The debt consolidation process can save you money on interest and help get your credit back on track
Up to this point on the blog, I’ve talked about how to save on everything from vacations to homemade cleaning products. The Frugal Grandma wasn’t always so good with her money though, there was a point when I spent way more than I earned.
Sometimes all the money saving tips can’t keep you from that impulse shopping binge that throws your financial life into chaos. When that happens, the debt consolidation process might be your best way back from the brink.
So you backslide a little on your finances. Even your Frugal Grandma has had a lapse or two in the past. There is help though to get you back on track if you stray too far.
Your answer, and the way back on track, may be found in the debt consolidation process.
What is Debt Consolidation?
Loan consolidation is taking out one big loan to pay off all your smaller ones. You might include your car payments in this if the loan is fairly small but you usually don’t include your mortgage. The consolidation loan is usually done either through a third-party credit counseling agency or the do-it-yourself system through a peer loan.
I know, it seems weird that taking out another loan would help you get your finances back on track but it does work. I know first-hand how the debt consolidation process works and how it can help boost your credit score.
Debt consolidation through a peer loan is the easier path but doesn’t include the counseling service that some people may need. You just apply for a loan on one of the peer lending platforms and then pay off your individual debt. We’ve talked about how to get a peer loan on the site, even for those with bad credit.
Peer lenders are still requiring pretty high FICO credit scores, usually above 640, so an alternative is a personal loan through PersonalLoans.com if your credit score is lower. PersonalLoans doesn’t charge an origination fee, which can be as high as 5% even on the peer loan sites, and accepts borrowers with credit scores as low as 580 FICO.
Some financial guru´s shun the debt consolidation process because they say it is a salve over a wound but not a cure. Consolidating your debt may put a little extra money in your pocket at the end of the month since you’re making one payment instead of many, but you still need to manage your money.
Use your debt consolidation as a tool to get back on your feet and not as a way to spend more.
Importance of Debt Consolidation
Quite a few people carry high-interest personal credit card balances. For some, these often reach hundreds of thousands of dollars, more than many have in their savings accounts. If the interest rate on your debt is higher than what you can earn from investments or loans, paying off the debt will be nearly impossible.
In this case, you need a consolidation program that will combine all your debts into one monthly payment. In fact, if you don't have a low-interest loan at your disposal, finance charges might swallow up most or all of your balance before paying off any of it.
Debt consolidation, unlike debt settlement, is a good option if you have a steady income and can make the monthly payments without too much trouble. The theory behind this strategy is that by paying down multiple high-interest debts with just one loan, you'll reduce the total interest paid over time. So it's essential to find an interest rate that's lower than what your other creditors are charging.
Many people who consolidate loans take out credit lines at their local bank or through credit unions. But before signing up for a new loan, talk to your current lenders and ask them if they would consider lowering your rates so you could refinance the entire balance into one account.
When consolidating your debt, make sure the lender is trustworthy and can provide detailed information about interest rates and fees. Look for a company that offers flexible repayment terms and will work with you to create a plan to pay off your balance as quickly as possible . Some creditors may even allow you to re-finance again when you're ready, getting rid of your debt once and for all.
Don't let your debts get out of control by taking out another loan. Instead, consolidate what you owe for lower interest rates and a better financial future.
The Debt Consolidation Process Explained
After you’ve decided where to go for your debt consolidation loan, it’s time to start the process.
I’ll run through the process with a credit counselor here but understand that you can do all this yourself, save months of counseling and get it all done in less than a week online.
You’ll need to put together your spending over the last three months to see where the money is going. A debt counselor will help you see where you can cut your spending to avoid overspending in the future.
Next, the debt manager will ask for your credit cards and he will have a very large set of scissors. It only hurts for a moment. Don’t try keeping any cards out, not even a small department store card. The credit counselor will probably find it through your credit report and you may not get the loan.
You'll be left with one emergency card. This will be used for that emergency car repair or for hospital visits. You and the debt manager together will attempt to work out all your debts so everything can be paid in one payment. Your counselor is going to find a way to pay all your debts within three to five years.
This is the biggest disagreement I have with credit counselors. They’ll tell you to totally avoid debt and to absolutely not use any credit cards except in case of emergencies. Using credit is the only way to improve your credit so neglecting it completely isn’t going to help.
You might pay off your debts eventually but your credit score will still be crappy and you’ll pay high rates on any loans you need. Use your credit card each month, only for necessities and pay it off monthly to avoid interest charges, and you’ll start improving your credit score.
Besides getting the credit counseling that will help avoid repeating your bad credit habits, debt consolidation also offers the opportunity to negotiate a lower rate and debt. Your creditors don't want to force you into bankruptcy where you might not pay them anything. Your credit counselor is going to try negotiating with your creditors for a lower interest rate and maybe even to lower the amount owed. The debt consolidation process will cost between 3% and 5% of the loan amount but the benefits usually outweigh the costs.
The debt consolidation process can take several months if you work through an agency but you’ll save money in the long-run. You save on paying interest on negotiated debt, late fees and all the individual fees you might have to pay. You sleep better because you’re not trying to juggle bills in your head. Getting a personal loan to consolidate your debts will take less than a week and may be a better solution for someone that doesn’t need the debt counseling.
