Debt consolidation might seem like the golden path to putting your debt problems behind you. But consolidating your debt can mean many different things with several implications, so you must be sure you’re following the best option for your personal case before signing on to any plan.
Before jumping into any consolidation plan, use these questions to determine if it’s the right step for you.
Can you use another method to pay off your debt?
Even if you’re being crushed under a mound of debt, consolidation isn’t the only option to get out of a big hole. Sometimes dealing with debts separately is the most simple and effective option.
If you’re frustrated by the number of different creditors you’re fielding phone calls from, consider taking on the debt snowball approach to paying off each account.
Simply order your debts in order of increasing principal balance and start by paying off the lowest balance completely while paying only the minimum on all other accounts. Then keep moving down the line in order of increasing balances. You may accrue more in interest using this plan, but it can be a big psychological help if you’re having trouble coping with many different accounts and collectors.
Of course, you can always go with the money-saving option of paying off debt starting with the highest interest rate. Follow the same process as the debt snowball, but order your accounts from highest to lowest interest rates and start paying from there.
No matter what you choose, stick to a system and take the guesswork out to make sure you’re handling the situation as efficiently as possible.
Is your debt unsecured?
When you’re thinking about consolidating your debt, your options–and the pros and cons–vary depending on the source.
If your debt is from a credit card, student loans, or medical bills, it’s most likely unsecured debt. This means that you did not need to sign over collateral to back up the debt. This can be advantageous since you’re not risking other assets in the case that you default on your loans.
If you have these unsecured debts, be careful to understand the risks if you convert to secured debt, like a home equity line of credit (HELOC). A HELOC typically takes your house as collateral, so if you stop paying your consolidated loan, you could lose your home or be sued by your creditor.
If you have student loans that are backed by the federal government, you’ll have your own set of options for consolidating these loans. You can combine these loans and get an interest rate that’s a weighted average of all the loans. You won’t save any money since interest rates are simply an average, but managing your loans can be easier.
Have you tried credit counseling first?
Speaking with a credit counselor doesn’t mean you must consolidate your debt. In fact, you might be able to work with a credit counselor to discuss alternative options that might be a better fit for you. Credit counselors will go over your specific case and provide personalized recommendations on how to proceed with your debt.
An alternative counselors may recommend is a debt management plan. With these plans, you don’t have to consolidate your loans into a secured loan like you do with a HELOC. Instead, you can consult with a credit counselor that will work with your creditors to set up a plan. If your creditors agree to your plan, you’ll make deposits, at an affordable level for you, into an account, with the payments then being distributed to your debt holders.
If you’re not able to get on a debt management plan, you may consider trying debt settlement. This means that you’ll pay only a certain fraction of what you actually owe because you can’t afford to pay the whole amount back. While you won’t have to pay your whole debt, your credit will take a hit. Plus, it’s always possible that your creditors won’t agree to this plan.
You must also proceed with caution as there are many companies out there that may promise something a deal that’s too good to be true.
Finally, bankruptcy might be seen as a last resort. While it might not be preferable or possible in all cases, it may be the right choice in certain situations. This is an option that you must discuss with a credit counselor before you’re able to file for bankruptcy in court.
If you’re considering any of these options, read over the Federal Trade Commission’s detailed guide to dealing with debt for a better understanding of your choices.
Are you getting a better deal?
Consolidating loans may reduce your payments up front. But realize that you’re often extending the term of your loan, meaning that you’ll be paying more money in the long run. If you feel you have no other options, this still might be better than defaulting.
To further ensure it makes financial sense, lock in a competitive interest rate. It can be confusing to understand what rate you’re actually paying, especially when advertisements might display lower rates than you’re actually able to qualify for. Make sure to ask all the questions before signing up for a loan you don’t understand the terms of.
Are you sure it will solve your problems?
Don’t forget that finding a way to deal with your debt now doesn’t mean debt won’t ever be a problem again. Without making changes to how you manage your money, it’s possible that poor financial decisions you made in the past resulted in some of the debt that you ended up with.
It’s time to start thinking about how you ended up in debt in the past and how to correct it going forward. This could include gaining a better understanding of how credit works, setting up a budgeting plan, and creating an emergency fund for unexpected situations.