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How Does a Debt Consolidation Program Work?
By Dave Murrow MONEY RESEARCH COLLECTIVE
Managing your debt can be overwhelming, especially if you have multiple credit cards. As interest rates rise in an uncertain economy, you may be looking to pay down credit card and personal loan balances through a debt consolidation program. But how does a debt consolidation program work?
Read on to learn if a debt consolidation program makes sense for your situation and if it might help you reach financial stability.
What is a debt consolidation program?
A debt consolidation program is a financial strategy to pay off multiple balances on credit cards, personal loans and other debts. For many people, managing numerous credit payments can be overwhelming. Missing a payment affects your credit score and can reduce your ability to open new accounts or buy homes. A debt consolidation program can help make payments more manageable.
Organizations vary in how they help consolidate your debt. You will end up with a single monthly payment that covers your debt burden, likely with lower total interest charges. There are several types of programs, each with different methods and tools for debt consolidation.
How debt consolidation programs work
Debt consolidation programs combine multiple debts into a single monthly payment to pay off your unsecured debt, including credit card debt and some personal loans. These programs aim to reduce interest charges, simplify the debt repayment process and help individuals get out of debt more quickly and efficiently.
Debt counseling
Debt counseling may be one part of a debt consolidation program. A counseling service will help you manage and pay off your debt. In debt counseling programs, an assigned financial counselor works with you to help manage your finances during the debt consolidation process and into the future.
The financial counselor will work with you to rebuild your credit and map out a financial strategy based on your income, credit score, credit history and other factors. Your counselor will help you understand good financial practices, possibly by creating a budget. A financial expert may negotiate with creditors or debt collectors to obtain lower interest rates and more manageable payments for you.
Debt counseling aims to help individuals get out of debt as quickly and efficiently as possible and may also help them avoid falling into debt again. Some debt counseling programs are for-profit services, while nonprofit organizations run others.
Setup fee and monthly service fees
Some debt consolidation programs may charge set-up fees and monthly service fees. Make sure you understand these fees before entering any debt consolidation program. Depending on your credit burden, monthly fees may be higher than what you save in interest charges.
Payment disbursement
Depending on the type of debt consolidation program you choose, payment to your creditors will be handled differently. Some may negotiate lower payments to each creditor and then take your single monthly payment to pay each creditor. If you choose to consolidate through a debt consolidation loan, all creditors will be paid off at once, and your new monthly payment will pay off the new loan.
Types of programs
Debt consolidation programs work differently on your behalf to consolidate your debt and get you back on steady financial footing.
Whether you choose a nonprofit to set up a debt management plan, an agency to work with creditors to settle outstanding balances, or a loan agency to take out a new loan to pay off creditors, you need to understand how each option works.
Nonprofit organizations
Nonprofit debt counseling services will help you set up a debt management plan. A debt counselor will set up a meeting — in person or virtual — to get a complete picture of your overall financial situation and review your income, expenses and debt. This counselor can also help you remove collections and charge-offs from your credit report over time.
Next, you and your counselor will create a budget to determine how much you can put toward paying off your debt each month. The debt counselor will also reach out to credit card companies to negotiate a debt management plan with lower interest rates and lower monthly payments.
After your creditors agree to the debt management plan, you will make one monthly payment to the nonprofit organization, which will then distribute payment to the creditors according to the debt management plan.
It may take longer to pay off your debt using a nonprofit debt counseling organization. They aim to make debt repayment affordable to you over many years, rather than to pay off debt as quickly as possible. But, over time and with the proper support and resources, enrolling in a debt management plan can help you rise to financial stability.
Debt settlement agency
You may also seek out a debt settlement agency if you have a high amount of unsecured credit card debt. A financial professional will negotiate to reduce the dollar amount that you owe the credit card company or other creditors.
Through debt settlement, you would stop making payments to your creditors. Instead, the debt settlement agency sets up a special escrow account. While the negotiations with your creditors continue, you keep paying into this account — not your creditors. The money in the escrow account will be used to settle your debt to creditors.
A debt settlement is not guaranteed. Credit card companies do not have to settle the debt, and some may also choose to take legal action. Plus, entering into a debt settlement program can negatively affect your credit score because as soon as the debt settlement agency starts negotiating on your behalf with your creditor, you stop making monthly payments directly to those creditors. Also, the fees you pay to the debt settlement companies can be very high — which is usually a percentage of the total debt settled. If you’re willing to take a short-term hit on your credit score and can handle the fees, this may be your best option.
