How Debt Consolidation Plans Work and What to Consider Before Entering Into One

by Clem Adamson on March 29, 2010

The past few years have been some of the most financially hard that many people have ever experienced. This has resulted in a wide number of consumers who had previously been in control of their borrowing, finding themselves drowning in a sea of missed payments, poor credit and financial despair. For people in such or a similar position, one of the best options may seem to be debt consolidation.

In fact, many consumers see debt consolidation as an answer to all their prayers and a get out of jail card that can end all their troubles. As if all too often the case in real life, things are not quite this simple. That’s not to say that it may not be the best route for some people to take, it is just that it needs to be carefully considered and researched to ensure it is an appropriate path to go down.

For those considering consolidation, there are a few key points to consider. The first and perhaps the most important is that it is not an easy option. It can work, but it demands a lot of effort from the consumer. He or she must commit to strict repayments and adhere strictly to any conditions. Failure to do so can have dire consequences and may result in an inability to gain any credit in the foreseeable future.

It should also be noted that many plans vary widely and not every one will offer any significant reduction of debt and the lower repayments that many people expect.

The principle of debt consolidation at first seems a simple one. A consumer combines a number of separate debts (different credit cards and loans) into one debt. They then pay a monthly repayment that will be lower than their combined payments, thus freeing up much needed capital. The problem is that this is an overly simplistic view. It may well be true that monthly repayments will be smaller, but ask yourself how this is possible?

It is a sad fact that many people are simply too happy to reduce their monthly outgoings that they do not look into the small print. This is a fundamental error because it is here that the true nature of consolidation can be found.

The company who offers consolidation makes it money by essentially extending the term of any lending. What this means in practice is that although monthly payments will be smaller, the amount of debt is not reducing and the term of repayment will actually be longer. The consumer may be barely reducing the debt over a period of a typical year and are to all intents and purposes just covering the interest.

It is all too understandable how tempting an option it can be, but it should be addressed with caution and only entered into with both eyes fully open to the financial realities of such an arrangement.

There are certainly other options available and these should at least be considered. It is, for example, possible to manage debt using credit cards. New cards often have a 0% interest rate for a period (say six months) and the balance can be transferred at the end of this period to another card, thus avoiding any interest. The problem with this method is twofold: first, it depends on the consumer to pay more than the minimum payment as not doing so will not make any significant reduction in the debt. The second issue is that it is now a lot more difficult to be approved for credit cards and many users will therefore find this route closed off to them.

It may also be possible to borrow against the equity of your home. This should be considered carefully as failure to maintain repayments can put your home at risk.

Whatever option you choose, including debt consolidation, it is important to study the facts and small print carefully to ensure your choice is an informed one.

Previous post:

Next post: