be half that (10% to 12%...again, these vary widely).

If you have debt, you are paying not just the actual amount you borrowed, you're also paying interest. Interest is the dirty little secret of debt because it keeps accruing, day after day after day. The longer you take to pay your loan, the more interest you'll pay. In fact, if you take long enough to pay off a high-interest loan, you can wind up paying more in interest than the loan itself!!

Think of sales tax. Here in Texas, where I live, we pay 8.25%. That seems high to me, and most of my fellow Texans will agree. But most interest rates on credit cards is double that-over 16%. Imagine paying double sales tax! That's how interest can really add up.

Coming back to our example, you owe $104,000 at a variety of interest rates. What if you could get a loan for $104,000 at, say, 12%. Would that make sense? You now swap out your many smaller loans for one giant loan at a much lower interest rate.

But let's look at the car note. If you're paying 12% or less interest on that, it would not make sense to pay it off and then take out a new loan at the same or higher interest!

Can you actually find lower interest rates? A lot depends on how low you need to go, how good your credit is, and many other factors. A big plus in debt consolidation is home ownership. If you own your own home, you may be able to get a home equity loan or refinance the mortgage in such a way that you can extract money from your home to pay off your debts. A mortgage company, banker, or debt consolidation professional can help you figure out if that works.

If you do not own your own home, do not give up. Debt consolidation may still be possible using a line of credit (a type of unsecured loan obtained through a bank, credit union, or financial institution). You may also be able to borrow money using something else of value (a 401(k) account, stock account, property) as collateral. Any time you have collateral, it's easier to get a loan and you'll likely have more clout in getting lower interest rates. That is because collateral means lower risk to the lender. If you put up your retirement account as collateral for a loan, the lender has the right to take funds from your retirement account to pay off the loan.

It is tough to make broad statements about debt consolidation, but you are a pretty good candidate if you have an uncomfortable amount of debt and at least two of these things is true about you: (a) you own your own home, even if it's mortgaged, (b) you have a lot of debt at interest rates around 20% or higher, (c) you have good credit.

There are some definite advantages to debt consolidation. First, because you pay off your debts, it does not hurt your credit score and may even help it. Second, it is an ethical solution that allows you to pay your debts (one of the dirty little secrets of bankruptcy is that many people who file for this sort of protection end up feeling ashamed). Third, it is smart money management.

However, before embarking on debt consolidation, you need to get the facts. There are lots of online and offline places to seek information and there are also companies and counselors who can advise you. One often overlooked source of information is your own hometown bank. Bankers know a great deal about borrowing money and can probably give you free advice if you call and make an appointment. (It's more likely you'll get high-quality face time with a professional at a bank if you're a customer, but I have heard of people getting great free financial advice from banks they did not even bank at!)

Keep your eyes open if you consolidate debt. Debt consolidation does not make debt disappear: you still have to pay it off. It also does not really help you change your financial ways; you'll have to take steps yourself to keep from digging yourself into debt again. But for the right people, debt consolidation can be a great way to manage overwhelming debt sensibly.

About the Author:

Mandy Karlik is a freelance writer. To read more of what she has to say about the basics of debt consolidation, click through to www.debt-consolidation-diva.com .