There’s a lot of confusion about what exactly debt consolidation is. At its heart, the term “debt consolidation” refers to incorporating several loans or debts into a new loan. The new loan, called the “debt consolidation loan” is equal to the amount of all the loans which were consolidated, and its interest rate may be either higher or lower than the rates on those old loans.
Pretty straightforward, right? Well, not quite. For one thing, countless so-called debt relief companies have been running ads on television and on the Internet for the past few years claiming to be debt consolidation companies. They’ve muddied the water when it comes to this topic, and the result is that many companies who offer debt settlement or debt management programs call themselves debt consolidation companies.
Unlike debt settlement and debt management, however, debt consolidation does not entail negotiating with your creditors to reduce your debt amount or change your payment terms. Let’s take a closer look at how it works and at the pros and cons of debt consolidation.
Types of Debt Consolidation
There are several types of debt consolidation, and while they all work similarly in principle, there are some distinctions you should understand:
Simple debt consolidation loan: As described above, a basic debt consolidation loan allows you to pay off other debts and replaces those debts with a new debt consolidation loan. You need to make monthly payments on the new loan, and the new payments may be equal to the sum of your previous monthly payments or even lower. Be aware that if the new monthly payment is lower, it is either because you reduced your interest rate or you extended the payment period (i.e. from 5 years to 10 years), which means you could pay for a longer time period.
Peer-to-peer consolidation loan: Identical to the simple debt consolidation loan except that these are borrowed from peer-to-peer lenders rather than from banks or credit unions. What is a peer to peer lender? Well, it is a financial institution that brings investors from all over together with borrowers and connects them (while taking a small commission for each loan). One of the most popular peer-to-peer lenders is called Lending Club (you can read a review of it here). Lending Club is a great option for people with good or above average credit scores.
Student Loan Debt Consolidation: If you have student loans, sometimes it makes sense to consolidate them, and for this you need to look for student loan consolidation options, not just any kind of consolidation. You can find out more about this particular kind of consolidation at the Department of Education website.
Credit card balance transfer: For credit card debt, there are tons of balance transfer options as long as you have good credit. The way a balance transfer works is you – surprise – transfer your credit card balance from one card to another. Usually the benefit to you is that you’re given a lower interest rate during an introductory period which can last anywhere from 6 months to 18 months. The key is to read the fine print to make sure you understand what you’re agreeing to before saying “Yes” to a balance transfer.
Pros of Debt Debt Consolidation
As you can see in the paragraphs above, there are quite a few types of debt consolidation, and as you might imagine, each one has its own advantages and disadvantages. On the whole, the pros of debt consolidation are that (A) it helps you simplify your monthly payments, (B) it can reduce your interest rate, and (C) it can lower your monthly payment in some cases – while also extending your repayment period longer.
Cons of Debt Consolidation
Like above, the cons of debt consolidation depend on your situation and the type of consolidation you are considering. Many people wonder if debt consolidation can hurt your credit score, and indeed that is one of the potential disadvantages. However, the only time it will hurt your credit score is if you consolidate credit card debt and then close the credit card accounts entirely, in which case your credit utilization would be lower, hurting your score.
On the other hand, if you decide to leave your credit card accounts open that might lead to another disadvantage: you could get even deeper in debt if you continue spending on your cards while also getting the debt consolidation loan.
Should I Do Debt Consolidation?
Ultimately, you have to decide for yourself if debt consolidation is appropriate for you. However, the good thing is that you now have the knowledge to make a wise decision and if you decide to go for it you can use these tips for finding a reputable debt consolidation company. As long as you follow this information and move forward carefully (and read the fine print!) you will be able to make a wise choice to secure your financial future.
Last Edited: 26th June 2013