If you're having difficulty making payments to your debt, you may feel yourself getting lured toward the promises of debt consolidation. However, before you commit to a debt consolidation loan or a debt management plan, it's vital that you understand both the risks and the benefits of such actions. While you may be able to pay off your debt at a lower interest rate or in a shorter period of time, the negative impact on your credit may not be worth the risk. You must be fully committed to repaying your debt completely so that you don't end up in an even worse financial situation further down the road.
Credit Report
The first step to resolving your debt issues is to take a look at where you currently stand by ordering your credit report. Everyone in the U.S. is entitled to one free credit report per year, as mandated by the Fair Credit Reporting Act (FCRA). You may order your complimentary credit report through the Annual Credit Report website, which is the only website that is part of the government's FCRA program (see Resources). The Federal Trade Commission warns against using any other "free credit reporting" websites, which may include add-on charges despite claiming to provide complimentary services. Once you receive your credit report, you must address any discrepancies immediately by sending a letter and documentation to the creditor and the credit reporting bureau. This is one of the fastest ways to improve your credit score, and you'll want your score as high as possible to qualify for consolidation.
Consolidation Loans
A debt consolidation loan has a significantly lower impact on your credit score than bankruptcy. A debt consolidation loan wipes out your current balances and you make one monthly payment to the loan rather than multiple payments to your accounts. When using a consolidation loan, you must provide a source of equity, such as your home. It's also important to note that a consolidation loan is a new line of credit, which means that when you apply for the loan, the lender will make an inquiry into your credit report, which has a negative impact on your score. However, if you are fully committed to paying off your debt and you avoid spending your newly freed credit, the positive effects will outweigh the initial inquiry.
Debt Management Plan
Another type of debt consolidation is a debt management plan (DMP). If you're working with a credit counselor and she has determined that you are unable to pay your debts (and to pay them on time) due to your current financial situation and/or the level of debt you've accrued, she may suggest using a DMP to lower the cost of repaying your debt. With a DMP, your credit counselor works with your creditors to negotiate lower interest rates and fees, if possible. Then she will set you up on a payment plan and you will make payments directly to the credit counseling company, which in turn pays your credit card accounts over a predetermined period of time. Credit counseling companies sometimes require that clients not apply for any new lines of credit while on a DMP.
Considerations
Oftentimes, debt consolidation loans are advertised at very low interest rates; however, those rates are usually available only to those with excellent credit. If you're at the point where you're having difficulty repaying your debt, it's likely that your credit score is suffering. Make sure that a debt consolidation loan actually gives you a lower interest rate than your current credit card rates, or else you won't actually save any money and the damage to your credit score isn't worth it. Also, both debt consolidation loans and debt management plans are negative marks on your credit report, and you may have difficulty obtaining new credit while they remain on your report. Negative information may be reported for up to seven years. You must be fully committed to staying out of debt for consolidation to be effective.
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