You have been overwhelmed with bills and made a personal vow to get rid of your credit card debt. In addition to 'snowball' and 'avalanche' debt repayment strategies, you are also considering debt consolidation. Although debt consolidation may make it easier to eliminate your debt, there are financial pitfalls that you should look out for with this type of method.
To avoid these pitfalls, you need to take caution before you sign up for a debt consolidation service. At a minimum, it's important to understand the types of debt consolidation solutions available and know what to avoid if you decide to go this route to eliminate your debt.
Types of Debt Consolidation
Your first step is to choose a financial institution or company that can meet your particular debt consolidation needs. There are three main types of debt consolidation. These are personal loans, debt settlement, and balance transfer credit cards.
When you consolidate your debt through a personal loan, you work with a lender, such as credit union or bank, to obtain a loan that equals the amount of your debt. You pay your debt off all at once with the loan and then start making one monthly payment to pay off your loan.
A debt settlement company works as a mediator between you and your creditors. They negotiate on your behalf and ask your creditors if they will accept a lower payment for the debt you owe.
Balance Transfer Credit Cards
Some credit cards are considered debt consolidation solutions. These cards are still credit cards, but they offer you a 0% (or low) introductory APR offer to consolidate your other debt onto that single card, typically in exchange for a balance transfer fee that gets tacked onto your existing balance when you make the transfer.
A 0% introductory APR only means that when you first open up the balance transfer credit card, you are not charged interest on your balance, for a limited introductory period. Once approved for the card, you transfer your debt onto the card and do your best to pay as much of the balance as you can before the introductory period ends. Since there's no interest during this time, the money you pay goes towards your balance directly.
In addition to the above, home owners may have a home equity loan option. Home equity loans can be a risky solution though because if you are unable to make your home equity loan payments, your risk foreclosure on your home.
Things to Avoid
Some common traps to avoid when using a debt consolidation solution include:
Paying High Fees
Debt consolidation costs money. However, some companies charge very high fees for their services in the form of upfront or monthly costs. It is important that before you sign up with a debt consolidation service you know what the exact charges are going to be.
Consolidating the Wrong Debt
Some types of debt are better than others. For instance, good debt might include student loans, auto loans, and a mortgage, while bad debt would include high-interest rate credit cards.
Although it is tempting to consolidate all your debt into one convenient monthly payment, you could be making a poor financial decision if you rolled debts into a loan that had a higher rate than your existing debt. Only consolidate higher interest rate debts into your loan and pay your lower interest rate debts on your own.
Thinking Debt Consolidation Solves all Your Problems
With debt consolidation, all you are essentially doing is restructuring your debt so that it is easier to pay it off. It doesn't wipe away your debt or solve your debt problem. It also doesn’t necessarily teach you how to manage debt prudently.
It makes the process of paying off your debt easier, but you've only completed your first step in eliminating your debt. You still have quite a ways to go before you are debt-free. You'll still have payments to make over a lengthy period, but it will be a large single payment rather than multiple smaller ones. The consolidated debt just makes it easier for you to monitor and pay off.
Staying Out of Debt
So, how do you stay on track and stay out of debt? It can be simple; you open a "spending account." The concept behind this is it increases your financial happiness and keeps you out of debt. Here are three simple steps on how to go about it:
- Open a money-market or savings account. This account is for funding your goals only. So, you will set aside a specific amount you want to put towards your goal. For instance, if you are planning a vacation and plan on spending around $4,000 on it, you may wish to transfer a few hundred a month into this account. If you are looking to buy a car that's worth $9,000, you can have a certain amount transferred into this account for that purpose.
- Automate the process. Have an automatic payment come out of your paycheck or checking account and transferred to your spending account. You can work with your employer on splitting your direct deposit into two separate accounts or have your bank or credit union automatically transfer funds from one account to another.
- Wait until you reach your funding goal before you spend. Throughout life, you are going to have endless expenses. You have to save for your car, emergencies, retirement, bills, mortgage or rent and more. Why not make life a little more enjoyable by saving extra funds each paycheck that you can use for things you enjoy, whether it is traveling, a hobby or something else. The key is to have money saved for these expenses rather than funding them with debt.
Debt consolidation can be a good thing for your finances and can get you out of debt quicker than you normally would if you choose your plan and company wisely. Consider the type of loan you want, the debt you want to consolidate and steer clear of financial traps when working with this kind of strategy.