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Debt Consolidation

Carve Debt Down to Size with a Consolidation Loan

(Updated Dec. 2014)

When monthly bills get out of hand, debtors frequently look to debt consolidation. This is the practice of rolling all your debts into a single, monthly bill. This not only simplifies the payments, but can also provide real debt relief by reducing those payments as well.

A consolidation loan can reduce your monthly debt payments in two ways. First, you may be able to get a lower interest rate on your consolidation loan than you were paying on your various other debts. With interest rates on credit cards often ranging from 12-18 percent, that can produce a real savings.

Second, you may be able to set up a consolidation loan that lets you pay off your debt over a longer time than your current creditors will allow, so you can make smaller payments each month. That's particularly helpful if you can combine it with a lower interest rate as well.

Loan consolidation basics

How does debt consolidation work? Basically, you borrow a single, lump sum of cash that's used to pay off all your other debts. There may be other wrinkles involved - for example, some of your creditors may be willing to write off part of your debt in return for an immediate payoff - but the key thing is that you're simplifying your finances by exchanging many smaller debt obligations for a single bill to be paid every month.

What types of debts can be covered by a debt consolidation? Generally, anything where you've incurred a debt that needs to be paid off over time - credit card bills, auto loans, medical bills, student loans, etc.

The exception would be your mortgage; if you're having trouble paying that, you need to work that out directly with your lender, perhaps through a loan modification. However, you might be able to use a cash-out refinance to roll your other debts into your mortgage payment, as described below.

What you can't roll into a consolidation loan are ongoing bills and debts - the type where you incur new charges every month, such as gas, electric, cable TV, Internet, phone service, rent and the like. However, if you've fallen behind on any of these and need to get caught up, you may be able to pay off your past due balances with a debt consolidation loan. You just can't use that loan to continue to pay your new obligations going forward.

Loan consolidation options

So how do you get a debt consolidation loan? There are several options, including going to a loan consolidation specialist or, if you're a homeowner with equity in your property, taking out a home equity loan to cover your debts. You can also seek to take out a personal, unsecured loan on your own or try to negotiate some sort of arrangement with your creditors. We'll take a look at each of these.

A direct loan or cash advance

The simplest, and most straightforward way to consolidate your debts is to simply to take out a new loan from your bank or credit union and use that to pay off the various bills you may have. You're then left with one monthly bill to pay rather than several. Many lenders specifically offer loans for this purpose.

Of course, this approach requires that you have fairly good credit - if your FICO credit score is in the mid-600s or lower, you may have trouble getting such a loan from a bank or credit union. It's also possible that the interest rate on such a loan won't be lower than what you're already paying - in which case any reduction in your monthly payments would have to come from arranging a longer repayment schedule than you have with your current creditors.

Another option would be to obtain a cash advance through one of your credit cards. As you may know, many credit card lenders freely offer these to their customers with good credit, in the form of blank checks the borrower is invited to use as they wish.

What's attractive about these cash advances is that they often offer 0 percent interest for a limited time, often 9 to 18 months, so they can be useful if you're able to pay off the whole debt that quickly.

However, these cash advances can also get you into trouble, because they usually reset to a fairly high rate once the no-interest period expires - often 16 to 18 percent. They also typically charge an up-front fee of several percent of the amount borrowed, so you need to take that into account as well. So proceed with caution here.

A home equity debt consolidation loan

One of the best, and most popular ways to consolidate your debt is through a home equity loan. You not only get one of the best interest rates available, but you can also stretch out your payments for 15-20 years or even longer, allowing you to minimize monthly payments.

A home equity loan is a type of second mortgage that is secured by the equity (ownership) you have in your home. Because it's a secured loan, you can get a better interest rate than you generally can on a personal loan or other unsecured loan. And because it's a type of mortgage, you may be able to deduct the interest payments on your federal tax return.

To qualify, you'll have to have fairly decent credit - mid-600s or above, perhaps 700 for some lenders - and a fair amount of equity in your home. Lenders will likely want you to still have at least 10-20 percent equity after taking out the loan.

Home equity loans come in two major types a standard home equity loan and a home equity line of credit (HELOC). The standard home equity loan is the most commonly used for debt consolidation because you borrow a single lump sum of cash, whatever you need to pay off your debts, and then pay it off over a period of years at a fixed interest rate.

There are some situations though, where a HELOC might be a more attractive option. A HELOC sets a certain amount you can borrow, called a line of credit, and you can draw upon at any time and in any amounts you wish. This makes them useful for situations where you need money for periodic expenditures, such as home improvement projects, but there's nothing to stop you from simply making a one-time draw to consolidate your debts.

There are a couple reasons you might opt for a HELOC debt-consolidation loan rather than a standard home equity loan. First, there are little or no origination fees with a HELOC. HELOC also are usually set up as interest-only loans during the "draw" period when you can borrow money before starting to pay it back, often 10 years - which can be helpful if you're experiencing temporary financial problems. On the other hand, HELOCs usually have adjustable interest rates, which can make them unpredictable and making interest-only payments greatly increases your out-of-pocket costs over time.

