What is Debt Consolidation?

The average American household has $134,643 in debt. Credit cards, overdue bills, student loans, and any other kind of debt imaginable, crush families beneath this weight. Sound familiar? There is a way out without declaring bankruptcy: debt consolidation. The average household pays about $1,300 per year in interest. Combining multiple high-interest accounts into a single debt consolidation loan can open the door to lower interest rates. You can spend that $1,300 reducing the principle instead of tossing it into the wind.

If greater challenges are facing you on your journey to lower your debt, consider credit counseling (which pairs you with a credit counselor to develop a payoff plan) or debt settlement (which involves negotiating new terms on your debt.) Regardless of the option you choose, the most important aspect is choosing to do something about your debt.

Benefits of a Debt Consolidation Loan

Combining your existing debt into a single payment has many advantages including:

Paying less every month: A personal loan used to pay off higher-interest loans reduces the amount of interest you pay and therefore reduces the amount you spend over the lifetime of a loan.

Things become easier to manage: If you're writing multiple checks to different organizations, you know how easy it can be to miss one. A single debt consolidation loan means you only write one check each month—far easier to remember where to send the payment and what each day of the month the payment is due.

You Have Options

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available options

Check out these three ways to reduce your debt. Find one that works for you.

Do it yourself: Take time and evaluate your personal debt situation. Finding a loan that makes sense for you is the first step in reducing your debt. This means looking at what loans have the best interest rates or a credit card with a better balance transfer policy. You can also reach out to your creditors and try to work out a payment plan that's more manageable. Once you're approved for this loan, use it to pay off your existing loans.

Local financial institutions: You don't have to go to a major bank for help. Local banks want your business, so checking with your local bank or credit union can be a great way to find someone to help you manage your debt. Your local business is more valuable to them than your business would be to a national chain, so smaller institutions are often willing (and capable) of working with you to help you out of financial trouble.

Debt service companies: Companies like us help you find the best solution for your needs. We're like matchmakers for debt reduction and consolidation. We provide a variety of approaches to help you become debt free. Other services just help in building a game plan.

Finding Your Solution

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find solutions

Never forget that professional help is available to get you out from under the burden of debt. The three main types of professional help are credit counseling, debt management, and debt settlement.

Credit counseling services: Credit counseling firms address the root of your financial problems. These companies help you build a budget, walk you through how to manage your money properly, and lay out a framework for getting out of debt. Nonprofit firms, local banks, credit unions, housing authorities, and even local universities provide credit counselors to help people buried in debt. However, not all of these services are free—and not all work in your best interests. If you aren't sure of an agency, check out the approved list provided by the US Department of Justice.

Debt management plans: Maybe you know how to manage your finances, but your current debt situation was caused by something outside of your control. If this is the case, a credit counselor might suggest a Debt Management Plan (DMP). These plans require a monthly deposit with a credit counseling company, which then uses this deposit to pay off your unsecured loans. DMPs can often negotiate lower interest rates or get your creditors to waive certain fees. DMPs frequently work off a 48-month plan, so make sure to examine the payment schedule of the DMP you're considering.

Debt settlement programs: While a DMP will work out a payment plan, debt settlement companies negotiate lump sum settlements. These settlements are actually less than what you owe on paper; to do this, the company will ask you to place monthly payments into an escrow account that can be used to pay off the debt in a single stroke. Creditors are more willing to forgive a portion of debt when receiving a large sum at once. However, be aware that debt settlement companies will sometimes request you stop making payments to your creditors, an action that runs the risk of lowering your credit score.

First Steps to Take

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first steps

If you're not sure which path is the best one for you, here's how to find one that fits:

  1. List out all of your debts on paper. This includes your mortgage, any car loans, student loans, credit cards, store cards, etc.
  2. Put each of these debts on their own line, and then beside each one, write the interest rate of that loan and the amount of principle remaining.
  3. Look at what you're paying each month. Are you reducing the principle or just making the minimum payment? Are you paying less than the minimum and getting penalized?
  4. Figure out how much money you're going to spend to pay off all of your debts. You can do this by multiplying the length of your loans by how much you pay each month; if you're struggling to find an accurate number, our debt calculator can help.
  5. Shop for a comparable loan for a smaller amount than your existing loan. If you find one and qualify, use this loan to pay off your existing loans.
  6. If you don't qualify, you have other options such as credit counseling or debt settlement.

Impacts to Your Credit Rating

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credit rating impact

You know your credit rating is important, and large amounts of debt can negatively impact it. If you reduce this debt, it can affect your credit score depending on how much you pay off. For example, if you have credit card payments that are just too high to make or loans that are past due, combining these into a single debt consolidation loan will allow you to pay them off immediately while paying the loan off with a lower interest rate. This will also improve your credit score over time.

Credit agencies use what's called a utilization score in determining your credit. This score measures how much of your credit you actually use; in other words, a ratio of your used credit to available credit. Maintaining a low utilization score is good for your credit rating, so paying off a maxed out credit card can mean an immediate improvement in your score.

You may be tempted to close a line of credit once it is paid off. Don't. Keeping lines of credit open, even if you aren't using them, keeps your utilization score low and provides a positive impact on your credit rating.

Bear in mind that using debt consolidation tactics (using a new loan to pay off old loans) may be seen as a risk factor to credit agencies. Your credit score may be negatively impacted, or the positive and negative impacts may cancel each other out. Once you've paid off your debt, you can work to improve your overall credit score.

Debt settlement firms take this task out of your hands and work with your creditors to reduce the total amount owed or to obtain more favorable terms. This will likely hurt your credit score, at least in the short term. That said, many people find the overall result to be worth it.

