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Debt consolidation, like any other financial decision, has its upsides and its downsides. If you're in heavy debt, especially to multiple different creditors, then debt consolidation can seem like it's all good. You reduce all of your various debt payments to a single monthly payment and save yourself some money while becoming debt-free even faster. You can do it through a variety of means, such as a personal loan or a balance transfer credit card, and get started quick once approved. Sounds like a win-win!
Not so fast. Before you decide that debt consolidation is all positive, make sure you know both the pros and cons. We've listed a few here as a broad overview of what debt consolidation is all about.
Pros of debt consolidation
Debt consolidation has plenty of upside, which is why it has helped so many people across the country get a handle on their debts and get their financial lives back on track. The major pros include reduced stress (through consolidated payments), reduced short- and long-term payments, and the ability to set a deadline on paying off your debt.A single payment equals less stress each month
When you owe debt to multiple different creditors, one of the worst parts of the experience isn't just actually paying them back; it's keeping track of all the different payments that you owe. Each payment is a different amount for a different debt, each due at a different time of the month. When those payments start to add up, it can be more than a drain on your wallet, it can make your head spin as well.
If you do lose track of one or more of your payments, this nightmare can get even worse. Not only do you have to play catch-up with one of your debts (possibly incurring late fees or other penalties), but you'll be likely to start getting those dreaded calls and threatening letters from collection agencies as well. The point of these communications is to harass and scare individuals who are in debt into taking drastic action in order to pay back their debts. Often, taking immediate action isn't very realistic, so the calls and letters start to come in at a higher frequency, until you start to feel a sense of deep anxiety every time your phone rings.
Missing payments can also harm your credit score, making a mark against your long-term financial health that can often be difficult to overcome. Your credit score is more than a measure of your creditworthiness. To lenders, and increasingly to potential landlords and employers, your credit score is a measure of your trustworthiness and level of responsibility. It may not seem fair, but to these individuals, a bad credit score can indicate that you are unable to get your responsibilities in order.
With a single monthly payment due to debt consolidation, these kinds of stressors and negative consequences are easy to avoid. With only one payment to worry about, you're much less likely to lose track of your finances and deadlines and much more likely to make your payment on time. That keeps the collection agencies away and helps keep your credit score from faltering any further.You might pay less each month and less overall
Not all debt consolidation programs are equal, but most share a common goal: to save you money on the debt that you owe. In the most helpful cases, a debt consolidation program can save you money each month while also reducing the amount that you pay over the lifetime of your debt, helping keep more money in your pocket.
In the short-term, debt consolidation may save you money each month simply by reducing the minimum amount you pay to your creditors. This circumstance may be more likely to happen if you currently owe money to many different creditors, especially many different credit card companies. Before debt consolidation, you're paying a minimum amount to each different creditor. While on their own, these sums may seem small. However, when added together, they can represent a huge chunk of your overall income. Your debt consolidation payment may be larger than any individual minimum payment you are making now, but ideally, it will be less than the sum total of all those monthly payments.
In the long-term, debt consolidation can save you money by reducing the overall amount you pay in interest on your debt. Your debt consolidation package likely does not accrue as much interest each month as the total accrued by your non-consolidated debts. It may still represent a large portion of your income, but it could end up being less overall, saving you money over the lifetime of your debt.
Taken together, then, these benefits may lead to you paying less in the short- and long-term on your debt, although this is not a guarantee with each debt consolidation package.
Setting a deadline on your debt can be a relieving experience
Overall, debt consolidation can be a relieving, de-stressing experience. Not only does consolidating your debt make it easier to keep track of, but also, many debt consolidation programs (such as debt consolidation loans) come with set payoff dates. Often, these dates are much sooner than they would be if you just continued to try to keep up with the monthly minimum payments for your various creditors. Few days compare to the day you become free from debt.
