Debt Consolidation 101

Debt-consolidation

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Debt consolidation can be a good option for consumers who are having difficulty making the minimum monthly payments on their bills.

America is a nation of debt. According to a recent NPR story, “Americans carry about $784 billion in credit card debt and they owe $1.34 trillion on student loans.”

Credit cards arrive in our mailboxes all the time, no qualifications necessary. We are bombarded by commercials at all hours of the day and night for expensive cars, electronics and clothes we are made to feel we need to have. It can be hard to resist, especially for college students. These newbie adults, who only months earlier were eating fish sticks off foam lunch trays and asking permission to use the bathroom, suddenly have a $5,000 line of credit. Never mind that they don’t even have jobs. That gray piece of plastic with their name embossed at the bottom can be more intoxicating and destructive than a full bottle of Oxycontin with a dozen refills.

Add this to the tens of thousands of dollars in tuition loans many students rack up, and it’s easy to see how any graduate who isn’t working as a divorce lawyer can feel like they’re drowning in debt.

Filing for bankruptcy is an option, but that doesn’t wipe out student loans, only credit card debt, and possibly not even that. Plus, even if you are successful in bankruptcy court, your life will still be significantly disrupted, and the record of your filing will be visible for seven years to anyone who looks.

For this reason, many people who are drowning in debt turn to debt consolidation.

What Is Debt Consolidation?

Credit comes with varying interest rates. The current rate for mortgages is about 4 percent, and auto loans are about the same. Student loans are usually 5 to 7 percent. Credit cards, on the other hand, can carry an interest rate of up to 25 percent. As high as this is, it doesn’t violate U.S. usury laws. According to Credit Karma’s debt repayment calculator, paying a monthly installment of $336 on a debt of $16,000 (the average American household’s credit card debt amount, according to Time) at 25 percent interest would take almost 20 years to pay off. The total in principal paid would be $16,150, and the total interest would be $62,810.

At this rate, many people will not live long enough to pay their debts. And this is assuming they don’t charge anything else on their cards that they can’t pay for that month.

Debt consolidation allows you to group all your debts and make one payment on them each month. This is helpful because:

  • You can get a more favorable interest rate, lowering the total amount of your debt.
  • Your monthly payment will be lower and thus easier to manage.
  • The chances of you forgetting to make a payment and having to pay a late fee are greatly reduced, since you only have one check to write per month.
Debt consolidation work
Is it time to end your credit card spending?

What Route Should You Take with Debt Consolidation?

Beware of credit cards advertised at 0 percent interest. While you could theoretically transfer your balances to a card like this and save money, you would have to pay off the entire balance quickly to come out ahead, and this is probably not realistic. Cards like this frequently charge an even higher interest rate once the 0 percent period has passed. This is how some cards recoup the losses incurred when lending money with no interest. You can win this game if you are expecting to come into a sizable sum of money before your interest rate spikes, but otherwise, let this “opportunity” go.

If you aren’t going to finance your debt consolidation with another credit card, your other option is to take a loan. Rates for a personal loan depend on your credit score, so if you’ve already missed payments or have other blots on your credit report, this route may not save you money.

On the other hand, if your credit is clean, you may be able to get a personal loan for under 5 percent. Just make sure the interest rates you’re paying now are higher than this; otherwise, this move wouldn’t make sense.

If you have a 401(k) account, you could also borrow money from this to pay your debts. This strategy is favored by many because even though you pay interest on the loan, you pay it to yourself (into your account).

Besides paying off a debt with a high interest rate, this method is sometimes used to finance a down payment on a home in order to avoid high private mortgage insurance rates, which are usually applied to borrowers who put little down, to protect the lender.

Why Do You Need Debt Consolidation?

An important consideration in the debt consolidation process is how you got to the point at which you needed it. Being mired in debt has many legitimate causes. Consider the following scenarios:

  • You went to an Ivy-League school and got a degree in philosophy and now your $300-a-month student-loan payments are hard to swing on your Costco cashier salary.
  • You bought a new car and totaled it in an accident that was ruled your fault and now you’re paying $500 a month for 72 months for a car you don’t have, and you don’t have any way to get to work.
  • You were injured in an accident and were left unable to work for a period of time, and the bills stacked up.
  • You were a victim of identity theft two years ago and you’re still fighting the erroneous charges.

There’s one more big reason people get into debt, however, and it’s overspending. It can be hard to live within your means, to deny yourself the fun, flashy toys that others have. But this lifestyle will catch up with you eventually, and it won’t be pretty.

If the reason you are overwhelmed with debt is that you bought a house or car that you couldn’t afford to make the monthly payments on, it’s time to face reality, sell them and get something you can afford. If the reason is that shopping online and getting boxes in the mail cheers you up, or because you eat out five times a week at expensive restaurants, it’s time to exercise some restraint. This is easier said than done, however. Like a diet, it’s a life adjustment, it’s hard and it takes time. Your local consumer credit counseling office can offer advice and support.

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