What is Debt Consolidation?
If you are struggling with debt, you may have considered debt consolidation but are unsure if it is right for your situation. Furthermore, you may be confused by the various types of debt consolidation. In its basic form, debt consolidation combines several debt accounts into one monthly payment. For some people, this may be an affordable solution to debt problems; however, you should only make this decision after discussing all of your options with an experienced attorney.
Types of Debt Consolidation
There are three types of debt consolidation options that most people use: a debt consolidation company, a debt consolidation loan, and balance transfer.
Debt Consolidation Company
A debt consolidation company negotiates with each of your creditors on your behalf to resolve your debt. You pay one monthly payment to the debt consolidation company and the company distributes that payment to your creditors.
Debt Consolidation Loan
Most debt consolidation loans require you to use collateral (i.e. your home) to borrow money to pay your unsecured debt in full. You borrow enough money to pay your other debts in full so that you only have one payment each month.
This is similar to a debt consolidation loan; however, you use a credit card or borrow a personal loan to pay your other debts in full. You are “transferring” your debts onto one credit card or combining them into one personal loan.
Pros of Debt Consolidation
Debt consolidation does have advantages that make it an affordable solution to debt problems for some individuals. Advantages of debt consolidation include:
- One monthly payment – By combining your debt into one monthly payment, it makes managing your finances easier.
- Lower interest rate – You may be able to lower the interest rate on many of your debts by combining those debts into one monthly payment.
- Reduce debt – A debt consolidation company may be able to negotiate with some of your creditors to reduce the balance owed on the account to reduce your total debt.
- Lower monthly payment – By combining your debts into one payment, that payment is often lower than the combined total of all of your current debt payments.
Cons of Debt Consolidation
Unfortunately, there are also disadvantages to combining your debts. Disadvantages of debt consolidation include:
- Risking assets – With a secured debt consolidation loan, you are transferring unsecured debt (i.e. credit cards) to secured debt (mortgage on your home). If you cannot pay the monthly payments, you risk losing your home.
- Debt consolidation company fees – Debt consolidation companies charge fees for their service. This adds to the total debt that you owe.
- You may pay more in the long term – In order to lower your monthly payment, a debt consolidation company typically negotiates a longer term on your debt. Once you pay all of the payments to the debt consolidation company, you will pay more than you would if you continued to pay the monthly payments to your creditors.
- Tax consequences – If a creditor does reduce the amount you owe on an account, the creditor will report the “forgiven debt” to the IRS at the end of the year. You are required to report the “forgiven debt” as income on your tax return. This could increase the amount of taxes you owe.
- Creditors can still file lawsuits – Your creditors are not required to work with a debt consolidation company; therefore, some creditor may continue collection efforts. Even creditors that initially agree to accept payments from the debt consolidation company can file a collection lawsuit at any time.
Filing Bankruptcy as a Better Option
The biggest problem with debt consolidation is that it only treats the symptoms but does not solve the problem. Debt consolidation does not get rid of your debts or resolve the issue of why you are unable to pay your debts each month. With a bankruptcy filing, you can get rid of your debts while protecting your property. Your creditors do not have a choice – they cannot choose not to participate in your bankruptcy.
A Chapter 7 bankruptcy will discharge most, if not all, of your debts so that you can have a fresh start. If you file a Chapter 13 case, you will be repaying a portion of your unsecured debts; however, you will not be paying interest on the debts. When your repayment plan is complete, the remaining debt will be discharged. These discharged debts will not be considered income as with “forgiven debt” in a debt consolidation plan. For many people who are experiencing problems with debt, a bankruptcy is an affordable solution with more advantages than debt consolidation.
If you would like more information about debt consolidation, download our Debt Consolidation eBook. In it we dive further into the advantages and disadvantages and help you determine if it could be right for you.