We’re a nation of borrowers. For individuals, businesses large and small, and the country, debt has become a crushing burden that affects us all. While most of us don’t play a direct role in solving the governmental or corporate debt issues, each of us is critical to controlling our own personal debt load.
In an ideal world, we’d all have enough money to pay for life’s expenses as they occur and debt wouldn’t be an issue. Still, there are very few among us who don’t have to take out a mortgage to buy a house or a loan to make major purchases like a car now and then. Those are known as secured debts in that the lender holds title to the property purchased until the loan is paid off. Failing to make the required payments on a mortgage or car loan ultimately results in the lender taking possession of the house or car. We explain several debt pitfalls below as well as ways to avoid them below. Knowing what's in your credit report is the most important bit of information you can have. For the easiest and most effective ways to get that information, take a look at our Credit Report Review site.
The Minimum Payment Trap
Unsecured debt is the focus of our debt consolidation site. This kind of debt is primarily credit card debt but it can also be other sorts of installment loans or personal debts for which the lender doesn’t have the recourse of repossessing property if payments aren’t made. Though estimates vary widely, it’s safe to say that the average American carries between $8,000 and $12,000 in credit card debt.
The interest rates that are charged on such debt is typically very high compared to secured loans with percentage rates often ranging from the high teens to nearly thirty percent. Because this type of credit is easy to obtain, many people find it easy to over extend themselves. Minimum monthly payments on credit card debt is small, often only two or three percent of the outstanding balance, so it’s easy to justify purchases. After all, we may reason, what’s anther $10 per month.
Of course, all of those little charges add up…quickly…and before long, many people find that just making the minimum monthly payment is a challenge. Making just the minimum monthly payment is a no win game. As an example, paying off $10,000 in debt on an account with an 18% interest rate and a 2.5% minimum monthly payment will take just under thirty-two years and the total interest paid would be nearly $15,000! And that example is pretty reasonable in the credit card world. A single percentage point increase in the interest rate to 19% would lengthen the payoff period by thirty-two months and increase the interest charge by $2,205!
It’s easy to see how one can easily get trapped in a seemingly endless financial nightmare. Millions of Americans owe far more than our $10,000 example and pay interest rates that are much higher than 18%.
Debt Consolidation to the Rescue…or Not
The term Debt Consolidation can elicit images of a knight in shining armor saving us from succumbing to debt overload. But don’t be fooled. Debt consolidation isn’t easy. It requires disciplined adherence to the terms of the consolidation plan including not taking on additional debt. Indeed assuming additional debt can be viewed as noncompliance by creditors who are then free to void any agreement and raise interest rates, fees and penalties as they wish. There’s no room for not making the required monthly payments of the consolidation plan and it inevitably has a negative impact on your credit, or FICO, score.
The good news is that, though expensive, debt consolidation will cost less than continuing on the losing path of making minimum monthly payment, or worse, not even making the minimums, and the credit score will be damaged less than by simply defaulting on obligations.
Not all debt consolidation plans are created equal and it’s essential to know the difference in the programs. They all combine debts owed to multiple creditors and allow the borrower to make a single monthly payment but that’s where the similarities end. Though there are variations on names, the primary types of debt consolidation are Debt Management and Debt Settlement. Please become familiar with the differences in the plans. Choosing the wrong one for your situation can be very damaging. It’s worth noting that all of the services we consulted that offer both types of service recommend debt management over debt settlement if feasible. We couldn’t agree more.
With a Debt Management plan, debts are typically paid off much faster than by simply continuing to make minimum monthly payments and the total amount paid in interest is far less. In such a program, the debt management company works to negotiate lower interest rates on behalf of the client and is often able to have penalties like late fees and over limit fees eliminated or reduced. Many creditors are willing to lower the interest rate and fees knowing that it’s far better for them to be getting paid, even at a lower rate, than it is for the debt to go unpaid.
The most important part of a debt management plan is that, when completed, the debt will have been paid in full. That is the most significant difference from Debt Settlement, described below. Once a borrower has successfully participated in a debt management program for about three months, collection calls and notices should stop as creditors see that the debt is being paid systematically.
On the down side, you can expect completion of a debt management program to take much longer than debt settlement. Generally a program will last for three to five years. Also, some future creditors may view the fact that a third party was managing ones finances as a negative indicator. Still, the negative impact on the overall credit worthiness is generally less than results from debt settlement, bankruptcy or defaulting on obligations.
If there’s a debt consolidation program that can seem like magic, it’s Debt Settlement and there are certainly advantages. But they come at a price. The big selling point of debt settlement is that it can get you out of debt relatively quickly, often in substantially less than three years, and you can save a lot of money. As good as that sounds, the devil’s in the details. Upon entering a debt settlement agreement, you’ll be told to:
• Stop making your credit card payments so that debts eventually are turned over to collection agents
• Pay a predetermined monthly amount to the debt settlement company to hold in trust for you
• Once the trust account contains enough money to be attractive to creditors, the debt settlement firm negotiates on your behalf to settle the outstanding debt for less than the total owed
Debt settlement is based on the logic that creditors would prefer to get something rather than nothing and, by the time negotiations begin, nothing is exactly what they’re getting. As months pass without payments being made on debts, you can expect you credit score to plummet. Indeed by the time negotiations begin, the debts have generally been turned over to collection agencies with the original creditor having written the debt off. Typically, these collection agencies keep about half of any money they collect giving the other half to the original creditor. Because something is better than nothing, debt settlements are often made for half or less of the original obligation.
From the standpoint of the borrower, the advantages of debt settlement are becoming free of debt in a rather short time while making a much smaller monthly payment. But the disadvantages are also substantial. Debts that are settled are reported as such to credit reporting agencies and future creditors will view a settled debt negatively compared to one that has been paid off. Of course, the overall credit score will be dramatically lowered and building it back up is a long, difficult road. An important intangible side effect of debt settlement is that most people will bear some psychological guilt at having failed to repay debts fully.
While debt consolidation services can be very helpful, especially when your financial situation has become desperate, many of the steps that are taken by these agencies can be accomplished by dedicated individuals. We encourage you to take a look at our accompanying article, Self-Help Debt Reduction. If you find that it’s time to get help, we invite you to the reviews of DebtWave Credit Counseling and Coastal Credit Solutions as well as other highly ranked firms that may meet your personal needs.