What is debt consolidation and should you do it?

Debt consolidation is often thought of when a person or business struggles with managing multiple debts. It can seem simple to take several payments and make your life easier by rolling all your debts into one payment. This blog post will break down what debt consolidation is, whether or not it is a good move for your credit, and how it may impact your life. 

First, let's talk about what debt consolidation loans are. When using debt consolidation, there are a few approaches. 

1. Taking more than one debt and rolling it with another or several others into a new line of credit 

2. Borrowing more against an existing line of credit to pay off a debt. (typically through a home equity loan, a 401k loan, or a balance transfer) 

3. Moving debts to a new line of credit to take advantage of a promotional interest rate situation. 

What is the process for debt consolidation?

When a person looks to consolidate their debts, they will go to a lender or credit card company and fill out an application. Next, they will provide a slew of documentation to show their finances, confirm their identity, cover their debts, and other details. After this, the lender will evaluate how much risk there will be in lending to you by looking at your credit score, debt to income ratio, employment history, etc. Lastly, if you are approved for consolidation, the company will either pay off your debts directly; other times, they will cut you a check for you to go ahead and pay off your debts yourself. 

Debt settlement and debt consolidation are not one and the same. 

Debt consolidation is essentially moving one debt vehicle to another. Debt settlement is when you hire a company to go to your lenders and get them to agree to accept less than you owe. 

I was stupid enough way back in the day before learning a better way to believe that this was a good way to get out of debt. When I was on maternity leave, with my oldest son and my income was less than expected I was grasping at straws to try to stay ahead of my bills. Want to know what I learned?

1. These companies are super expensive and charge you about a fourth of your total debt to work out a plan for you.

2. They rarely tell you that their common approach to get the lender to agree to settle your debt for less is to simply not pay your debts.

3. Let's say that you owe $40,000 in debt, and they settle that for $20,000. You pay the $20,000 to get out of the debt feeling like you won, except they fail to tell you that the lender still wants late fees and interest charges paid and you are still expected to pay that.

4. As you can imagine this destroys your credit but when a mortgage lender reviews your information it sets a precedent that you are someone that can't be trusted to repay debts that are owed.

5. If you smartly decide that their plan is not in your best interest and want to get out of their clutches, it is harder than getting dried blood-red nail polish out of a white shag carpet.

Keep in mind that it is a violation of rules set by the Federal Trade Commission if they charge you prior to settling or reducing your debts. 

Debt consolidation has an interesting history. 

• 2001- debt consolidation became popular as interest rates hit drastic lows.

• February 8th, 2006, The Higher Education Reconciliation Act of 2005 (HERA) was signed.

1. This act changed options to borrowers of federal loans on how they could be consolidated. Before HERA was signed, a borrower was only allowed to consolidate with one lender rather than having options.

2. A borrower could no longer consolidate a loan while enrolled in school.

3. Couples could no longer group all of their loans into one joint consolidation. As you can imagine, this was great news. The number of complications that can arise when a couple separates is much worse if they share a loan with a former partner.

4. Variable interest rates were replaced with fixed rates for non-consolidated Direct, PLUS, and Stafford loans.
   
   

When should you consolidate, and when should you not?

• Credit card balance transfer- typically, this will not benefit you as they often include fees and can see huge spikes in interest rates with late payments.

• Debt Consolidation Loans- These companies can offer lower payments or lower interest rates because they extend the loan term to keep you in debt longer, so these are not beneficial in most instances.

• Home Equity Line of Credit (HELOC)- Almost anyone you ask would agree that the last thing you want to put at risk of losing is the roof over your head. A HELOC is taking that home and giving away a portion that is yours to the bank for the sake of something you can't or couldn't afford to pay for outright. One of the most valuable components of your overall financial picture is owning your home; borrowing against your home is going in the wrong direction.

• Student Loan Consolidation- this one is often an excellent area to review and see what your options are regarding lower interest rates, provided that the new interest rate is fixed at that lower amount. Be careful not to move to a consolidation that solely pushes out your loan term to lower your payment or a loan option that has charges to consolidate. The goal is to be in debt for less time, not more.

If you shouldn't consolidate, what can you do instead?

When debt consolidation is not a wise choice, that does not mean that you are stuck. It might seem obvious that you need to work to pay off things more aggressively to get things moving in the right direction. As someone who has walked this path, I know it sounds great in theory; however, creating more space between your income and your spending is not always easy. 

Creating a budget to cut impulse spending, curb lost dollars, and be more intentional with the money you have will help. Often when I say this, you think that creating a budget sounds great, but you have seen that go awry before, or perhaps you started with the best intentions and did well for a bit until the motivation dried up. The key isn't the goals or your motivation, and as soon as you know that, you are on the right track. Hands down, the most important key to hitting your financial goals is your system for getting there. 

The system that you will want to employ is a two-part plan:

1. An Everydollar Budget- is a budget plan set up to assign every dollar of your income to a specific place.

2. The Debt Snowball method- is a repayment plan that works on paying one debt at a time and minimums on everything else until the debt is repaid, going from smallest to largest. This may seem to some to be a bad plan because of interest rates and such. The problem is that other methods that seem to be more financially savvy are not considering that motivation wanes when you are not seeing progress. Let's imagine you were on a diet and forced to eat things for weeks or months, and you cut out pizza and cookies. (I know it sounds awful, right) Fast forward three months later, and for some reason, you did not lose a single pound, and your clothes were fitting just as poorly. I don't have to be a betting person to know that you would definitely quit. Your money is precisely the same; if you are not getting rid of debts, you will not keep cutting out the take-out.

What if you are awful at numbers, living paycheck to paycheck, or are not great at staying on a plan?

I know it can seem counterintuitive to hire a coach to walk you through your financial progress. When it comes to managing your finances people often are worried I will be judging them. I will tell you I am a recovering natural spender that has been where you are. I have struggled to stay on a plan and I have made every mistake with money that you can make. I know what it takes to overcome what you are bringing to the table and I am here to show you there is a better way. Don’t live another day worrying about your money. Set up a free no-obligation first session to see if coaching might be right for you.