Any proper discussion of methods for reducing debt load should begin with the following disclaimer:
Dealing with excessive debt is, in several ways, analogous to losing weight. You did not acquire all that weight/debt quickly, and it may take you even longer to lose it — and without changes in eating/spending habits, the weight/debt will come back. Any debt consolidation measure must contain some form of credit counseling. At the very least, you should understand what habits got your personal or business finances into this predicament in the first place, and have a strategy to change them.
“If you are facing a mountain of debt, the first thing you need to do is stop digging,” counsels financial writer Tiffany Aliche known as the Budgetnista. “Put down the credit cards, right. Because if you are swiping and swiping away, you are going to keep digging and digging, so first things first, stop digging.”
Three terms related to debt reduction are often used interchangeably, but should not be.
Debt Consolidation: This means consolidating multiple debts into one debt stream. Debt consolidation does not reduce your debt — it just simplifies payment by having only one creditor. While this may help you keep track of payments, the main purpose in consolidation is moving higher interest rate debt into a single payment with a lower interest rate by one of these methods:
- Loans – Consolidation loans are usually secured loans against assets (such as a home equity loan). If your credit rating allows for an unsecured loan, it is a much better situation, as your assets will not be put at risk. Once you close the low-interest loan, high-interest loans like credit cards can be paid right away.
- Balance Transfers – Opening a new credit card account with favorable terms (usually a short-term promotional rate) and paying off the old cards and other debt with the new card.
Do not be fooled by the sudden appearance of a much larger credit capacity. Avoid using this credit if possible, and use it sparingly if you must. In addition, when extending payment periods, consider the time value of money as well as the interest rates.
Debt Management: Debt management companies prioritize and allocate your debt. Instead of paying off the previous creditors and replacing them with a single debt source (loan or credit card), you are keeping the same creditors, but having one person manage the payments for you with money you pay them from your account. It is a form of debt consolidation — but only from your viewpoint.
Debt management companies can either be for profit or non-profit, but they are not free. Even non-profits have overhead expenses. Often they will attempt to negotiate better interest rates or lower finance charges with creditors, using their relative stability as leverage.
It can take three to five years to complete a debt management program, and possibly longer depending on your debt-to-income ratio. Credit effects are minimized by successfully completing the program. Since a lot of your credit score is based on making payments on time, “…just by being in the [debt management] program, the bills get paid on time every month, and that has a really, really positive implication for your credit score,” says April Lewis-Parks, Director of Education and Public Relations with Consolidated Credit, one of the nation’s largest credit counseling organizations.
Debt Settlement: Debt settlement is designed to reduce your overall payment amount. Debt settlement companies usually advise you to stop making payments to your creditors, and deposit money in a separate account for a future settlement.
The theory is that creditors will eventually write off your debt as bad debt and take whatever they can get through the settlement company. Generally they will, but there is no guarantee that the settlement company can settle with every company. This could leave you with unpaid debt and significant charges.
Usually, this is a quicker method of getting out of debt. However, your credit score will be damaged for years, and may never return to higher levels. Since you have made a choice not to pay your bills in full, potential creditors may decide you are an unacceptable risk.
All debt reduction methods have associated fees and/or closing costs, and some have tax ramifications with possible deductions or penalties, so consider this when doing cost-benefit calculations. Be aware that there are many scammers who try to take advantage of people in dire straits; dealing with them, you could end up with even more debt and more headaches.
If you want to reduce your interest payments and lower your debt, try the free Debt Optimizer by MoneyTips.
Photo ©iStockphoto.com/studiocasper