Debt Consolidation Example
Consolidating your debt can be really easy but I thought I’d give you an example. We had some emergency expenses back in 2003 when the car decided to clunk out and the furnace stopped working all at the same time. The easiest thing to do was to put both on our credit cards but we didn’t realize the trouble we were looking at down the road.
When the monthly statements started coming in, it was obvious we weren’t going to be able to make the bills. The interest rate on our credit cards was as high as 24% and that was making the monthly payment hundreds of dollars.
So we took out a debt consolidation loan, one loan of $18,000 to pay off all the credit cards. We used an online lending site so it only took about five minutes to fill out the application and we had the money in our bank within four days. The consolidation loan had an interest rate of 14% and monthly payments over five years. That meant the payment was going to be over $100 less than the payments we were looking at on all our cards.
We wrote checks to pay off the credit cards and cut them up so we wouldn’t be tempted to use them again.
We’ve used PersonalLoans.com for consolidation but there are a few other websites you can try to check your rates. For good credit borrowers, SoFi usually offers the lowest rates but you’ll need a higher credit score. For really bad credit, there’s badcreditloans.com which can accept borrowers with the lowest FICO scores.
What Debt Can Be Consolidated?
Any debt can be consolidated but there are some rules you want to follow to save as much money as possible. A consolidation loan is really just a personal loan, which means you get the money deposited into your bank account and can use it for whatever you want.
When you’re deciding which debt to consolidate, plan on paying off the highest interest rate debt first. That usually means those credit cards and maybe the car loan.
You also want to check your rate on the consolidation loan before making the final decision. Checking your rate doesn’t affect your credit score so you can check it on a few different websites to see which gives you the best offer.
Once you know what rate you can get on a debt consolidation loan, you can decide which other debts to pay off. You’ll only want to consolidate loans with a higher interest rate than your consolidation loan. That’s how you save money, by borrowing at a lower rate to pay off high-rate debt.
Debt Consolidation vs Debt Settlement
Debt consolidation is NOT debt settlement and the difference is more important than you might think.
Debt settlement is where you work with a settlement company to negotiate payments with your creditors. Debt settlement companies can sometimes get creditors to knock off thousands from the debt you owe but there’s a catch.
For debt settlement to work, you’ll have to stop paying your bills for months. That gives the debt settlement company negotiating power over the creditors. It also destroys your credit score though and you’ll have trouble getting any loans for years afterwards. You’ll also be on the hook for thousands of dollars in fees to the debt settlement company. In fact, sometimes the fees are so high, you’re really not saving that much on your debt.
Is it a good idea to consolidate your debt?
Our debt consolidation loan was the only way we could have avoided bankruptcy. Are the interest rates high, yes. Is it just trading old debt for new, yes…but interest rates are almost always lower than credit card rates and that means you’ll save money.
Look, I would say just don’t get into debt in the first place but we all know that isn’t going to happen. Sometimes expenses just come up and you have to put them on high-interest credit cards. Unless you want to be paying on those cards for years and losing thousands to interest payments, consolidation is your best option.
Can I do debt consolidation myself?
The best part about a consolidation loan is that it’s so easy. You just apply online with PersonalLoans.com or one of the peer-to-peer lenders. You get the money deposited in your account and then write a check to pay off your debts.
There’s no middleman or debt company in between ‘helping’ you out and charging thousands in fees. You can manage the entire consolidation process yourself in less than a week.
Do debt consolidation loans hurt your credit?
Actually debt consolidation can help your credit. Applying for a loan doesn’t affect your credit score because the lenders do a soft-pull on your credit. You might notice a small drop in your credit after getting the loan because you have more debt on your credit report.
Once you start paying off those other debts and credit cards though, you’ll notice your credit score increasing within a month or two. Better still is that with those monthly payments on the consolidation loan, you’ll be building a good credit history and increase your score over time.
Using the Debt Consolidation Process for Financial Freedom
Once you’ve consolidated your loans, your payment is fixed for the next three or five years. Keep to your spending program and check in with your credit counselor if you feel like you’re falling from the path. Your credit report will reflect that you’re making payments through a third-party credit agency and some creditors may think twice about giving you new credit, which is probably a good thing anyway.
You won’t have this problem if you just go the personal loan route to pay off your debts. Creditors will see that you paid off all your previous debts and are making payments on a single loan.
Used correctly and debt consolidation can save you big money. The graph below shows a hypothetical situation starting from $25,000 in debt on a 21% interest rate and payments over ten years. A debt consolidation that can reduce the debt to $20,000 and get your rate down to 13% can end up saving you almost $60,000 over ten years.
This is where you really have to make a commitment to a better financial future. Are you committed to your long-term financial goals? Do you want to kick the paycheck-to-paycheck curse and eventually have the freedom to go on vacations and relax in retirement?
Are you ready to take this step? The debt consolidation process isn’t an easy solution but it can be a great tool to get back on track to meeting your financial goals. Only you can decide if you’re ready to commit to the process but I promise you’ll be so happy when you do.
Read the Entire Debt Consolidation Series
- 4 Steps I Used to Negotiate Debt and Save $6,500
- 12 Best Books about Debt Relief and Credit Repair
- Should You Use Debt Consolidation to Pay off Debt?
- Should You Pay Off Debt or Build Emergency Fund First?
- Payoff Review for Debt Consolidation Loans [No Hidden Fees]