Understanding debt consolidation and settlement options
If you carry multiple debts, it can be cumbersome to pay those bills each month. Plus, many of those debts, especially credit cards, can carry high-interest rates. For some, even the minimum payments consume too much of their income.
One way to make your unsecured debt more manageable and potentially lower the amount of interest you pay each month is through debt consolidation.
Debt consolidation combines several unsecured debts, such as credit cards, medical bills, and personal loans, into one bill with a single monthly payment. In addition to turning multiple bills into a single monthly payment, debt consolidation also typically reduces the rate of interest paid and the total amount required each month to satisfy those debts.
The downside of debt consolidation is that debt is usually stretched out over a longer period. Debt that could be paid off in, say, five years under the pre-consolidation terms, might be stretched to 10 years. This means the total amount of finance charges will be more than if the debt wasn’t consolidated.
Critics of debt consolidation also say that it does little to discourage the financial habits that caused the debt. Having lower monthly payments may actually encourage more spending.
There are two major types of debt consolidation:
Debt consolidation loan. A debt consolidation loan allows you to borrow from one lender to pay off multiple creditors. There are several ways to do this, including personal loans, home equity loans, or transferring the debt to a single credit card with a lower interest. A debt consolidation loan should have a fixed interest rate that is lower than what you were paying, which reduces your monthly payments.
In fact, if you have a decent credit score, some banks and credit unions will offer zero-percent interest for an initial period, typically a year. But be wary because the rates will climb to double-digits after that initial period.
Debt consolidation loans are a popular way to bundle multiple bills into one payment that makes it easier to track your finances. One of the downsides is that you will likely face a longer repayment period before you finish paying off the debt.
Debt management plan. A debt management plan is typically administered by a non-profit agency. The process includes a credit counseling session to determine what you can afford to pay toward debt each month.
You send your payment to the agency, and they then split the money amongst your creditors. The benefits of this option is paying a lower interest rate, having an agency deal with your creditors, having late fees reduced and ultimately being debt-free in three to five years.
The agencies who offer this service typically have preset arrangements with most financial institutions, many of which lower interest rates and fees. This allows more of your payment to reduce your debt balance rather than paying finance charges.
Typically under these arrangements, you will not be allowed to use a credit card, borrow money or buy anything on credit until your debt is paid in full, unless it’s an emergency.
Another potential negative of these plans is that lenders may perceive them negatively because it means you need help paying your bills. Some even go as far as to treat it like bankruptcy, even though you’re committing to paying off your debts. Your debt management plan won’t affect your credit score, but it will be reflected on your credit report for seven years.
In addition to debt consolidation, another option to deal with unmanageable debt is through a debt settlement plan.
Under these plans, you and your creditor(s) agree to settle your debts for less than you owe. An agreement is typically brokered by a settlement company that charges a fee to the debtor.
The main advantage of a debt settlement plan is that you will be out of debt much sooner than if you opt for debt management or a consolidation loan. That’s because you’re essentially reducing your total debt instead of stretching it out. Some settlements can cut your debt by up to 50 percent of what you owe.
On the downside, debt settlement will negatively affect your credit score for several years because creditors will report the debt as settled for less than agreed to the credit bureaus. Also, many of the companies claiming to work in this area use unscrupulous practices, which may make your situation worse than it was. Make sure if you opt for a debt settlement plan that you research companies before signing an agreement.