Debt Consolidation Explained

Debt consolidation is often presented as a saving grace for an overburdened consumer. The thought of replacing numerous high-interest debts with a single low payment can appear too good to be true. Unfortunately, that's often the case. Too often, people will jump at the chance to consolidate their debt without fully understanding the situation.

Secured vs. Unsecured

Unsecured debt is the most common factor in seeking consolidation. Secured debt is backed by collateral such as real estate or other assets. The higher your debt, the more difficult it will be to obtain unsecured consolidation such as a personal loan. If you have equity in your home, you may be able to refinance your mortgage or apply for a home equity loan. There are two downsides to this method. First, it may be difficult to get approved if you credit has suffered as a result of your debt. Second, you will be decreasing the equity in your home. However, this may be a small price to pay, especially if you are overwhelmed with debt.

Payments

The primary draw of debt consolidation is converting many payments into one. Ideally, the payment will be lower than the combined sum of all current payments. Alternatively, those who can afford it may opt for higher payments. This will pay off the consolidated debt quicker. An individual contemplating debt consolidation should read all terms and conditions of the deal. If he is basing his decision to consolidate on the lower fixed payment, he should ensure that the payment remains fixed. If he is raising his payment to eliminate debt faster, he should ascertain how much of the payment reduces principal and how much is allotted for fees and interest.

Interest

Another major draw of debt consolidation is combining multiple high-interest debts into a single low-interest obligation. If an individual chooses to go this route, he must carefully read all documentation pertaining to the rate. Many rates start low, but, if not paid off by a certain time, can shoot up past the original rates. This is especially prevalent with balance transfers. A consumer may receive 0 percent interest for 18 months on balance transfers. At the end of that period, however, the rate will increase, usually to a rate higher than the standard purchase annual percentage rate (APR). For example, a card may charge 13.99 percent for purchases, but 24.99 percent on balance transfers after the promotion ends. Know what you are getting into or you may end up worse off than before.

Outside Agencies

Toward the end of first decade of the 2000s, the United States was in a deep recession and debt consolidation agencies began springing up. Their claims sound good. Hire them and they will negotiate with your creditors to reduce your payments, interest and even principal balance. In return, you make your payments directly to them and they remit the funds to your creditors. What they do not tell you is that they charge a fee for this service, which is lumped into your monthly payment. Additionally, the principal reduction they promise is not guaranteed. Ultimately that decision lies with the creditors themselves. Always research a debt settlement agency thoroughly and only do business with it as a last resort.