This article is an overview of how debt consolidation works and based on this, we'll talk about how you can tell if the consolidation is a good idea for you. But before we start, I would like to clarify that those regulations and services vary from country to country.
And if the situation varies from country to country, imagine how it varies from person to person! Therefore, I prefer to give you guidance in making your own decisions, instead of just saying: "do agree" or "do not agree".
How does debt consolidation work?
The concept is really simple: imagine you have three debts (A, B, and C). You have trouble paying them off, so that a financial institution (a bank, for example) offers a new loan (D) - theoretically with better payment terms - to settle your debts A, B, and C. Now, you only have to pay D.
Another type of consolidation is when the financial institution negotiates on your behalf with your original creditors to make reductions in interest rates. You agree to pay a certain amount periodically to such entity and they are responsible to paying off your debt to your original creditor. You usually have to pay a commission fee for each payment.
How do I know whether to consolidate?
To answer this, let's start with a brief analysis of what those involved in the process win or loss. Keep in mind that any lender gives you money now in exchange for more money later. What you have to pay extra are the interest fees.
What gain or lose your current creditors?
In general, lenders prefer constant cash flows for a certain amount of time (the term of a loan), to holding lot of money at a given moment. This is because the former involves more interest.
If your debts A, B, and C are credit card debts, when you settle all of them to a single one - the interest in long term is reduced.
What win or lose the entities that offer consolidation?
Usually what such organizations offer for "uninsured" debts - is that you pay less each month than you'd have to pay for your debts separately.
In other circumstances, those entities may offer a "secured" loan (against a guarantee like a house, a car, etc.). This allows the bank to reduce the risk of no payment if you haven't already paid. Thus you can be offered better interest rates.
It is very important to make clear clear which type of consolidation you need. The more complicated getting the loan seems, the more attention you have to pay.
What will you win or lose?
The answer is simple: you win a simplification in your debts management. The more debts you have, the more the advantages: you no longer have to worry about 3, 4, or 5 debts but a big single one.
Easiness to cover the minimum payments. They are smaller than the minimum amounts you have to pay off for your debts separately.
Of course, these benefits come at a price:
A debt with a higher payment or at higher interest rate.
The possibility of losing collaterals if you can't afford to pay.
So, assuming that your debts will not increase while you are paying off, you must:
Calculate the total cost of your debts separately. Remember to take into account memberships and any other extra costs associated with your debts.
Calculate the total cost of the consolidation. Find out any extra costs or hidden fees that you must pay. It is important, imperative, essential, to perfectly understand the debt consolidation contract. If you don't, it's like you want to double your money in a casino to pay off your debts. Well, in the casino you'd probably have more fun.
Take into account whether the interest rate you're being offered to consolidate credit card debt is fixed or variable. You must find out whether it will rise or fall and under which conditions. What if you pay earlier? Is it possible to lower the interest rate if you pay earlier?
As you can see... it's not easy. Precisely for this reason, there are many horror stories of people who consolidated their debts and finally it did prove to be what they expected.
First use your judgment to evaluate your options. Do not rely on the promises such as: "REDUCE PAYMENTS TO 50%" or "PAY ALL YOUR DEBTS WITH ZERO INTEREST RATE". It is likely to go by promises of easy and quick solutions that actually put you into even a higher debt. Always read the contract and understand it. Call professional help if you have no experience with contracts.