4 Biggest Myths Behind Debt Consolidation
You've probably heard the term "debt consolidation." Maybe you heard a commercial on TV or saw something or the Internet or heard the term in casual conversation. There's a lot of mystery and misinformation around the topic, so this guide will help you make sense of what debt consolidation is (and what it isn't).
"Debt consolidation is the process of paying off two or more open loans with one new loan, thereby 'consolidating' several accounts," explains James Poe, founder of Texas Retirement Specialists.
In other words, you take out a single loan -- it may be a debt consolidation loan, a home equity loan or another type of loan -- and use it to pay off other debts such as credit cards.
Joe Parsons, a senior loan officer, mortgage broker and banker at PFS Funding in Dublin, Calif., explains that the main purposes of debt consolidation are:
1) to make your monthly payments easier to deal with by combining multiple loans into one loan (and thus one monthly bill); and
2) to lower your monthly payments by providing you with a single (ideally) lower-interest loan.
Here are four myths about debt consolidation and the truths behind them:
Myth #1: Debt consolidation is always a scam
Yes, there are scams around debt consolidation, and not all debt consolidation loans or plans save you money. But there are reputable companies that offer debt consolidation plans and/or loans, which can help ease your financial headaches and lower your monthly payments so you can free up money to pay for your everyday living expenses. "Debt consolidation is a useful tool in the right situation, and can provide financial benefits to you when you choose a good loan from a low-rate lender," says Poe.
Myth #2: Debt consolidation and credit counseling are the same thing
Because debt consolidation and credit counseling are often mentioned in the same context, people often confuse the two. But credit counseling is what it sounds like: counseling for people who have financial troubles, explains Parsons. The credit counselor may provide budgeting advice, a debt management plan and negotiate with creditors for lower rates and pay off your bills on your behalf.
Myth #3: Debt consolidation will hurt my credit score
Using a debt consolidation loan to pay down other debts shouldn't significantly impact your credit score, experts say. Here's why: Only a small part of your credit score is derived from "new credit" -- which looks at whether you've opened up a few new credit lines recently -- so opening this single new credit line shouldn't do much to change your credit score. (More important for your credit score is whether you make your monthly payments on that and other loans on time, as well as how much you owe and the length of your credit score.) What's more, in some cases, consolidating your debt may improve your credit score, since "you're converting score damaging revolving debt to score benign installment debt," says John Ulzheimer, the president of consumer education and SmartCredit.com.
Myth #4: Debt consolidation always leads to more debt
Debt consolidation is using one loan to pay off a bunch of other loans. So, assuming you get good terms on your new loan, there is no reason debt consolidation should lead to more debt. In fact, it can lead to lower total debt, says Parsons. But for some people, especially those who don't change their habits, it does lead to more debt, he says. "If you reuse the existing, newly paid-off credit cards and end up back in the same debt, then you're actually in debt twice over," says Ulzheimer. To avoid going into more debt, once you've paid off those credit cards with a debt consolidation loan, avoid using them as much as you can, says Parsons.