The 6 Biggest Debt Consolidation Myths: Know the Truth

If you’re looking for a way out of debt, chances are good you’ve come across the term “debt consolidation” and chances are just as good that everyone you talk to has a different opinion about it.

The simple truth is that debt consolidation most often is a financial strategy used by people trying to take control of credit card debt. They owe thousands, maybe tens of thousands of dollars to card companies – almost always involving multiple credit cards – and decide to combine those debts into one manageable payment through debt consolidation.

Is it good? Is it bad? That is for you to decide, but first, let us set the record straight on some of the myths you might have come across in your research.

Myth No. 1: Debt consolidation is a scam

Debt consolidation is a legitimate avenue to pay off debts, but it pays to research the credit counseling agency that offers this solution.

Unfortunately, the debt consolidation industry was dealt a black eye following the Great Recession in 2008. Predatory lenders popped up left and right taking advantage of people who suddenly found themselves deep in debt.

Search for a reputable debt consolidation company that has been around long before 2008, and make sure it is a registered nonprofit 501(c)(3) organization.

A red flag should go up if the company asks for a large lump sum of money upfront and plans to quit paying your creditors. This notorious technique is called debt settlement – the source of many of the problems in the years after 2008.

Myth No. 2: Debt consolidation and debt management plans are the same thing

Debt consolidation and debt management plans (DMPs) are similar, but have a few key differences. When you consolidate debt, you take out a loan (from a bank or credit union), and the rest is really up to you. Ideally, you use the funds to pay off your creditors and thus have one monthly payment (the loan).

DMPs work a little differently. There is no loan involved. You still have one monthly payment, but it is to a program offered by a credit counseling agency. The credit counselor calculates a monthly payment that the borrower can afford and determines how long it will take (at that rate of payment) to eliminate the debt. The borrower sends the monthly payment to the credit counseling agency, who strategically distributes the funds to each creditor in agreed upon amountsthat pay off the debt quickest. Because credit counseling agencies work with creditors regularly, they have agreements in place to lower interest rates and waive penalties.

Myth No. 3: Debt Settlement is the cheapest way to square your debts

You’ve probably seen billboards that shout “settle your debt for a fraction of what you owe!” On the surface, it sounds like a great deal. But if you think it’s too good to be true, it probably is. What it doesn’t say is that debt settlement companies charge substantial fees, usually 20-25% of the final settlement. The IRS considers whatever money saved in the settlement as income so you must pay income tax on that sum.

Debt settlement companies stop all payments to creditors as a negotiation tactic, and they have to negotiate with each creditor individually, which takes time. During that time, late fees and interest are piling on top of the growing balance, and missed payments tank your credit score. Debt settlement is then noted on your credit report for seven years.

The real bottom line on debt settlement is that they “hope” to reduce the amount you owe by 50%. When you add in their fees, the interest rate penalties (most settlements take 2-3 years) and extra taxes paid on whatever amount is forgiven, the consumer’s real savings typically dwindle to something closer to 10%-25%.

And your credit score is scarred for seven years.

All of that factored into the cost makes it an extremely risky proposition, especially considering the fact that lenders aren’t required to accept the settlement terms.

Myth No. 4: A debt consolidation loan will save you money

There are several types of debt consolidation loans, one of which may be the best route to saving money, but that takes some research. Your choices are a) straight debt consolidation loan from a bank or credit union; b) home equity loan, using your house as collateral to get a low-interest loan; c) unsecured personal loan.

The purpose of any debt consolidation loan is to save money. In the examples mentioned above, credit score is going to play a prominent role in the interest rate you receive. If you have a lot of credit card debt, your credit score usually suffers, which means you probably will pay a high interest rate so keep that in mind as you shop around.

If the interest you pay on debt consolidation loans isn’t considerably less than you were paying on your credit card bill, a debt management plan might be a better option. DMPs have agreements in place to lower interest rates regardless of credit scores.

Myth No. 5: Debt consolidation leads to more debt

A common refrain you might hear is that debt consolidation doesn’t fix the root of the problem. You can wipe your debts clean, but if you haven’t changed your spending habits then you can end up right back where you started.

Debt management plans require credit counseling, which is designed to curb that trend. The same can be accomplished individually with debt consolidation. There are plenty of tools available online to help create a budget and information about important financial practices like building an emergency fund. Increasing your financial literacy is the key to a staying debt free.

Myth No. 6: Debt consolidation hurts your credit score

The two most important factors of a credit score are payment history and credit utilization (how much you owe versus how much credit you have available).

Initially, your credit score might take a slight dip either due to opening new credit (via a consolidation loan) or closing existing accounts (through a debt management program). However, it should recover quickly and continue to rise as you make on-time payments and reduce the amount of money you owe.

The early drop shouldn’t worry you too much because you shouldn’t be in the market to add a new credit line when you’re in debt anyway. What’s more important is where your score lands at the end of the process. Whether you do a debt consolidation loan or debt management program, your credit score will be better off when you are debt free.


Sources:

myFICO (2018) What’s In My FICO Scores. Retrieved from https://www.myfico.com/credit-education/whats-in-your-credit-score/

NA, (2018, January 18) 8 myths about debt consolidation debunked. Retrieved from https://www.finder.com/debt-consolidation-misconceptions

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