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Debt Consolidation: What to Consider

Debt consolidation

Debt consolidation can be a big help to people hoping to start on a path to personal financial recovery. When used correctly, it can provide piece of mind and real monthly savings. However, it’s important to pay attention to potential pitfalls. While numerous businesses offer solutions for debt management, the Federal Trade Commission recommends starting with a self-help approach of budgeting and communicating with creditors before pursuing outside help. If you do decide to work with someone offering debt consolidation services, do your homework to ensure you don’t end up paying more in the long run.

Tip #1: Ask about fees upfront

Debt consolidation is often very beneficial, but it sometimes provides an opportunity for individuals and companies to take advantage of people looking for solutions to their debt and credit problems. Companies may offer debt management programs that have high fees or misrepresent the management process. Request all fee information up front when you’re going through the application process. Ask about origination fees, closing costs, annual fees, balance transfer fees (if applicable), late fees and early cancellation fees.

Check with consumer protection agencies and your state attorney general’s office to find out the reputation of any business you are considering. Look for complaints online and proof of licensure. Be sure to read all contract terms carefully and understand before you sign.

Tip #2: Understand term options

Whether you’re going for a lower monthly payment or looking for a lower interest rate, be sure to weigh the benefits of all your options and the amount of money you could ultimately save. Consolidating debts across a longer term could provide you a lower monthly payment, but consider how much more you will be paying in interest over the life of the loan. Or, if you’re shortening your loan terms, do the same with the difference in your monthly payments. No matter your goal, ensure you can handle the change financially both in the short and long term.

Tip #3: Do the math

With the longer term mentioned above, even though monthly payments are lower, the borrower may actually pay more money in interest over time than with the shorter, indefinite debt with higher interest rate and higher monthly payments.

Consider this simplified example of a $50,000 loan with a 7% APR (which ignores the time value of money):

Term Monthly Payment Total Interest
10 years $580 $19,665
20 years $388 $43,036
30 years $333 $69,754

Be sure to look for a consolidation plan that will provide you a monthly payment that fits your budget over a term that gives you the best value. Use a debt consolidation calculator to get a general idea for how debt consolidation can help.

Tip #4: Manage your risk

If you use a home equity loan or a home equity line of credit (HELOC) for debt consolidation, you may get a lower interest rate through the use of your home for collateral. But make sure to evaluate if you will be able to make your mortgage or home equity payments over the life of your loan. Because if you find yourself unable to fulfill your payments, you risk losing your home.

The short term effect of a missed mortgage payment is a bad mark on your credit score, which can have an impact on your ability to get other loans or to get good interest rates. The longer term effect can be a foreclosure on your home.

To avoid putting your home at risk, you can consolidate debt with a personal loan or balance transfer, but the interest rates on those types of loans are often much higher than home equity loans. So weigh all of your options and do what makes most financial sense for your situation.

Tip #5: Keep a budget

One of the biggest problems with debt consolidation for many people is that it provides a false sense of security. Lower interest rates and lower payments reduce the stress from monthly financial reconciliation. This new, financially safer situation may prompt people to relax their thrifty ways or increase spending since they have more cash available each week. Remember, consolidating your debt does not get rid it. Maintaining responsible spending habits and a proper budget is key to prevent your debt from growing back.

Tip #6: Debt counseling

These issues can be difficult to understand and correct. After all, if it were easy, most people would be able to avoid or correct debt problems on their own. Credit counseling can be a good place to start to learn how to make the best decisions for your personal situation. The Federal Trade Commission provides helpful information on selecting legitimate organizations and avoiding scams or high-fee options.

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