8

I've seen 'debt consolidation' advised for people who have a lot of debt (from different credit cards, etc). What does that involve, exactly, and why is it a good idea?

Say I have:

  • $1000 at 5% from A
  • $5000 at 10% from B
  • $5000 at 5% from C

As I understand it, debt consolidation would mean that you would take on an $11000 loan to pay off this debt. If that loan accrued interest at 5%, then that clearly saves money, but I don't see how there's any reason why that should happen. If anything, I'd expect debt consolidation loans to carry higher interest rates, since the borrowers would be more risky.

Is it essentially paying for the convenience of only having to deal with one creditor, or is there something more to it?

7

The debt on Credit Cards is pretty high. Its in the range of 30-40% APR. There could also be a case very high personal loan for medical or other personal emergencies at a rate in excess of 15%.

The debt consolidation would offer this at a very low APR

There are institutions that offer debt consolidation services that would consolidate all your debt into a single loan at a lower rate of interest. They would also negotiate with all your lenders to waive charges and accrued interests to the max extent. The benefit to the institution offering this service is that they have a larger loan on books and hence the servicing cost is less. Most of the time the debt consolidation is offered with some asset as the guarantee for the new loan.

By doing this the advantages are:

  • Receive lower APR rates
  • Only have one payment per month
  • Start repairing your credit rating

Of course if you are looking for the balance transfer on cards to new one, then its same and in fact may at times be more expensive.

6

With the scenario that you laid out (ie. 5% and 10% loans), it makes no sense at all. The problem is, when you're in trouble the rates are never 5% or 10%.

Getting behind on credit cards sucks and is really hard to recover from. The problem with multiple accounts is that as the banks tack on fees and raise your interest rate to the default rate (usually 30%) when you give them any excuse (late payment, over the limit, etc). The banks will also cut your credit lines as you make payments, making it more likely that you will bump over the limit and be back in "default" status.

One payment, even at a slightly higher rate is preferable when you're deep in the hole because you can actually pay enough to hit principal. If you have assets like a house, you'll get a much better rate as well. In a scenario where you're paying 22-25% interest, your minimum payment will be $150-200 a month, and that is mostly interest and penalty. "One big loan" will usually result in a smaller payment, and you don't end up in a situation where the banks are jockeying for position so they get paid first.

The danger of consolidation is that you'll stop triggering defaults and keep making your payments, so your credit score will improve. Then the vultures will start circling and offering you more credit cards.


EDIT: Mea Culpa.

I wrote this based on experiences of close friends whom I've helped out over the years, not realizing how the law changed in 2009.

Back around 2004, a single late payment would trigger universal default on most cards, jacking all rates up to 30% and slashing credit lines, resulting in over the limit and other fees. Credit card banks generally apply payments (in order, to interest on penalties, penalties, interest on principal, principal) in a way that makes it very difficult to pay down principal for people deep in debt. They would also offer "payment plans" to entice you to pay Bank B vs. Bank A, which would trigger overlimit fees from Bank A.

Another change is that minimum payments were generally 2% of statement balance, which often didn't cover the monthly finance charge. The new law changed that, resulting in a payment of 1% of balance + accrued interest.

Under the old regime, consolidation made it less likely that various circumstances would trigger default, and gave the struggling debtor one throat to choke. With the new rules, there are definitely a smaller number of scenarios where consolidation actually makes sense.

  • 3
    People offering you credit cards isn't a problem. Having no self-control about obtaining / using credit cards is a problem. ("My credit is trash" is a very poor workaround to that problem). – fennec Oct 5 '10 at 19:33
  • Also, -1/Wrong because "one payment, even at a slightly higher rate" is financially worse than multiple payments at lower rates. If you want to "hit principal", just pay more than the minimum payment on the debt with the worst rate. Paying extra money in interest is a lousy way to get out of debt. – fennec Oct 5 '10 at 19:39
  • Uh, no. When you are in hock with credit cards, they establish minimum payments based on a formula. Those payments escalate dramatically once you fall behind and incur penalties. If you have multiple accounts that you are paying interest on, you're basically guaranteed to default. The person asking the question was looking for information, not moral judgement. – duffbeer703 Oct 5 '10 at 21:18
  • @duffbeer: I can't really follow your third paragraph either. You say that one big loan will result in a smaller payment. That must surely be true - otherwise debt consolidation wouldn't be helpful. But why does it result in a smaller payment is what I want to know. Especially since you say it may be at a higher rate. – Larry Wang Oct 6 '10 at 2:27
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    Un-minus-1. I like this edition better. – fennec Oct 6 '10 at 4:02
3

This can mean a few things to me. Some of which has been mentioned already.

It can mean one (or all) of the following to me:

  1. You take out a new credit card and transfer ALL other credit balances to it. (Only good if you destroy the others, this is a 0% offer, AND you plan on paying this card off furiously.)

  2. You do the loan thing mentioned earlier.

  3. You go to a credit consolidation service who will handle your paying your payments and you send them one payment each month. (Highly discourage using them. A majority of them are shady, and won't get do what they say they will do. Check Better Business Bureau if you find yourself considering them as an option.)

In the first two cases, you are just reducing the number of hands reaching into your bank account. But keep in mind, doing this is not the same as paying off debt. You can't borrow your way out. You can do this as part of your plan, but do so CAREFULLY.

2

Debt consolidation is basically getting all your debt into one loan. This is possibly more convenient, and lets you close the other accounts (in the case of credit cards, preventing you from incurring any more debt). Ideally, your consolidated debt will have a better interest rate, so it saves you money as well.

If you're defaulting on your debt already, you're likely combining this process with some negotiation with your existing creditors.

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