Debt consolidation can work as a way to pay off debt faster. However, if you’re not disciplined and look for help in the wrong places, you’ll end up spending MORE time paying off your debt.
Let’s take a look at what debt consolidation is, where to find a reputable organization to help you, and ways you can get out of debt fast.
What is debt consolidation?
Debt consolidation combines all of the debt you owe into a single payment with a lower monthly interest rate. This typically works by taking out another loan in order to pay off all of your other debt.
Let’s say you have debt across three credit cards and you owe the following:
Credit card A: $2,000 at 10% APR
Credit card B: $1,000 at 20% APR
Credit card C: $1,000 at 15% APR
Each month, you’re contributing $100 to each card for a total of $300 — however, a portion of each is being eaten by interest:
Credit card A: $16.67
Credit card B: $16.67
Credit card C: $12.50
So in all you’re paying $254.16 towards your debt rather than the full $300.
With debt consolidation, you take out a loan of $4,000 and pay off ALL of the above debt — and you get a lower interest rate for the loan at 10%.
Now each month when you contribute $300 you’ll pay $266.67 towards your debt rather than just $254.16.
In theory, this means you’ll be able to pay off your debt faster.
The interest rate you’re able to get depends on which type of loan you attain:
Secured loan. This is a loan where you put up an asset (e.g., car or home) as collateral. If you default on your loan, your creditor will repossess said asset.
Unsecured loan. This is a loan that just uses credit. As a result though, you might end up with higher interest rates than if you had a secured loan.
If you want to get your debt consolidated, you’ll have to go through one of the two routes above — which we’ll get into later.
Before we do that though, it’s important you know the dangers around consolidating your debt.
The problem with debt consolidation
But before you click on one of those scammy internet ads marketing “DEBT CONSOLIDATION — BE DEBT FREE IN 3 HOURS,” consider the big drawbacks to debt consolidation:
1. It could take longer to pay down your debt
If there’s anything I’ve learned about human psychology over a decade of studying behavior and personal finances, it’s that things like that are easier said than done.
For example, if the average person ends up saving $300 in interest payments because of debt consolidation, do you think they’ll use that extra money towards their debt OR do you think they’ll end up spending it?
Most likely, the latter.
Human willpower is limited. It’s the same reason why cutting out lattes or skipping lunch to save money doesn’t work.
A person with 300 “extra dollars” might end up just blowing it on something else.
What happens then is it takes longer to pay down debt. This results in even MORE fees they have to pay.
Aside from diminishing willpower, many debt consolidation loan companies offer up longer loan terms than people realize. So while the interest rate is lower, they end up paying more because they didn’t take into account how long they’d have the loan for.
2. You could lose your home or car
If you decide to put your car or home down as collateral you stand to lose much more than a few thousand dollars off the life of your loan.
A home equity loan is also known as a second mortgage. Taking a second mortgage out on your home means you risk losing your house if you fail to make payments.
Of course there are some advantages to going this route. For one you can deduct the interest payments from your home equity loan from your taxes. Plus you’ll be able to get a lower interest rate than if you went the unsecured route.
Overall, though, it’s just not worth the risk — especially when there are better ways to go about it.
3. Your credit score will suffer
There are a few things that go into making a great credit score. One of them is your credit history — or how long you’ve had credit for.
It actually accounts for 15% of your overall score.
That might seem small but consider this: If you get rid of a bunch of different lines of credit at once, your credit score is going to take a huge drop. That drop gets bigger with more and more lines of credit you close.
How to consolidate debt — and get rid of it completely
If you’re STILL interested in consolidating your debt, I want to help you.
Because there are a LOT of scammy consolidation services out there. These “businesses” will promise that they’ll help you get out of debt fast through their loan packages …
… only to screw you with hidden fees, bloated interest rates, and long loan terms.
The trick here then is to separate the good debt consolidation organizations from the bad ones.
Step 1: Find a non-profit debt consolidation firm
Non-profit debt consolidation firms are 501(c)(3) organizations that help provide you with consolidation services, credit counseling, and will even negotiate with your creditors for you.
The best part: They do so with little to no costs to you since they’re funded by third-party sources such as donations and grants.
Unfortunately, even scammers and bad consolidation services have non-profit status. So you’ll have to do your research into finding a reputable one.
Two good signs a non-profit debt consolidation firm is the real deal:
Fees. A reputable non-profit will likely have monthly maintenance fees. Luckily, they’re relatively low cost — and if you’re in really dire straits, some non-profits will waive the fees entirely for you.
Non-profit status. This might seem like a no-brainer but it still needs to be said: Ask them for verification of their non-profit status. Too many scam companies pretend they’re non-profits in order to lure people in. Don’t be one of those people.
Make a list of 5 to 10 non-profit debt consolidation firms. Spend the next week calling each of them and getting a consultation on your situation and what they can do for you.
A good non-profit will spend about an hour on your consultation. Beware of any organization that wants to take your money and put you into a plan right away. They are NOT looking out for your best interests.
Step 2: Eliminate temptation
Luckily, a non-profit debt consolidation firm will take care of a lot of legwork for you. That means they’ll call your creditors, negotiate down your debt and interest rate, and work with them to consolidate all of your debt into one manageable monthly payment.
Unluckily, that’s the easy part. The hard part means actually doing the work of paying down your debt — and that’s up to you.
To do that, you need to first get rid of the temptation of using your credit cards until you’re debt-free. If you ever expect to pay down your debt, you can’t add more to it.
Here’s my favorite tip: Plunge your cards into a bowl of water and shove it all into your freezer.
Seriously. Remember what I said about human willpower? It’s very weak — so weak that a solution like freezing your cards is necessary sometimes to delete temptation.
When you literally freeze your credit, you’ll have to chip away at a massive block of ice in order to get it back — giving you time to think about whether or not you want to go through with whatever purchase you were going to make.
You can also give them away to a loved one to keep until you’re out of debt.
Step 3: Decide how you’re going to pay down your debt