| What Is Unsecured Debt Consolidation |
| By Credit Federal |
Published
03/26/2008
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Debt Consolidation
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Unsecured Debt Consolidation Defined, Pros and Cons
Which is better; or easier... Making one big payment per month, or a bunch of smaller payments that; when added up, are less than the one bigger payment?
On the surface, the one bigger payment sounds better, as well as easier. But now add up all those bigger payments and compare it to the total of all the smaller payments. What if in the long term, the one bigger payment; though less total per month, actually is a larger sum than all the smaller payments? Doesn't sound so good afterall.
Yes, it can happen. Your one bigger payment; although smaller than the sum of all the smaller payments, could cost you more if it has a longer term. For example, paying $500 per month is a lot less (per month) than paying $200 for one credit card, $300 on a second credit card, and $100 on a third credit card. In fact, the one lump $500 monthly payment is $100 less than the three smaller payments. But, the one lump $500 monthly payment is for 48 months, versus 38 months for all the little payments. That means the one lump payment of $500 per month totals $24,000, whereas the little payments total only $22,800.
Or, a different problem could occur. What if the total to be paid back is less with the debt consolidation plan, but still takes a longer payback time? Or what if the debt consolidation causes your credit score to be lowered? With a bad credit report score, you could end up paying higher interest on other lines of credit (loans and credit cards), even on existing cards and loans and could prevent you from getting new lines of credit.
Next picture this... you agree to a plan presented to you by some debt management company. After several months in the plan you apply for a new car loan but are rejected, or you get approved but at a high risk interest rate. Why? You discover that the plan was actually a type of debt settlement, which often negatively impacts credit scores. So who's to blame? If you received full disclosure, complete Terms and Conditions from the company, then you are to blame for having not read and understood them.
But what if it was a legitimate unsecured debt consolidation plan drafted for you, and the reason your credit report score was lowered was due to the re-structuring of the payment plan. Often a creditor will agree to modifying how, when, and by how much you repay the money you owe but only if you agree in return that doing so will adversely affect your credit report. Once again, did you fail to note that particular item of the Terms and Conditions? Or maybe the creditor agreed not to make a negative entry on your credit report, but your debt management company did because you failed to pay them in full; or on time, for their services? It may be best for you to restructure payment plans directly between you and the creditor to avoid any confusions and to help you fully understand the Terms and Conditions.
The variables of what could happen to you are many, and could be worse than the debit itself. So maybe its best to take the tedious approach of simply paying your bills as they currently are, at their current amounts, when they are scheduled due.
As you can see from our examples above:
- Debt consolidation may not get you out of debt any faster than normal repayment, nor save you any money nor reduce monthly payments.
- Debt consolidation is often confused with other debt solutions that are far more aggressive and potentially hazardous to your credit score.
- You might be better off consolidating debt on your own, directly between you and your creditors.
What is debt consolidation? In simple terms, when you consolidate debt you place multiple piles of debt into one huge pile. You get the convenience of one payment instead of many, but that payment won't necessarily be less than what you were previously paying. And if it is, you may find yourself paying for months or years longer than if you'd just paid under the original terms.
Here are examples of what debt consolidation is not:
Debt consolidation is not debt management or credit counseling. With debt management, a credit counseling agency reviews your finances and puts you on a repayment plan to retire your bills in three to five years. These agencies have agreements with credit card companies that can lower or eliminate your interest costs. Entering a debt management plan can have consequences for your credit scores, but if you pick a legitimate counselor affiliated with the National Foundation for Credit Counseling or the Association of Independent Consumer Credit Counseling Agencies, any impact should not be long term and should be easier to recover and improve credit scores. If you've already fallen behind on your payments and think you could get out of your hole if you could just get your interest charges reduced, a debt management plan might be a good option.
Debt consolidation is not a credit card chargeoff plan. With chargeoff, you simply stop paying on the debt. This is the worst thing; next to bankruptcy, you can do to your credit ratings. This can prevent you from getting further credit for up to 7 years, and can cause the interest rates on any existing credit to rise and will cost you high risk rates if you get approved for new credit.
Debt consolidation is also not debt negotiation or debt settlement. With negotiation and settlement, you repay dramatically less than what you owed. As with chargeoff, this can also destroy your credit rating. And, like the chargeoff, you risk being sued by your creditors if they did not agree to it.
WARNING: Debt elimination is a scam. Debt elimination companies claim you can legally erase your debt with high-priced documents you can buy from them.
Before you leap, first ask if you really need to consolidate?
If you've got a credit card with a decent rate and a high credit limit, you might consider transferring your other balances to it. Your issuer might even help by giving you a lower, promotional balance transfer rate or raising your credit limit to accommodate the extra debt.
But beware of the following:
- Your rate could change. There's no such thing as a true fixed rate with credit cards. Issuers can change terms at any time with 15 days' notice.
- You'll need to put the card away. You should be careful not to use this card for purchases until you've paid off the debt because those new charges will accrue interest at a much higher rate, and your payments will go toward paying off the low rate balances first.
- You'll need to be disciplined about paying down the debt. Revolving lines of credit such as credit cards don't force you to pay off much of your principal, so you could still be in debt decades from now. If you opt for this solution, you should make hefty payments each month, not just the minimum.
- You could damage your credit scores, which can raise the interest rates on your current lines of credit, deny you future credit, or cause you to pay high risk rates on new credit.
NOTE: FICO, your credit report score, is better (higher) if you have wide gaps between your balances and your credit limits, particularly on credit cards. Typically it's better to have small balances on a number of cards than a big balance on one card.
Other options instead of consolidating debt:
Home equity loan: Use the equity in your home for a low interest loan, and payoff credit cards starting with those that have the highest interest rate.
A 401(k) loan: Many employers allow you to borrow up to half of your retirement account balance and pay back the loan at a relatively low interest rate over five years. You're essentially paying yourself interest, rather than a lender, and the loan doesn't even show up on your credit reports, which could be good for your scores (all that debt disappears from your credit cards). But there are serious potential disadvantages. What if you lose your job? If you leave your employer, it's likely you will be required to repay any 401(k) loan in a short period of time. Any unpaid balance would be turned into a withdrawal, which means you'd pay taxes and penalties and lose all the future tax-deferred returns the money could have earned. Another drawback is an idle 401. Your retirement account funds would probably earn more over time invested in the stock and bond markets than what you're saving on interest payoffs. And you could end up deeper in debt if you continue charging.
Unsecured personal loan from your bank: Unfortunately these types of loans typically require a very good credit rating, and are only for a few thousand if you don't own a home or other security.
Summary: Don't immediately jump on the debt consolidation bandwagon. Each household has unique variables, different types of debt and needs as well as long term goals. Review all those variables carefully, as well as all your options.
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