Rebuilding your credit score doesn't happen overnight. It's a long-term process that happens as you pay off your debts.

Loan Qualification

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will you qualify

Maybe you've read this far and thought to yourself, "I don't know if I qualify for a loan." Debt consolidation loans usually require the following information.

Income: Any lender will need to see your current income and current amount of debt. This number, called the debt to income ratio, helps lenders determine how likely it is you will pay off the debt.

In fact, there's a ratio – called the debt to income ratio -- to help lenders analyze how much debt a person carries relative to his income.

Payment history: Lenders look at payment history to see how consistent you are with payments, as well as to determine if there are any red flags like late or missed payments.

Assets: Not all lenders will want to look at your assets. However, if seeking a secured loan, you may need to supply collateral. Unsecured loans like credit card balance transfers don't require any collateral, but a secured loan like a mortgage or car payment allows the lender to seize those assets if the payments are not made.

Are You a Good Fit?

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if you can't pay

Simplifying and reducing monthly obligations is a tried-and-true method to get out of debt. A single, lower interest rate debt consolidation loan makes handling your loans and monthly payments easier. Review our debt settlement and credit counseling sections for other options that may be better suited for you.

Word to the wise: There are underlying problems that lead to debt. Don't just assume it's because of a few bad decisions; debt happens gradually. Examine your relationship with money, and review the articles on our site to learn valuable skills to get out — and stay out - of debt.

If You Can't Pay

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unsecured vs secured

When you borrow money, the lender expects it to be paid back. If you can't pay, there are several ways lenders can recoup their losses and ensure they get their money back.

Unsecured loans: A loan that doesn't require collateral is an unsecured loan. Certain loans from banks, credit cards, and other lenders don't require you to pledge assets. Lenders will check your past lending history and credit score to determine how likely it is you will repay the loan. If you fail to pay back an unsecured loan, you will negatively affect your credit score and your ability to get loans in the future.

Secured loans: A secured loan requires collateral. An example of a secured loan is a second mortgage or a home equity line of credit (HELOC). Failure to pay a secured loan can result in liens being place on your assets. These loans are less risky from a lender's point of view, so the interest rates are typically lower than an unsecured loan. However, you put your personal property at risk when taking out a secured loan.

The Bankruptcy Option

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2012 saw the lowest personal bankrupty rates in four years—a drop of almost 20% nationwide. U.S bankruptcy courts reported 1,221,091 new bankruptcy filings in 2012, a drop of 13 percent from 2011. After the 2008 economic downturn, more people focused on reducing their debt and remaining in good financial standing, a trend that continues today.

Another reason bankruptcies may be down is the complexity of the new Title 11 bankruptcy code. It's not as easy to clear yourself of debt by filing bankruptcy; while those who follow the rules can receive a discharge (a statement absolving you of certain debts), it isn't as easy and has a longer impact than filing for bankruptcy once did.

Bankruptcy negatively impacts your credit report for ten years, compared to the seven years bad debt remains on your report. This makes qualifying for future loans, mortgages, or even life insurance far more difficult than it would be otherwise. However, in seemingly hopeless scenarios filing for bankruptcy can be a fresh start for people who can't find any other viable option to get out of debt.

Two Types of Personal Bankruptcy: Chapter 13 and Chapter 7

Chapter 13: Chapter 13 bankruptcy allows those with consistent income to retain property that might otherwise be lost in a bankruptcy hearing. A court will evaluate this income and decide on a three-to-five year payment schedule to discharge debts

Chapter 7: Chapter 7 bankruptcy requires you to liquidate all of your assets that aren't exempt. These assets will then be given to creditors or sold through a court-appointed trustee.

Avoid Being Scammed

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Not everyone who offers to help conquer your debt has altruistic motives. There are scammers that offer a panacea for your debt, but it's a lie. Some scammers offer loans if you pay upfront, but never provide their side of the money. Others create complex schemes through deceptive marketing practices. Watch out for the warning signs.

Advance fee loans guarantee a loan if you pay an advance fee. The fee might be small—$100 or so—or thousands of dollars. These practices are illegal. A legitimate creditor will not, and cannot, guarantee that you'll receive a loan. Under the Telemarketing Sales Rule set by the Federal Trade Commission,a seller cannot inform you of the likelihood of receiving a loan and may not accept advanced payment for that loan.

Protect Yourself

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what you should do

Scams are not as difficult to avoid as you might think, but you do need to be diligent in guaranteeing a company you work with is legitimate.

Check 'em out: Use the Better Business Bureau (BBB) or the FTC Consumer Information websites to research a company and any services they offer. Reach out to your creditors and ask if they'll work with a company before you make any commitments.

Use a magnifying glass: Read the fine print. Always read the fine print before signing anything, and don't let yourself be pressured into singing something—particularly if it requires upfront payment.

Watch like a hawk: Once you turn over your debt to a firm, make sure to keep a close eye on your credit statements. Contacting your creditors and ensuring they receive payments on time isn't a bad idea.

Moving Ahead

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vs bankruptcy

America is finally pulling itself out of one of the worst recessions in history. While the economic situation is improving, many Americans still find themselves under mountains of debt. Shady companies took advantage of many people during the recession and failed to deliver on their promises, all while hiding the fees of those same things. Credit scores across the country plummeted.

The FTC cracked down on unlawful maketing practices in 2010 and forced several large companies to shut down, which resulted in fewer companies fighting to address the debt of the American public.

This created two tiers in the market that remain today: small companies fighting for whatever scraps of the market they can get their hands on, and large banks and financial institutions that control the majority of the business.