Debt Consolidation is the technique of gathering several credit card debt, loans and other liabilities and combining them into one. A debt consolidator thus consolidates all of his debt by taking out a single loan to pay off the debt as a whole. Debt consolidation allows you to combine all of your loans into one loan, usually at a lower negotiated interest rate.
US households with at least 1 credit card had $9000 debt per each credit card owned. So if a typical household owned 3 credit cards, they would be in $9000 x 3 = $27000 in debt.
According to the Bank of England, the consumer debt in UK has topped the £1-trillion mark.
Video: How to Settle Credit Card Debt on Your Own
Example of Debt Consolidation
Assume you have $35000 worth of unsecured debt. One debt is a 2 year $15,000 loan @ 10% APR while the other debt is a 4 year loan of $20,000 @ 12% APR. This means you have to make debt payments of $750 on the first loan while making payments of $617 on the 2nd loan. This means your total monthly payment on these debts is:
Debt Consolidation Loan #1 ($15,000 Principal @ 10% APR for 2 years)
The total monthly payments on the debt = $617 + $750 = $1367. If you approach your debt consolidation company, they will tell you that they can lower your APR to only 8% and combine both your monthly payments and make it only $750 per month. This means you will be able to save:
Who wouldn't not want to save an extra $617 per month?! However, the debt consolidation company will NOT tell you that you have to keep paying this $617 per month for 6 years. Here's the cost-benefit analysis:
Pre-Debt Consolidation Payments: $750 x 12 months x 2 years = $18,000 $617 x 12 months x 4 years = $29,616 After-Debt Consolidation Payments: $750 x 12 months x 6 years = $54,000
If you did not consolidate all your debts, you would have paid $18000 + $29616 = $47,616. After debt consolidation, you would have paid $54,000. Notice that you are actually paying more on the loan after debt consolidation than before it. The difference amount that you will be paying is $54000 - $47616 = $6384.
Now you know why debt consolidation companies are still in business? Because they are making money off you!
What is Debt Consolidation?
Debt Consolidation takes all of your debt, loans and liabilities and moves them into 1 account under 1 standard low interest rate. Some of the debts include:
Home Equity loans
Credit card debt
If carried out properly, debt consolidation will result in a lower annual interest rate, lower monthly payments and therefore more disposable income for you every month.
Pitfalls of Debt Consolidation
While there will be some people who use debt consolidation to really pay off their debt, most people won't. For example, immediately after consolidating all of their debts into one, most people will go on a shopping spree and max out their credit cards. What happens next? They're in debt again!
Actually, it is estimated that 78% of debt consolidators see their debts grow back to original levels after the original consolidation. This is because these consumers have less savings, bad spending habits and no real determination to get out of debt.
Debt Consolidation Advice
Reducing your total debt owed month by month is critical for your debt consolidation program to work. Experts in the finance industry suggest that your outstanding debts (that includes credit card & mortgage debt) should NOT exceed 36% of your Gross monthly income. This 36% is also referred to as the Debt-to-Income ratio.
Debt to Income Ratio = Amount of Money Paid to Debts Outstanding / Total Income Earned
For example, if you spend $1500 a month to pay off your car loans, mortgage payments & credit card debt while your monthly income is $3000, then your debt to income ratio is:
Debt to Income Ratio = 1500 / 3000 Debt to Income Ratio = 50%
Most people who calculate their debt to income ratio are surprised that their percentage is much higher than the suggested 36%
Using Debt Consolidation to Improve Credit Rating
Many American households are in deep debt. Studies have shown that over 40% of American families spend more money than they earn (income) and that the average American household is in $10,000 credit card debt. Note that this does NOT include car loan debt, mortgage debt, student loans, etc. If you have a bad credit rating, debt consolidation might just be the financial program you need to improve your credit.
Debt Consolidation is also known as debt reduction because it consolidates all of your unsecured credit card & other debt into 1 payment. For example, consider this scenario where the consumer owes debt to several credit cards. The hypothetical interest rate (APR) is also indicated:
After the debt consolidation program, the above hypothetical schedule would look like this:
Debt Consolidation Lender
This means you will not have to keep track of the 4 separate bills each month; Visa, MasterCard, American Express and Trust Union. You will have to only make 1 single payment every month to your debt consolidation lender with a lower APR of 8%.
Video: Be Aware When Choosing a Debt Consolidation Company