Debt consolidation loans
A debt consolidation loan pays off multiple debts by combining them into a single, larger loan. The loan works by giving you one monthly payment to a single lender rather than having to make individual payments to multiple lenders.
Debt consolidation loans often come with a fixed interest rate, which means that you’ll pay the same monthly amount because the annual percentage rate (APR) stays the same over the loan term. This gives debt consolidation loans a clear advantage over sticking with individual credit card payments, which usually have variable APRs that rise and fall with economic conditions.
The interest rate on a debt consolidation loan is generally lower than the interest rates charged by credit card companies — but only if your credit score is excellent — making it easier to repay your debt and get out of debt faster.
You should take steps to improve your credit score before entering into a debt consolidation loan to get the lowest interest rate possible. Removing collections and charge-offs from your credit report will improve your credit score.
Both your current income and existing debts will figure into being accepted for a debt consolidation loan. Understanding how a debt consolidation loan works will help you decide if this is your best choice for future financial stability.
Debt consolidation program benefits
Researching and entering a debt consolidation program can be time-consuming and daunting. But there are short-term and long-term benefits.
Simplified debt repayment
One short-term advantage of a debt consolidation program is simplified debt repayment. Paying off multiple creditors every month can be challenging to keep track of. If you miss a payment or two, your credit score will be affected, and you may start getting calls from collection agencies. Paying one amount every month — knowing that all your creditors are covered — can give you peace of mind and, hopefully, save you money in the long run.
Affordable interest rates
If you have excellent credit, debt consolidation programs can offer more affordable interest rates by combining multiple debts. With a credit score above 740, you’ll likely see favorable interest rates for a debt consolidation loan.
You’ll pay higher interest rates if you fall into the “good” credit score range (670-739). If your score is below 670, you’re likely to see much higher interest rates for a debt consolidation loan, which may not make financial sense. While it’s possible to get a consolidation loan if you have bad credit, you may want to improve your credit score before applying for a debt consolidation loan.
Faster debt payoff
Another advantage to a debt consolidation program is acquiring better loan terms. Besides gaining lower interest rates, you may also get better repayment terms. Many online lenders with debt consolidation programs will offer 24-, 36- or 48-month loan terms to pay down your debt and become debt free.
Debt consolidation program drawbacks
Debt consolidation programs can also have drawbacks, and some programs may not fit your financial needs.
Costly fees
There may be costly fees associated with debt consolidation programs, and companies may charge set-up and monthly fees for their services to negotiate with your creditors. Make sure that these fees don’t take too much away from the money you’re saving in lower interest rates.
Only applies to unsecured debt
Debt consolidation programs only apply to unsecured debt — which is debt that doesn’t have attached collateral, like a car or home. While you may minimize your credit card and personal loan debt burden through a debt consolidation program, that may only be a piece of your total debt load. Make sure you consider the bigger picture when agreeing to debt consolidation.
How to get out of a debt consolidation program
Many different approaches can help you get out of a debt consolidation program.
- Pay off the full amount of your consolidated debt: Windfalls happen, but don’t count on them. Keep in contact with your loan program administrator to help you work through your original agreement in making your payments on time.
- Refinance your consolidation loan: If interest rates plunge, you may have the opportunity to refinance your consolidation loan if the original loan agreement allows it.
- File for personal bankruptcy: This should be a last resort if your debt load is so overwhelming that you can no longer pay your debt.
In all cases, know your options and seek out the help of a financial or legal expert.
Is a debt consolidation program better than a debt consolidation loan?
Being in a debt consolidation program can bring you lower interest rates and lower monthly payments through a negotiated payment plan. This might help simplify your debt repayment, but it could also negatively affect your credit score, especially if you choose debt settlement.
Comparatively, having a debt consolidation loan means borrowing money from another source to pay off multiple existing debts. This helps consolidate your payments into one payment with lower interest rates. But you may still have significant debt with a longer repayment term.
Depending on your circumstances and financial outlook, your ultimate course of action should be decided by the amount of debt you have, your credit score, your potential to earn more money and other factors. In all cases, it’s worth speaking with a financial advisor.