Debt consolidation is one of those terms that gets thrown around a lot when people talk about money management and paying down debt. While it is a great strategy (at least for certain people), it is one of the least-understood money management approaches going. In fact, there are at least ten classic misconceptions about how debt consolidation works that people in debt need to have debunked.
Of all the financial plans available for people dealing with overwhelming debt, this is probably the most valuable and the least understood. In fact, you may already believe some of these common myths. Find out the truth!
Myth #1 Debt consolidation is the same or similar to debt management, debt settlement, and bankruptcy.
Truth Although the terms are thrown around a lot and even used interchangeably, there are some key differences. One things that set it apart is that it is not really a program (you can do it yourself if you want to) but more of a strategy.
In debt consolidation, you lump all of your debts together and repackage them. Debt settlement and debt management typically involve dealing with a company or counselor and the object is to reduce the amount you owe. Bankruptcy is a legal proceeding that involves a date with a judge.
Myth #2 Debt consolidation reduces your debt.
Truth No, it doesn’t. If you owe a total of $80,000 on several credit cards and loans and you consolidate that debt, you still owe $80,000.
In the strictest sense of the term, debt consolidation does not re-negotiate, settle, write off, or reduce any of your debt. What possible advantage is re-organizing your debt like that?
If you have a lot of loans at high interest rates, repackaging those higher-interest debts into one larger loan at a lower rate reduces your interest and the amount you have to pay. This means you can either pay less a month or (even better) pay the same amount but get the debt paid off sooner.
Myth #3 Debt consolidation will hurt my credit score.
Truth If you do it properly, it is likely to have no negative impact on your credit score. In fact, it may even improve your credit score! That’s because you’ll be paying off a bunch of smaller loans and any time a loan is paid in full, that helps your credit score.
Myth #4 Debt consolidation requires getting help from an outside agency or a lawyer.
Truth While there are companies and counselors in the marketplace who will help you deal with debt (in many different ways), you can also consolidate debt on your own.
Of course, if you want to handle this on your own, you have to know a bit about how to do it and what the options are. But it can definitely be a do-it-yourself project for people good with money (or who are willing to learn enough to get good with money).
If you reorganize your debt yourself in that way, it is also not necessarily visible to outsiders. Your bank, the credit bureau, and other parties may not even be aware that you have consolidated debt. (However, if you negotiate or try to settle your debt, that will send up some red flags.)
Myth #5 Debt consolidation is something for financial losers and lightweights, not for people who know how to manage money.
Truth This is the most far-out myth. Reorganizing and structuring your debt more favorably is a principle that is used in business and by the super-wealthy all of the time. It is a way of organizing and structuring your debts in a way that is most advantageous to you.
Myth #6 Debt consolidation is just robbing Peter to pay Paul; you’re just getting more debt!
Truth It is indeed a way for you to pay off one debt by getting another debt. But not all debts are equal.
As an example, let’s say that you owe $10,000 and the loan is set up so that you have to pay 22% interest. For example, let’s suppose that I go to my credit union and work out a deal to borrow $10,000 at 12% interest. While both debts are still in the amount of $10,000, the debt at 12% interest is a better deal for me. I won’t have to pay as much per month or, if I make the biggest payments I can, I can pay it off sooner.
Myth #7 Debt consolidation requires you to be a homeowner.
Truth There is a grain of truth to this, in that owning a home definitely offers an advantage to anyone who wants to re-structure debt. (It doesn’t matter if your home is paid for or not, but you do need some home equity.) There are ways to reorganize your financial obligations even if you do not own a house.
Myth #8 Debt consolidation will make it harder for me to get future loans.
Truth In most cases, it is unlikely that anyone but a forensic accountant could figure out that you have reorganized your debt (unless you go through a debt consolidation company-that could leave a paper trail).
If you borrow money in one loan and then take out another, more advantageous loan to pay off the first one, you’re more likely to leave a paper trail of somebody who pays off debt responsibly. It is more likely to make you a desirable creditor.
Myth #9 People who consolidate debt just wind up digging themselves in deeper in debt!
Truth It is absolutely possible to consolidate your debt and then keep spending and get yourself in a big mess. That’s why you need good information and a plan to pay off your existing debt, manage your finances now, and start planning for your financial future.
There is no reason that many financial management programs cannot work to get you out of debt for good, but you have to have a plan.
Myth #10 Debt consolidation will allow me to write off some of my debts and it will stop bill collectors from calling.
Truth Let’s take these one at a time.
Unlike bankruptcy, true debt consolidation will not allow you to write off any of your debt-not a penny of it. Whatever you owed as a debt before consolidation is the amount you’ll owe after consolidation.
So why would anyone use this approach? Well, it is a new loan and it is structured in a more favorable way than the older loans. You do not get existing debts cancelled or decreased! Now it’s true you can work that out in other debt management solutions (debt settlement lets you reduce debt, bankruptcy will let you write some debt off) but they come at a price. Both of these approaches can have a negative impact on your credit score, will make it hard for you to get future loans, and stay on your record for quite a while. Bankruptcy, in particular, is an extreme solution that involves an actual court proceeding and a judge who has the authority to make certain decisions about your financial situation (including forcing you to sell some items to pay off debts).
If you regroup your debts in this way, it can only stop bill collectors indirectly. Here’s how: let’s say you have six debts and you’re getting calls all of the time. If you re-organize your six debts into one large loan at more favorable terms, you’ll pay off all of those littler debts. Bye-bye, bill collectors!