Debt Negotiation > Debt Consolidation

DOOR NUMBER TWO: DEBT CONSOLIDATION


Here’s a simple multiple choice test question:

Debt consolidation is:

  1. Borrowing enough money from a bank or finance company to pay off all your bills at one time, leaving you with a lower interest rate and a single lower monthly payment.
  2. Borrowing against the equity in your home to pay off credit cards and other unsecured debts.
  3. A service offered by either for-profit or non-profit organizations, who work with your creditors to lower your interest rates and help establish a repayment budget. (These programs may be called “credit counseling” or “debt management plans” or “debt adjusting plans” depending on the agency or company involved.)
  4. Bankruptcy under the chapter 13 procedure.
  5. All of the above.
  6. None of the above.
What’s your guess? The chances are that you’ll pick (a), because that is what most people think of as true debt consolidation. However, the correct answer is (e) “all of the above.” Let’s take each one of these variations on debt consolidation in turn.

a) BORROWING—Say you owe $25,000 in credit card debts, to be consistent with our previous example. Remember that it will take you up to 25 years to pay off those debts with minimum payments, depending on how the bank handles the interest calculations.

If you go to a finance company instead, and borrow $25,000 at 12% interest, with a $400 minimum monthly payment, you’ll have the loan paid off in less than 9 years using a lower monthly payment. Sounds better, right?

There’s a problem, though. Who’s going to lend you $25,000 without collateral (like a house or other property)? In the real world, few people who do “consolidate” are accomplishing what we’ve described here.

Very few people who are in financial trouble have access to the credit necessary to borrow the lump sum in the first place. If you’re behind on your payments, expect that to show up on your credit file, and therefore expect to get turned down by every loan officer in town.

If you’re still current on your payments, you might pull this off, but it’s still unlikely that you’ll be able to borrow enough to solve the problem. (Many people simply add to their debt this way, by obtaining another line of credit, which then becomes part of the original problem.)

This is also where the scam operators flourish. Desperate consumers respond to advertisements for “guaranteed loans.” The ads state “no credit check required” and offers attractive terms. BEWARE: These are usually variations on the “Advance Fee Loan Scam.” The catch is that the operator on the other end of the telephone asks for a payment up front in order to process the application, anywhere from $25 to $300 or more. You send the money and never hear about the loan, or you are turned down for the loan.

People in financial difficulty are usually too broke to hire an attorney to chase the scam artist who ripped them off, or they’re simply too embarrassed to go after them. Don’t fall for this con game. If you’re going to borrow money, do it in your hometown, where you can look the lender in the eye!

b) EQUITY—Another variation on “debt consolidation” is based on your ownership of real estate. If your home is worth more than you paid for it, you have equity, and many banks will gladly lend you money against it (assuming your credit report looks good enough). There is little risk to the lender, because if you default, they can force a foreclosure on your property to recover their money.

So, let’s say you have $25,000 equity in your house, and you find a bank willing to loan you $25,000 with your house as collateral. This is the ever-popular “second mortgage” or “equity line of credit.” You then pay off your credit cards. At this point in the program, things can go well or not so well. If you are a very disciplined person financially, and your hardship situation was temporary, you may emerge from the scenario with your credit intact. You still have the same level of overall debt, but it is structured in a way that you can live with.

Many people, however, find that they end up in worse shape using this approach. Why? Because they suddenly have $25,000 worth of credit available with new offers for credit cards coming in the daily mail. Then they get busy planning for the holidays, or they just have to buy that awesome home theater system for $3,500. Before they know it, they owe $10,000, $15,000, or even $25,000 again on those pesky credit cards, PLUS they have the second mortgage to keep up. The result is disaster.

There’s also another big problem with borrowing against your equity. You trade an unsecured debt for a secured debt. If you default on a credit card balance, the creditor (if you ignore the problem long enough) can sue you and obtain a court judgment. Then they can put a lien against your house, so that if you ever sell the house, you’re forced to hand over the money. But they usually will not force the sale of your house. A secured debt is a far more serious matter, because you’ve pledged your house as collateral. If you default on a debt that has been secured by your house, then you risk losing that home.

Why trade unsecured debts for secured debts? For most people, this is not the best move to make. Yet countless individuals fall for this trap year after year.

c) DEBT MANAGEMENT PLANS—The third variation on “debt consolidation” is not really consolidation at all in the true sense of the word, as described above. Instead, you are enrolled into a debt repayment program. You meet with a counselor who analyzes your monthly budget. The counselor then makes contact with your creditors and attempts to get them to lower the interest rate. You make one monthly payment to the agency, which then disburses the funds to your various creditors.

The theory here is that your overall payment per month is lower due to the counselor’s success at obtaining lower interest rates and more favorable terms with the credit card banks. This approach is the one most often recommended by the banks themselves, and in the financial press these debt repayment plans (through “non-profit” agencies) is touted as the cure-all for debtors who are in over their heads.

So, does this really work? Well, maybe yes, more likely no, depending on your situation. More than half of all who enroll in such programs drop out before finishing the plan. First, you have to understand that these agencies actually receive most of their compensation from the bank you owe the money to. So, whose side are they really on— the side of the consumer who’s paying a monthly $20 administrative fee, or the bank that’s paying 8% to 15% of the restructured debt in the form of a kickback? Second, these agencies say that they can have your interest rates lowered, and they can, for only about six months, the same thing you could have done on your own. You don’t need to be a genius to figure out that these programs won’t work for a lot of people. In fact, many industry critics view such agencies as debt collection companies in disguise.

Second, most counselors are not going to work all that hard at getting an uncooperative bank to cooperate. The net result is that they simply enter into a typical hardship program that you could have easily obtained for yourself without the extra fees.

Third, with a debt management or debt repayment program, the most frequent complaint we’ve heard from ex-participants is that they have little or no insight into what the agency is doing on their behalf, and they have virtually no control over the process. They send in their single monthly payment, with no idea of how much is going to which creditor, and since most counselors are busy people who work based on high volume, getting a return phone call can be difficult.

Now, we’re not saying that all such organizations do a poor job. Like any business, there are good and bad services out there. However, they don’t really SOLVE the problem at all. In other words, if you walk into the office of a debt consolidator owing $25,000, you’ll still owe $25,000 when you walk out.

In our judgment, debt repayment plans or debt management plans (whether through a for profit or not-profit agency) are a helpful approach only for the consumer who knows that their financial hardship is temporary (say 6-12 months or less) and simply does not want to deal with the hassle of creditor phone calls in the meantime. Otherwise, stronger medicine makes more sense.

d) CHAPTER 13—The final form of “debt consolidation” is actually not consolidation at all, but rather a form of bankruptcy called “Chapter 13.” We’ll discuss it below under its proper heading.
Read about door number three: bankruptcy.