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Know the Risks of Debt Consolidation

Debt SettlementWhen you got your first credit card, you had no problem making the monthly payment. But before you realized it, you had maxed out the first card and taken out other cards to pay for a financial emergency. Suddenly a manageable monthly payment turned into an unmanageable debt. Should you try a debt consolidation loan?

Debt consolidation loans combine all unsecured debt into one loan and one monthly payment. Positive outcomes can include lowering your interest rate, protecting your credit, lowering monthly payments and getting out of debt faster. However, there are risks involved.

Types of Debt Consolidation Loans

There are two types of debt consolidation loans: secured and unsecured. Secured loans are the most common, and the ones to be most cautious of. These loans require collateral, such as property or a vehicle, meaning that if the borrower is unable to make the monthly payment, his or her home or car could be at risk.

Unsecured debt consolidation loans are safer, because they don’t require any collateral, but they are harder to obtain because borrowers typically must have excellent credit.

Debt consolidation only makes sense when the monthly payment, interest, and payback terms offered are less than your current payment. Before signing any agreement, research the debt consolidation company, including checking for complaints with the Better Business Bureau, and avoid companies with a high interest rate or large fees.

What are Alternatives to Debt Consolidation?

Debt consolidation is only one option. If you are unable to manage your debt, you also might consider debt settlement, a debt management plan, or filing bankruptcy.

  • Debt settlement. Debt settlement involves negotiating with creditors for a reduced payback amount or a lower monthly payment. While credit card companies are under no obligation to negotiate, many will if you explain your financial hardship and the reasons you are unable to make the monthly payment. You can do this on your own or a debt settlement company can assist in negotiating down the debt on your behalf — though usually for a fee.
  • Debt management plan. You can enlist a nonprofit credit counseling agency to help develop and maintain a debt management plan for you. A financial counselor can help set a realistic budget and negotiate lower fees and payments with creditors. Every month, you then deposit money into an account from which the debt management organization makes your monthly payment. These types of debt management plans require diligence. Many such plans are contingent upon you making consistent payments on time. If you pay even one payment late, you could lose the lower interest rate you negotiated and accumulate even more fees.
  • Bankruptcy. No one wants to file for bankruptcy, but in some situations, it is the best option. Consult a credit counselor or other unbiased advisor to weigh the pros and cons. And keep in mind that some debts — such as student loans, alimony, child support, taxes and restitution as the result of a criminal sentence — cannot be discharged in a bankruptcy. Some assets, such as retirement accounts and 401(k) plans, also are off-limits and cannot be used to pay off debts in most cases.

Carrie Pierson, human resources manager for the Wyoming-based nonprofit Family Financial Education Foundation (FFEF), says facilitated debt management is a good option for some people because a financial counselor is able to negotiate a lower payoff amount with the lender (although, as stated, you also can do this for yourself by calling your creditors directly). In addition, organizations such as FFEF provide a budget review and financial analysis as well as payment distribution from a FFEF account so you are sure to make your payments on time.

Pierson says most of FFEF’s clients come to them when they are behind on their bills or close to becoming delinquent.

“It’s a great program because it helps clients get out of debt without adding more debt,” says Pierson.

Pierson cautions against taking out another loan to pay off debt. You may believe debt consolidation will be better because you only have to deal with one lender instead of 10, but the interest rate usually is higher and you have to put up some kind of collateral to get an unsecured loan.

It is important to carefully consider options before agreeing to work with any debt consolidation or debt management agency. Avoid companies that charge large fees, don’t provide a fee schedule, resist getting everything in writing, or promote too-good-to-be-true offers.

To find a reputable credit counseling agency, start by visiting the Justice Department website.

[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]