Reverse mortgages and cash-out refinancing

There are two other home equity options you might consider. Persons age 62 and older might opt for a reverse mortgage, a type of home equity loan that does not have to be repaid as long as you reside in the home. Fees and long-term interest costs can be steep, however.

The other possibility is to do a cash-out refinance, where you refinance your current mortgage and borrow against your home equity as part of the process. You receive a sum of money at closing and the balance owed on the new loan will be higher than you owed on the old one. This can make sense if you're paying a higher interest on your current mortgage than you could get by refinancing. However, the origination fees will be much higher than on a standard home equity loan.

With any home equity loan, the big downside to keep in mind is that you're putting your home at risk, because that's what you're using to back the loan. If you fail to make the payments, you could lose your home, even if you remain current on your primary mortgage. So it's important to keep that in mind before proceeding.

Debt consolidation services

Another way people seek to consolidate their debts is through a debt consolidation service. These services are available in most cities across the nation. They provide relief from the stresses of debt - large monthly payments, high interest rates, and the harassment of creditors.

The way debt consolidation services work is they essentially give you a loan to pay off your other debts. However, rather than giving the money directly to you, they'll typically pay your bills off for you once you've signed the agreement. This is often described as "buying" your debt.

While you may be able to get a lower interest rate through a debt consolidation service than you're currently paying on your credit cards or other bills, the main way they reduce your monthly payments is by stretching out your term, the time it takes to pay the loan off.

While this can provide some relief for your monthly budget, it also means you end up paying more in interest over the long term. This can be true even if you're getting a lower rate, simply because you're paying interest over a longer period of time. You'll probably have to pay an additional fee up front as well. As a result, using a debt consolidation services will usually cost you more money over the long term than simply continuing to pay your bills, even though your monthly payments may be reduced.

Debt management and settlement

It's important not to confuse debt consolidation with debt management or debt settlement, even though some companies offering the latter two will advertise themselves as debt consolidation services. In reality, they're quite different.

With debt management, a company helps you get a handle on your debts, but doesn't provide financing to lump them all into a single bill. Rather, you make a series of agreed-upon monthly payments to the company, which then makes your bill payments for you. The debt management service may also seek to negotiate with your various creditors to arrange lower interest rates or monthly payments on your behalf.

As part of the process, you take part in debt or credit counseling, which helps you look at your spending patterns and get your spending habits under control. It will help you identify regular expenditures you can reduce or eliminate as part of a long-term plan toward paying off your debts and living within a budget. It can also include help with rebuilding your credit if you have fallen behind on your bills and have a poor credit rating as a result.

About debt settlement

Debt settlement, on the other hand, is where a company negotiates on your behalf in an effort to get your creditors to accept a reduced amount in return for paying off the debt. This often involves the creditor agreeing to forgive some or all of the interest charges and penalties that have accumulated on a past-due debt.

Debt settlement can be risky. It usually involves a debtor depositing a set amount into a designated account every month for several years, while ceasing to pay their bills. Meanwhile, the settlement company attempts to reach a negotiated settlement with creditors. If those efforts are successful, the funds in the account are eventually used to settle the debts.

However, there's no guarantee those negotiations will be successful - your creditors may still insist on full payment. Also, your credit is going to take a pretty serious hit, if it hasn't already - the failure to make timely payments on bills will be reported to the credit scoring agencies and even if you do obtain a negotiated settlement, that will still go on your credit record as a debt settled for less than the full amount - which is another black mark.

Debt settlement is also an area where you may encounter scam artists, who promise to settle your debts but merely end up pocketing the money you deposit in the special account. Be wary of any companies that guarantee they can settle your debt for a fraction of what you owe, that charge steep fees up front, that try to get you to commit to a debt settlement plan before thoroughly reviewing your finances with you or ask you to make payments into a special account before your creditors have agreed to accept a settlement.

Finding the right service

Finding a reliable service to help you consolidate, manage or settle debt can be a challenge. One of the first things you can try is checking with your own financial institution or state or local consumer protection agency for the names of legitimate services.

Reputable debt service companies will often be registered with eitherThe Association of Independent Consumer Credit Counseling Agencies or The National Foundation of Credit Counseling, or perhaps both. You can also check with the Better Business Bureau to see if a company is listed and what, if any, complaints may have been made about them.

Non-profit agencies often provide credit counseling and other debt services, but you can't assume a company is truly a nonprofit just because they say so. Some may still charge high fees that enrich the operators or pressure clients for further "donations" that put them deeper in debt. Ask to see their 501(c)3 certificate to determine if they really are a nonprofit. Be careful of companies that prominently advertise a link with a certain religion or public agency; check to make sure there's an actual affiliation.

A word of caution

One final warning. Loan consolidation won't help you unless you get your finances in order and correct the spending habits that got you into debt in the first place. Too often, consumers use loan consolidation arrangements to free up their finances in order to continue spending as they have been. Instead of helping them get out of debt, a loan consolidation only lets them get in deeper.

In that respect, loan consolidation can be an attractive trap. That's why credit counseling or financial planning is a key part of loan consolidation. Unless you can learn to live on a budget and not spend more than you're taking in, loan consolidation will only postpone the inevitable reckoning.

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