When Is Debt Consolidation Legitimate?

Does the phrase “debt consolidation” mean anything to you? For some, it brings to mind the idea of financial scams and disreputable companies trying to take advantage of unsuspecting consumers.

But is that really the case?

Well, yes and no. Debt consolidation, at its most basic level, is simply the action of grouping all your debt into one combined debt. For example, say you have three student loans and decide to use debt consolidation to combine all three into one larger consolidation loan. In that case, the new loan would have a balance equal to the sum of the other loans.

Sounds pretty simple, right? Unfortunately it gets complicated by the fact that certain companies advertise themselves as “Debt Consolidation Providers” when in reality they actually do something called debt management, which is different.

Why do they call themselves something that they’re not? Because they know people are out there looking for debt consolidation loans and they believe people won’t recognize the difference between debt consolidation and debt management.

The reality is that debt consolidation is a legitimate tactic for managing your debt — but only under the right circumstances. Here’s what you need to know before diving into debt consolidation:

How Does Debt Consolidation Work?

As we mentioned above, the idea is pretty simple, but it turns out there are a variety of ways you can actually do debt consolidation, and each one has specific advantages and disadvantages. Here is a quick overview of the types of debt consolidation programs:

1. Standard debt consolidation loan: This requires you to get a loan from a bank, credit union, or peer-to-peer lender who will agree to consolidate all your debts (usually credit card balances) into one new loan. The benefit to you is that the interest rate on the consolidation loan is often lower than what you were paying before.

2. Balance transfer offers: Technically, a credit card balance transfer is a type of debt consolidation, because it involves consolidating all your credit card debt onto one new card. Often, you will see 0% interest periods of 12-18 months on a balance transfer offer, which can really help if you are sure of your ability to pay off your balance during that time. If you don’t pay off the entire balance before the introductory period expires, you may accumulate steep interest charges.

3. Home Equity Loan or HELOC: While this is only an option for people who already have a mortgage, it is one that many Americans have been using in recent years. A home equity loan means that you are borrowing against the value of your home to pay off your credit cards (or other debts). The home equity loan will charge less interest but comes with the added risk that if you cannot pay it back your lender can foreclose on your home.

4. Student loan consolidation: A student loan consolidation can be slightly different from a standard consolidation loan because many times you are borrowing from the federal government. Usually, the government offers low interest rates and flexible repayment schedules. But keep in mind that student loan debt is much harder to discharge through bankruptcy than other types of debt, and the government can sometimes garnish your wages if you default on your federal student loans.

How Can You Find a Reputable Debt Consolidation Company?

So what should you do if you’d like to pursue a standard debt consolidation loan? You’ll need to prepare yourself to identify a reputable debt consolidation company. First, try contacting your local credit unions and banks and ask them what interest rates they can offer you. Then compare and see which ones offer the most attractive deal. You can also research companies like Lending Club that offer peer-to-peer loans. According to Gerri Detweiler Credit.com’s consumer credit expert, “true debt consolidation loans can be hard to find. The more debt you have, the harder it is to qualify for a new loan. But some lenders, especially social lending firms and credit unions for example, offer consolidation loans at reasonable rates.”

As you do your research, watch out for any company that tries to sell you something other than debt consolidation, is pushy, or makes you feel uncomfortable in any way. Don’t get hoodwinked by a fast-talking salesman who convinces you that he can make your debt go away quickly or whose promises sound too good to be true.

Does Debt Consolidation Hurt Your Credit Score?

If you’re interested in debt consolidation, it’s very important to determine how it will impact your credit score. And in order to tell whether debt consolidation hurts your credit score you must know which type of consolidation you’re going to be doing. Applying for any type of loan usually requires a hard credit check, which can lower your score a small amount.

But more importantly, you should be aware of how your credit utilization will be affected. Credit utilization refers to the percent of your available credit that you’re currently using. For example, if the credit limit on all your credit cards combined is $30,000 and you have $15,000 in credit card debt then your credit utilization is at 50%. But if you get a debt consolidation loan and close all your credit card accounts, your total debt will still be $15,000 but your credit utilization will now be 100%, which may hurt your credit score.

According to Detweiler, “a debt consolidation loan shouldn’t hurt your credit score. You may see a dip temporarily since you have a new account. But if you pay it on time, that should even out. If you close all the credit cards you’ve consolidated you may see your scores drop – though for some that may be safer than running the risk of charging on those cards and getting deeper in debt!”

Ultimately, debt consolidation can be a good option, but it’s not something you need to rush into. If you evaluate all your options and use the information above to research whether debt consolidation is right for you, then you’ll be in the good mindset to make a wise decision.

This story is an Op/Ed contribution to Credit.com and does not represent the views of the company or its affiliates.

Image: BLW Photography, via Flickr