Sometimes people who have accumulated a significant amount of debt from a range of creditors will consider obtaining a "debt consolidation" loan, which will pay off most or all of their existing debt, and will often result in a smaller monthly payment than they were previously paying. While this can be a very good idea for some debtors, particularly those who have a lot of high-interest debts, it isn't always a good deal. Before you consider debt consolidation, you should closely examine the proposal and make sure it is right for you.
A debt consolidation service provides a loan which pays off some or all of your existing debt, and replaces it with a single loan with a single payment. The promise is to replace various high interest loans, such as credit card debt, with a single loan with a lower total monthly payment.
A related type of service is a debt management service, which does not provide a consolidation loan, but instead pays your various debts for you.
It may seem at first blush that there is no downside to debt consolidation - you end up with a lower monthly payment and have more cash on hand at the end of each month, while your debts are still being paid off. However, depending upon how the consolidation loan is structured, you may end up paying a lot more interest on your consolidated loan, and taking a great deal more time to pay off your debt, than if you keep paying your present individual debts.
Additionally, there is a chance that obtaining a debt consolidation loan will hurt your credit. Depending upon the scoring used, obtaining a new line of credit and paying off existing loans can result in your being classified as a greater credit risk.
For people who are able, the best way to resolve outstanding debt is often to pay more each month to service their debt - focusing on paying down the principal of the highest interest debts with non-deductible interest (e.g., credit card debts).
Finally, you must ask yourself if you will demonstrate the fiscal discipline necessary to benefit from debt reconsolidation. If you obtain a consolidation loan with a lower monthly payment, but immediately run up new credit card debts, you will almost certainly end up in a worse position than you were in prior to consolidating your debts. You can even end up in a cycle of obtaining "consolidation" loans, with the commissions, fees, and interest rates accumulating to put you deeper and deeper into debt.
It is not unusual for a debt consolidator to obtain a commission of 10% or more on your new loan. It is possible also that the consolidator will be able to obtain a rebate from your lenders when the new loan is applied to pay off those debts, resulting in an even greater commission. The chance for significant, easy profits can inspire unethical debt consolidators to encourage people to obtain consolidation loans which are not in their best financial interest.
In many cases, those seeking debt consolidation are exploring that option because they are already experiencing difficulty making their payments. If so, the chances are that they will not qualify for a low interest rate. If they obtain a higher interest consolidation loan, any reduction in their monthly payments will likely result from the fact that the bulk of each payment is for interest, with little going to the principal balance of the loan. As a result, although their monthly payment is reduced, they will make very slow progress toward paying off the loan, and they will likely pay a lot more interest over the life of the loan.
Before you sign on for a "debt consolidation" loan, consider your alternatives:
Negotiate With Your Creditors
Sometimes your creditors will offer you a lower interest rate, or will waive certain fees associated with your accounts, if you simply call them up and ask. This is most often true of credit card companies.
You may be better served by utilizing a debt management service. With a debt management plan, you deposit an amount of money each month with a service which pays your bills for you. Sometimes creditors will work with your debt management service to offer reduced interest rates or waive certain fees associated with your account.
Using a Traditional Lender
You may also be better served by using a traditional lender, as opposed to a debt consolidation service.
Unsecured Loans - If your credit is relatively good and you are employed, you may be able to obtain an unsecured "personal" loan which you can use to pay off some of your higher interest debt, such as your credit card debt.
- Secured Loans - As many debt consolidation services will use your home as collateral, you may well be best served by refinancing your home or obtaining a home equity loan, and using the proceeds to pay off your debts.
There is a possibility that your best option is to declare bankruptcy. If all consolidation will do is forestall an inevitable bankruptcy, consider whether you will be better served by proceeding directly to bankruptcy.
Some services promise not only to consolidate your debt, but also to provide you with insurance and perhaps even investments, while at the same time lowering (or at least not raising) your total monthly payment. You should be wary of this type of service.
First, the odds are that if you were in a good position to make additional investments, you would not be in the market for a debt consolidation loan. You will likely be better served by applying the "insurance" or "investment" payments to your debt.
Second, the commissions associated with investments and insurance policies can be extremely high. Often the reason these services are trying to sell you additional products is so that the salesman can pocket an additional, substantial commission.
The best approach for most people who choose to consolidate their debt will be to obtain the best possible debt consolidation loan they can find, and to examine their other financial needs only after they have resolved their prior debt situation. Also, most people will benefit from using a professional financial planner, as opposed to buying insurance or mutual funds through a "debt consolidation" salesperson with little actual knowledge of investment, and who offers a much smaller range of investment options.
There are some debt consolidation schemes that are sold through multi-level marketing schemes. While there may be a certain comfort level in purchasing a financial plan from a friend, co-worker, or relative, consider this: What are the odds that this person truly is an investment professional? Most multi-level schemes offer very limited options to the customer, and all require very high commissions for the salesperson and the salesperson's "upstream" - those who sponsored the salesperson into the organization.
You should treat a multi-level program like any other option - see how it stacks up against your alternatives, then select the one that is in your financial best interest. But don't be taken in by the fact that you like the person who is selling the program, or the suggestion that you will be doing them a favor - many of these programs offer the "potential for six figure income", and your friend intends to profit handsomely by convincing you to sign up for their service.