Debt Consolidation - The Last Line of Defense

We have all seen the ads for debt consolidation companies.  They begin by showing worried-looking people with furrowed brows, sometimes sitting at a table covered with credit card bills.  The ads close with images of the same people after having called Such-and-Such Debt Consolidation; now, they seem happy and stress-free, ready to begin a new life of no worries.

The fact is that debt consolidation is not an end or destination.  It is merely a tool - a single option - that can provide one with the means to eliminate credit card debt.  Remember the old saying that reminds us to use the "right tool for the right job?"  When it comes to your battle to achieve financial freedom, that saying has never been truer.  As the title of this page suggests, debt consolidation should be the last line of defense.  It may be used to prevent bankruptcy, but it does carry significant implications of its own.

First, we will explore how debt consolidation companies work, and then we will discuss the financial and credit implications it carries for the borrower.

Let's make a distinction here between a debt consolidation service (which is the subject of our discussion), and debt consolidation loans.  A "debt consolidation" loan can be any loan a person obtains in order to pay off unsecured debts like credit cards.  It could be a personal loan from a local bank, or a home equity loan from a national lender.  Usually, but not always, one has to have a good credit rating to qualify for these loans.  Applying for a loan will require the lender to pull your credit.  These credit inquiries can be detrimental to your credit rating, so consider all your options before making a final decision.

How Debt Consolidation Services Work

When you call a debt consolidation company, the first thing they will need to do is discuss your financial situation - your various debts, your income, etc.  A bit of good news that you can expect from any of the many reputable companies that provide debt consolidation services is that they will be honest with you.  Severe legal consequences will be levied against any company that misleads people in regards to their debt options.  Still, some will be more efficient or more effective than others will, so it is best to shop around.

After the financial review, they will give you details about your particular situation of which you may not have been aware, such as:

• How long it will take you to pay off your debt making minimum payments.
• How much money you will waste on interest payments over that time.

Next, they will tell you what they can do for you.  Some of the benefits they may provide include:

• Negotiating lower interest rates (sometimes eliminating interest payments entirely).
• Lowering monthly payments.
• Allowing you to make one payment per month - they will distribute the funds to your creditors for you.

They have done this before for many other people, so you should expect to get a good estimation of the results they can produce.  At this point, end the conversation without committing to their service.  Feel free to tell them you need to shop around before making a decision, because they may then offer you additional benefits or services in order to get your business.

What the Ads Don't Say

In speaking to the debt consolidation specialist, you will discover that they have to close the accounts that you wish to consolidate.  Credit card companies deal with them because they would rather compromise than have you default or declare bankruptcy.  Some money is better than no money. 

As part of the terms of a debt consolidation agreement, you will not be able to apply for any new credit or loans during the repayment process.  The credit card companies need to know that you are serious about paying off your debt.  Of course, once all the debt is paid and your contract with the debt consolidator is complete, you may then apply for new credit, if you so desire.

How Does Debt Consolidation Affect Credit Ratings?

Using a debt consolidator primarily has a bad effect on your credit.  One of the biggest factors in determining credit ratings is called the "debt-to-credit" ratio.  This is a ratio comparing the total amount of all your lines of credit to the amount of your outstanding debt.  For example, if you have five credit cards each with $4000 lines of credit, your total credit would be $20,000.  If you made exactly $2000 in purchases on each of the five cards, your debt would be $10,000.  In this case, your debt-to-credit ratio would be fifty percent, which is not ideal, but it is not terrible.  (A lower debt-to-credit ratio is better.)

When a debt consolidation company closes your credit card accounts, you have zero dollars in credit, but you still have debt.  In essence, your debt-to-credit ratio goes to infinity.  That is a pretty bad mark on your credit.

The good news is that as you continue to pay down your balances on time, your credit score will slowly rebound.  Therefore, the only time someone should opt for debt consolidation is if his or her credit is in trouble already.  How do you know if calling a debt consolidator is the right thing to do?  That is what the next section is all about.

How to Know If Calling a Debt Consolidator is the Right Thing to Do

Many people call for help from debt consolidators unnecessarily.  The fact that making credit card payments every month is inconvenient is not a valid reason to compromise your credit rating.  It may be inconvenient.  It may be uncomfortable.  It may be nearly unbearable - but if you can do it on your own, you must.  However, here are a few scenarios that might call for assistance from a debt consolidator.

• Inability to make even minimum payments

If you cannot make the minimum payment on one or more of your credit cards without sacrificing basic necessities - like food and the electric bill, not eating out, buying jewelry, or opting for the big cable TV sports package - you may consider making the call.

• Making minimums, but pay off date is too far away

If you are able to pay the minimum payment on all of your credit cards, but not a penny more, then check to see how long it will take you to pay them off.  (There are many very good debt calculators online, like this one from CNN Money.)  If it will take more than about ten years, go ahead and call the debt consolidator.  The reason I say ten years is that it usually takes three to five years for a debt consolidation service to get you out of debt, and then you will need a few more years to get your credit rating back in shape.  If you can make your payments on time for eight to ten years, your credit rating may well be in a better position.

This is a subjective opinion.  You should always consult with your financial advisor before making these potentially life-altering decisions.

• Credit rating already compromised, and in need of monthly cash flow

If you have late payments, accounts closed unsatisfactorily, or other bad marks appearing on your credit rating and you need more monthly cash for necessities or for an emergency, consider debt consolidation.  The point here, as in the other circumstances, is that it must be a dire situation for you to use a debt consolidator.  Don't do it just to free up money for betting on the horses or buying designer shoes.  Under no circumstance should you sacrifice your financial future for the sake of immediate gratification.

Whatever your current financial situation, you can chart a path to success.  It takes grit, determination, and an unswerving focus on your goals, all things you already have or you can get.  Consider all your options and start making your future today!