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.
Facts about Debt Consolidation in America
- According to the Federal Reserve Board,
debt in American households has reached the $2 trillion
mark, excluding mortgage debt.
- US households with atleast 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.
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) |
Outstanding Debt: $15,000
APR: 10%
Annual Interest = $15,000 x 10% = $1500
Monthly Interest = $1500 / 12 = $125
Monthly Premium = $15,000 / 2 / 12 = $625
Total Monthly Payments = $625 + $125 = $750
|
Debt
Consolidation Loan # 2 ($20,000 Principal @ 12% APR
for 4 years) |
Outstanding Debt: $20,000
APR: 12%
Annual Interest = $20,000 x 12% = $2400
Monthly Interest = $2400 / 12 = $200
Monthly Premium = $20,000 / 4 / 12 = $417
Total Monthly Payments = $417 + $200 = $617
|
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:
Savings
= Pre-Debt Consolidation Payments - After-Debt Consolidation
Payments
Savings = $1367 - $750
Savings = $617 |
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:
- Personal loans
- Home Equity loans
- Credit card debt
- Mortgage debt
- Car loans
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:
| Credit Cards |
Debt Owed |
Interest Rate |
| Visa |
$4500 |
19% APR |
| MasterCard |
$8000 |
12% APR |
| American Express |
$1000 |
15% APR |
| Trust Union |
$2000 |
10% APR |
After the debt consolidation program, the
above hypothetical schedule would look like this:
| Credit Cards |
Debt Owed |
Interest Rate |
| Debt Consolidation Lender |
$15,500 |
8% APR |
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%
Debt Consolidation Trivia
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