We Know: How Debt Consolidation Works

What Is Debt Consolidation?

Debt consolidation is taking out a single loan to pay off several others. The three primary reasons for doing this are to get a lower or fixed interest rate, to be able to pay back only a single loan, or to decrease your total monthly loan payments.

Is Debt Consolidation Really A Good Deal?

It depends on the loan and on your circumstances. If you're consolidating unsecured loans into another unsecured loan with more favorable terms, then it almost certainly is a good deal. Most debt consolidation loans, however, involve using an asset as collateral, making them secured loans. This puts your assets at direct risk. However, this almost always results in a lower interest rate because the risk to the lender is lower.

If your new loan results in payments you are certain you can afford for the life of the loan, it's at least worth looking into.

What Should I Look For?

If you use debt consolidation as a financial strategy, you can save huge amounts of money. Some of the things to look for include:

  • When you're in danger of bankruptcy, the lender can sometimes discount loans -- that means your consolidator will buy your current loans at a discount from the original lenders. Shop around for this sort of deal, because the higher interest can add up quickly; some consolidators will pass a portion of the discount to you, though. These loans are more likely to work with credit card and other unsecured debt.
  • Do all the math on your debt consolidation; figure out how much you must pay on your current loans, interest and all, and then compare that to the same figure for your consolidated loan.
  • If you consolidate your credit card debt, do NOT go out and open up another credit card line. Prior spending habits will probably continue, resulting in your running up even more debt. Instead, talk to your consolidator about credit counseling and budgeting; many of them offer these services.

When Should I Not Do A Debt Consolidation?

You should weigh all your options when looking at debt consolidation. If your consolidation is simply a more convenient and money-saving way to get your debt into one place, then it's probably a good idea. There are several circumstances where you should not do a debt consolidation, or where you should weigh the idea carefully.

  • How's the housing market? Many consolidators use your home as collateral; if your housing market is fluctuating, you might want to think twice about the consolidation. Extra equity in your home can lead to a better deal in a year, while less equity could put you in a financial bind later.
  • Can you realistically make the payments on your new loan? If you are already having significant trouble and your consolidation doesn't put you in a much better position, you might want to weigh bankruptcy, or look at the possibilities of a chapter 13 financial restructuring bankruptcy, which could lead to your debts being discounted in a consolidation.
  • If debt consolidation is your last hope before bankruptcy, try to get yourself in a better position before you consolidate. The closer you are to bankruptcy, the higher your interest rate is likely to be. Do whatever you can to make three or four months' payments on everything on time, and pay more than the minimum on credit cards if possible. This will make your situation look better on paper.

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