Cons of debt consolidation
Of course, debt consolidation is not a perfect solution to a common problem. If it were, then every person who had a significant amount of debt would consolidate that debt immediately. Debt consolidation has its fair share of cons, including the fact that it can be risky and difficult to get, and that it only treats the symptoms of debt and not the causes.If you have bad credit, decent debt consolidation packages can be hard to find
The most common form of debt consolidation is the debt consolidation loan. With a debt consolidation loan, you work with a lender (often a bank or a credit union) to secure a personal loan that equals the total amount of the debt you owe to your various different creditors. You use that loan to pay off all your debts at once, and then focus on paying back the loan.
Another common form of debt consolidation is a balance transfer credit card. With a balance transfer credit card, you apply for a credit card that offers a 0% introductory APR. In other words, for a set period, the credit card won't accrue any interest on the balance. If approved, you use that card to pay off all your other debts, consolidating them into a single credit card. During the offer period, you make a concerted and significant effort to pay off all your debt, or at least as much as possible. Every payment you make goes towards paying off your debt, not fighting off interest. Ideally, before the offer ends, you'll have paid off all your debt and won't need the credit card any longer.
What do both of these common forms of debt consolidation have in common? In both cases, you need approval to be able to access them. Every loan needs a lender, and every credit card needs a credit card company willing to finance your purchases.
Consider what lenders and credit card companies look at when deciding whether to approve you. Among other things, they look at your credit score. Your credit score isn't a perfect measure of your ability to pay back money you owe, but it's the best measure that most institutions have at their disposal. If they see a bad credit score, they're much less likely to do business with you.
In addition, what do people who really need debt consolidation often have in common? The answer is bad credit scores. They've fallen behind on their various debt payments and really need help, but being unable to pay back their debts has taken a significant toll on their credit scores, making them less eligible for some of the most common forms of debt consolidation. It's a sad truth: those that need help the most often don't qualify to receive it.
Secured loans can be more risky than they're worth
If you do have bad credit, and you are still able to gain approval for a debt consolidation loan, chances are strong that it will be a secured loan. There is a world of difference between a secured and an unsecured loan.
With an unsecured loan, your lender approves you purely based on your creditworthiness. The lender looks at your credit score and financial history and decides that you would be a good investment, deeming you likely to be able to pay off your debt according to the terms offered. The lender has no concrete security in making this deal with you; it simply decided to trust you.
Secured loans, on the other hand, require that you put up some form of collateral in order to secure the loan. Collateral can be any significant asset, such as your car or house. This collateral acts as security for the lender. If you fall behind on your payments or can't keep up your end of the bargain, it can seize the collateral and get some of its money back, in which case you are out a car, a home, or some other major asset.
Lenders are more likely to offer secured loans to individuals with spotty financial histories as a way to hedge the bet they're making by lending money in the first place. For the individual taking on the debt consolidation loan, this can be bad news. You can never be certain what will happen in the future, and if for some reason you can't pay off your debts, you could lose a major asset and end up far worse off than when you started.
If you can't change your spending habits, you'll be worse off than before
The most important warning you can give someone who is considering debt consolidation is that it is not a solution to his or her problems. It's a temporary stopgap measure designed to alleviate the overall burden of debt and give the individual a little bit of breathing room to figure things out. It's a means to an end, not an end in itself.
While many individuals get into debt through no real fault of their own, many others find themselves in debt due to poor decisions. They used credit to spend impulsively, driving up credit card balances in order to afford luxuries, recreational experiences, and generally to live outside of their means.
When these individuals seek debt consolidation, they have two options. They can confront the reasons they got into debt in the first place and change their ways; or, they can use debt consolidation to free up some credit and get right back into spending irresponsibly.
If you make the first decision, then you're using debt consolidation the right way, as a method to make your life a little easier and give yourself the freedom you need to get your finances in order. If you make the second decision, you're just looking for the easy way out and likely to fall into an even deeper hole.
It seems like an easy decision to make, but the sad fact is that many individuals who seek debt consolidation find themselves deeper in debt only a few years later.