A company might do this if it took out several small loans to finance growth and now finds interest rates lower than they were for the original loans. Most often, though, we hear the term in reference to consumer debt.
We’ve all seen ads that promise the moon when it comes to debt consolidation: “Debt relief is just a call/click/email away!” “Slash your payments!” “Reduce your interest rates!”
What Debt Consolidation Actually Does
Debt consolidation, when undertaken using a sound lender completely on the up and up, can help reduce your monthly payments while increasing your credit score. It isn’t, however, a cure-all for all your financial woes.
30% of your FICO score is determined by revolving charges and credit card debt. One of the easiest ways to improve your score is to pay outstanding credit card debts. Consolidating credit card or other outstanding debt into a mortgage refinancing or home equity loan can do just that. Your credit card balance will be instantly lowered, improving nearly one third of your credit score.
The second benefit of consolidation is a lower debt-to-income ratio. The lower your debt is in relation to your income, the higher your FICO score. This may sound a little counter-intuitive, because your credit card debt will be transferred to another type of loan. You might find yourself thinking that you’ll still owe just as much, but to another lender.
That much is true, but the interest rates affixed to home loans and respectable consolidation loans are much lower than the interest rates of credit cards. This means that your monthly payments will usually drop, leaving you with extra money to pay down your debt more quickly.
Plus, even if your total debt to annual income ratio doesn’t change, your ratio of monthly debt liabilities to monthly income will improve. Since you’ll be making lower payments, a smaller percentage of your monthly take-home pay will go towards debt. (Even if you kick the money saved into paying extra, your FICO score only cares about minimum payment requirements!)
For those in seriously dire straights due to credit card debt, consolidation may be a powerful stopgap to prevent bankruptcy. Credit card interest rates are often above 20%. Letting balances snowball can leave you owing much more than you originally purchased, have you paying monstrous amounts of in interest, and put you under enormous financial pressure.
Bankruptcy will adversely affect your credit score for years. If you’re forced to choose between consolidation and potential bankruptcy, consolidation is the way to go. If reducing your payments to help you avoid bankruptcy, don’t wait. Start looking into consolidation loans as soon as possible.
What About Debt Settlement?
If you’re seriously underwater with old credit card debt, it may be a good time to see if a debt settlement service can help you out of the fire.
Debt settlement is another tricky business, though, and you should thoroughly vet any firm you consider doing business with. That said, if you’ve missed payments on your credit card balances and have received collection notices from a third party collector, a debt settlement arrangement could be right for you.
Many times, creditors will sell “bad debts” to other companies for pennies on the dollar. These companies are often willing to settle such debts for very small amounts. An upright and professional debt settlement agency can potentially help you out of a hairy financial situation. Also, removing outstanding balances from your credit report will also help your score.
Potential Problems with Consolidation Loans
Debt consolidators and debt settlement companies are known for underhanded practices that could cost you more money in the long run. While there are certainly reputable companies out there who really do want to help, you’ll need to be on the lookout for problematic loans and settlement practices.
If a contract or loan sounds too good to be true, it probably is!
Plus, consolidation loans can actually negatively affect your FICO score if you take out too many of them. Avoid this problem by applying for consolidation loans at multiple lenders within thirty days. Then, all of these applications will count as one “hard pull” on your credit report – rather than a bunch of them, which will lower your score.
One other potential issue to watch for: debt consolidation can give you an excuse to spend yourself into even more debt! Lowered payments (which usually mean longer repayment terms, as well) can leave you with extra money burning a hole in your wallet. Resist the temptation to go into more debt, though!
Instead, practice discipline by putting those extra dollars into paying off your consolidation loan as quickly as possible. This will save you money in interest in the long run, and get you out from under all that debt!
A great way to start the debt consolidation process is to sign up for a free account at DebtGoal. There, you can track all of your debts with an easy to use interface that will allow you to see whether or not you actually need a consolidation loan.
Published or updated April 5, 2013.