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If you’re interested in debt consolidation, what follows are the top five myths that people believe in and the truth about them.
If you’re saddled with debt and are looking for a way out, the chances are that you’ve come across the term debt consolidation more than once.
If you’ve talked to people about it, you’ve probably heard many different opinions about what debt consolidation aims to do and whether it’s a good idea.
The bottom line on debt consolidation is that it is a financial strategy to help you deal with credit card debt more efficiently.
When you owe thousands on multiple credit cards, the debt consolidation strategy has you combining all of them into one manageable debt that’s less troublesome to keep track of.
As simple as the concept of debt consolidation is, it tends to be the subject of considerable mythology and confusion.
Quick Table of Contents
The Myth That Debt Consolidation Is A Racket
Debt consolidation is a legitimate way to manage your debts and make it easier to deal with.
The debt consolidation business does tend to attract predatory, disreputable lenders, however, as was seen during the financial crisis of 2008.
You can determine if a provider of debt consolidation is reputable by checking that they are a registered nonprofit 501(c)(3) organization.
It also makes sense to look at their mode of operation.
If they ask you to make a large lump sum payment upfront or ask you to stop paying your creditors, you should know that they deal with an approach called debt settlement, which is different from debt consolidation, and usually not a good idea.
The Myth that Debt Consolidation Is The Same As Debt Management
Debt consolidation and debt management share features but are different in a few ways.
With debt consolidation, you take out a loan from a lender to pay off all your credit cards.
In the end, you’re left with the one loan with the one lender, and you have just the one payment to make, which can save you a little money if the interest rate on your consolidation loan is lower than the interest rates your credit card issuers charge you.
A debt management plan leaves you with just one payment to make, as well, but there is no loan involved. The credit counseling agency that offers debt management calculates for you what kind of single monthly payment you can afford to make.
You pay the credit counseling agency each month, which then divides up the payment to send to all your different credit card issuers.
The credit counseling agency has agreements in place with the credit card companies to ensure that you are charged a lower interest rate than you would otherwise be and waive all penalties.
The Myth that Debt Settlement, not Debt Consolidation, is the Best Way to Go.
You’ve probably seen advertisements that tell you that you can settle or pay off your debts for a fraction of what you owe.
It’s essential to understand what is left unsaid in those advertisements, however.
When a debt settlement firm takes over your case, they first have you stop all payments on your credit cards as a negotiation tactic.
The move is intended to send a message to the credit card companies that you are simply unable to make your payments, and they would be smart to take what you offer them.
While the credit card companies may (or may not) go along with the plan, not making payments can greatly damage your credit score.
If your debt settlement plan does go through (there’s no guarantee that it will), and you end up having only to pay half of what you originally owed, you still don’t get off lightly.
If you owe $30,000 on all your credit cards and the debt settlement agency manages to get the credit card companies to settle for just $15,000, the $15,000 that’s forgiven is considered by the IRS to be money you’ve made.
You need to pay taxes on it. The debt settlement agency, as well, charges you about 20 percent of the final settlement as fees.
When you consider the cost of the harm done to your credit score, you end up having saved perhaps a mere 10 percent. For these reasons, debt settlement isn’t a good deal.
The myth that debt consolidation always saves you money
A debt consolidation loan may be made against collateral or without it. In either case, the interest rate that you pay on the loan may be high or low, depending on what your credit score is.
If you’ve been having trouble paying your credit card bills, however, the chances are that your credit score has suffered.
If you have collateral to offer and have a good credit score, you may end up paying a lower interest rate on your debt consolidation loan then you pay to the credit card companies.
The lower interest rate isn’t guaranteed by any means, however.
If you don’t get a lower interest rate, a debt management plan may be a better idea because it doesn’t take your credit score into account.
The myth that debt consolidation damages your credit score
Your credit score is largely determined by the regularity with which you make payments on your debt and your credit utilization – the degree to which you’ve borrowed money against the credit that’s available to you.
When you take out a debt consolidation loan, you do, for a brief period of time, have twice as much debt as you had before.
Once you use the loan to pay off all your credit card debts, your credit utilization is back to normal. The hit to your credit score should be minimal and should recover very quickly once you begin making payments and working down your debt.
Debt consolidation and debt management are good ideas if you owe a great deal on multiple credit cards.
However, if you choose debt consolidation, it’s essential to research your options and find a lender who offers you the lowest possible interest rate on a loan.