How Debt Consolidation Works

In today's credit-crazy culture, life's necessities, such as a car, a home or an education, are often impossible to afford without loans. With household credit card debt hovering around $8,650 [source: Center for Responsible Lending], it seems that most people could benefit from greater financial literacy and restraint. But before you decide debt consolidation is your lifeline, it's a good idea to create a budget. Here are the basic steps:

By comparing how much you make and spend each month, you can get a better idea of what impact loan payments have on your life and whether it's worth it to consolidate. Read more about budgets in How to Make a Million Dollars.

Merely having debt doesn't necessarily mean you need to rearrange your finances; however, you should recognize the signs that you are struggling [source: Garman, Kiplinger]. These signs include:

Once you do the math, you'll know whether you're ready to consolidate. Consolidating your loans, as we explained before, simply means taking out one bigger new loan to pay off several existing loans. As with any loan, you'll have to pay an extra charge determined by the interest rate, a percentage of the amount borrowed. If you find a consolidation loan with a low interest rate, then reduced payments could make your immediate financial situation more manageable and free up other income for savings and investments. In addition, if you're juggling multiple loans, combining them means that you'll only have to deal with one monthly bill. Since late payments are factored into your credit, having a more manageable payment system could make it easier to build better credit.

Many financial advisors consider bankruptcy a last resort, and recommend evaluating all other alternatives first, such as debt management.

If you have decided that you want to consolidate your debts, the choices you will face could quickly get stressful and overwhelming. Given the risks of losing your home and amassing debt, it's wise to proceed with caution. Read the next page to find out about some of the options you will have.

Knowing all your options is important before making a major financial decision. You don't want to entangle yourself in an agreement only to find out you have sunk deeper into debt.

Your first step is to decide whether you want a secured or unsecured loan. A secured loan occurs when a valuable asset, such as a house or a car, serves as collateral in case you, the debtor, stop making payments (known as default). If default occurs, then the company that loaned the money can legally repossess your house or car. In contrast, an unsecured loan merely uses the debtor's credit to back the loan. Because of the collateral, companies are willing to offer lower interest rates with a secured loan. You'll have to decide whether lower interest rates are worth the risk of losing your home or car.

Next, decide if you want to:

Going through a bank is often the best way to get a consolidation loan [source: Wilmington Trust]. You usually can qualify for a lower interest rate from many banks if you can deduct payments from an account you have with them. If you have a low credit score, which is an indicator of how creditworthy you are based on your payment history, banks are less willing to fork over cash. This is why many debt-ridden people turn to finance companies.

Finance companies are simply companies that offer loans to individuals or businesses. They often are willing to take more risks and lend money to people with lower credit scores. In exchange for that risk, they typically charge high interest rates. Many non-profit companies offer debt management as well. They will help you find a debt consolidation loan and provide counseling. Remember that even though they are non-profit doesn't mean there won't be fees attached to some of their services.

If the first option for managing your debt doesn't appeal to you, you could try taking out a home equity loan. This is a secured loan, also known as a second mortgage, in which your house serves as collateral. Despite the risk of losing your home, this kind of loan has some advantages. For one, you can deduct the interest payments on your taxes. You also can get a fixed interest rate (as opposed to a variable interest rate, which may rise) with a home equity loan.

Another option for consolidating your debt is using credit card offers. Many credit card companies advertise 0 percent balance transfer fees -- you can bring over the old credit card debt with no charge. Some people pay off debts by jumping from one low-rate introductory offer to another. To avoid hurting your credit when you close accounts, ask the company to report the account as being closed at your request [source: Dunleavey]. You also might consider leaving these accounts open, even if you won't use them, because it will improve your debt-to-credit ratio.

If those old student loans are still hanging over you, read the next section to learn about some of the special rules that apply to consolidating them.

As college tuition costs soar higher than inflation, student debt has risen as well. The Project on Student Debt reports that about two-thirds of students graduating from four-year institutions have debt averaging $19,200 [source: Singletary]. Although student loans can work as a kind of investment in your future, the starting salaries for recent graduates are not keeping up with this rise in debt [source: The Project on Student Debt].

Lowering monthly payments with consolidation proves appealing to cash-strapped graduates. Luckily, restrictions cap interest rates for former students who want to combine their federal student loans through the Direct Consolidation Loan government program. The maximum interest rate for a federal Direct Consolidation Loan is 8.25 percent. [source: Direct Consolidation Loans].

If you have both private and federal student loans, however, you cannot lump them together under a federal consolidation loan. Nor is it a good idea to combine them under a private loan, as your interest rates will most likely rise [source: FinAid]. In addition, you would miss out on important perks that could come in handy for your federal loans, including advantageous repayment, forgiveness and cancellation opportunities [source: FinAid]. Another benefit of federal student loans is that the interest you pay on them is tax deductible.

Assuming that you're still bent on consolidation, you can consolidate your loans with any institution, not just the one where the loan originated. If you can do the research and comparison shop, you will find companies that offer interest rates lower than the federally instituted maximum. Some of these offers stipulate that you must be on time with all of your payments or else your interest rate may rise. That could be harder than you think, especially when you consider the lifespan of your loan.

A bank or a credit card company will not be inclined to offer you a good deal with less than a stellar credit score (such as the 500s), so there are some nasty tactics to look out for if you opt for a finance company. Even alumni associations have been accomplices in the tactics of loan consolidation companies. In exchange for payments, some associations have provided alumni lists to Nelnet, a company specializing in education loans [source: Paley]. Read the next section to learn more about debt management scams and how hidden fees could end up putting you more in debt.

Who doesn't want to believe that their debts will disappear after they complete three easy steps? People who are concerned and confused about their debt situation pose exceptionally tempting prey to scammers. Many cons are as simple as companies asking for payment up front and not delivering on the loan. By the way, U.S. and Canadian companies legally cannot call you and promise you a loan then ask for an advance fee before the transaction is completed [source: Federal Trade Commission (FTC)].

Another trick is to claim non-profit status. The FTC has exposed several so-called non-profits, such as the National Consumer Council and Debt Management Foundation Services, which were funneling funds to a for-profit company. Given their deceptive names, it's not surprising that unsuspecting people were willing to trust them.

The victims of these scams fell deeper in debt and suffered a rise in interest rates, as well as other penalties and damage to their credit. Some people even went bankrupt after being misled by these fraudulent companies. In addition, by hiding behind supposed non-profit status, these organizations called numbers on the National Do Not Call Registry to advertise their services. The FTC charged them with not only lying about what their services would do, but also failing to disclose the penalties and fees that would result.

Now that you're looking over your shoulder, why don't you take the following precautionary steps recommended by the FTC before taking out a loan with a finance company: 

Although they aren't exactly scamming you, many finance companies simply don't warn you about the excessive fees they charge. These fees can add up so that you pile on even more debt. In a related article on debt settlement, SmartMoney writer Aleksandra Todorova named a few fees to watch out for: 

The FTC also cautions against companies that pressure you to pay "voluntary fees." One company that the FTC exposed, called AmeriDebt Inc. collected about $200 million in hidden costs like these [source: Federal Trade Commission].

Just as diet pills are usually too good to be true, so are most debt consolidation offers. Remember, no new loan is going to free you instantly from your debts. But like losing weight, you can climb out of debt with good old-fashioned discipline. Inspired? Check out the next page to find a Web site that will help you to create your own budget and to read more on related topics.