—Article by Daniel Gelinas

You may have heard of the term “debt consolidation.” But are you aware that there are several ways in which to consolidate debt? For example, a “debt consolidation loan” is very different than “debt consolidation” that is offered through a consumer credit counseling agency.

Which is the best option for you? It depends on a number of factors.

This document was prepared by The Center For Debt Management to highlight the differences between a “debt consolidation loan” and “debt consolidation” through a credit counseling or debt management agency. If you are considering debt consolidation, it is important that you understand these differences.

Debt Consolidation Loans

For some consumers a debt consolidation loan may be their best option. This is particularly true for consumers who may have considerable debt but not enduring financial hardship. If the average interest rate on their various accounts is high, a debt consolidation loan at a low interest rate could save the consumer a significant amount of money over time. Even if there is no significant change in the interest rate, the ease of making one payment each month may be reason enough to obtain a debt consolidation loan.

Most consumers considering debt consolidation, however, are enduring financial hardship. This equation magnifies the necessity of consolidating one's debt—and may also add to the complexity of doing so.

While a consolidation loan may sound appealing, the truth is—often it does not resolve the debtor's financial hardship. In fact, it may compound it. The reality is, it's very difficult to get a low rate consolidation loan unless the would-be borrower is financially sound, has excellent credit and/or has very good collateral, typically one's equity in real estate or a motor vehicle. Lenders that accept lower standards, and therefore increase their risk, charge high interest rates—21% or higher being common. Even with excellent credit and very good collateral, often the interest rate is higher, or very near the borrower's current average interest rate of the debts being consolidated.

It is important to understand that a debt consolidation loan simply “transfers” the debt to a new lender. Furthermore, a debt consolidation loan may not lower a consumer's overall interest rate. In fact, for many consumers a debt consolidation loan increases their overall interest rate—and usually with greater consequences if the borrower defaults!

If a financially burdened consumer is able to obtain a debt consolidation loan at an overall lower interest rate it could very well prove to be the right decision. Even if the consumer's overall interest rate is somewhat increased, a debt consolidation loan could prove beneficial for consumers consolidating debt on past due accounts that are accruing late fees and other punitive charges. The higher interest rate could be off-set by the fact that the past due accounts would be paid -in-full as a condition of the loan, thus, eliminating the late fees.

In the above situations, however, it is important that the borrower is “reasonably assured” of being able to meet the conditions of the loan, making all payments as scheduled. Otherwise, as detailed below, the decision to take out the loan could prove disastrous.

A major point to consider is understanding the type of debt being consolidated; secured, unsecured or a combination of the two. An example of secured debt would be a car or boat loan. On the other hand, credit card debt or a medical bill is typically unsecured debt. Should a consumer default on a loan, whether secured or unsecured, the creditor may elect to file suit in an effort to collect the debt. In most cases, however, should a consumer default on a “secured” loan, a creditor need not file a suit, but rather may opt to repossess the secured item (the surety) under the terms of the agreement.

Debt consolidation loans are typically secured loans with the collateral being the borrower's equity in a motor vehicle, real estate or some other major asset. Should the borrower default, repossession, foreclosure or legal action often comes swiftly. Lenders who make consolidation loans understand full well their legal recourse and some will stop at nothing until the debt or a judgment is satisfied.

The important aspect to understand here is that while “unsecured” creditors can take legal action, they are typically slower to do so—and more willing to negotiate a settlement. And the fact is, consumers often consolidate “unsecured” debt in exchange for “secured” debt—which often proves detrimental to the consumer!

Another point to consider is that, by consolidating, the borrower is faced with “one large payment to one creditor” rather than “many smaller payments to many creditors.” While this can be very beneficial (in the right circumstances) the problem is—one large payment is a harder nut to crack. If the debtor is even one dollar short, the account is considered in default. While being a little short may not in itself result in foreclosure or legal action, usually late fees and/or penalty charges kick in and warning alarms sound off. These additional fees often make it more and more difficult for the borrower to catch-up, and with each successive payment the debtor falls further and further behind. Before long, the borrower is considerably past due and legal action may soon follow.

In the above scenario the perceived benefit of having only one payment becomes a nightmare. Had the borrower dismissed obtaining a consolidation loan and elected to continue making smaller payments to many creditors, running short of funds would allow for greater options. The debtor, for instance, could then be selective and direct available funds to critical creditors, and perhaps allow an account with an "unsecured" creditor with a small balance and/or one who typically does not access late fees become delinquent. As noted above, unsecured creditors, especially those with small balances, are least likely to take legal action. Lenders making large consolidation loans, however, are prone to do so and some are downright ruthless.

Another concern with consolidation loans is that borrowers are sometimes allowed to keep their credit cards. Having access to these cards, debtors often fall into the same trap—charging many of their purchases and/or expenses. Before they realize it, these charges mount. In addition to having to make their consolidated loan payment, now they must again make a credit card payment. Short of funds, eventually they take cash advances to make their payment, thus only increasing their debt. It becomes a vicious cycle, until finally bankruptcy is the only alternative.

While a debt consolidation loan may be the right decision for some consumers, it may lead other consumers to financial ruins.

Home Equity Loans and Second Mortgages

Everything mentioned above regarding debt consolidation loans apply here as well. In fact, consolidation loans are often home equity loans. Consolidation loans, however, need not be a home equity loan.

A home equity loan and a second mortgage both use the equity in your home as collateral. A home equity loan typically provides a “line of credit” and only when funds are drawn from it do interest charges accrue and payments begins. In contrast, a second mortgage typically provides the borrower with a “lump sum” of money. Interest is charged on the entire amount borrowed and monthly payments begin immediately. Both types of loans typically require processing fees, an appraisal fee and possibly other costs.

The annual percentage rate (APR) of such loans may be extremely reasonable. Consumers, however, must factor in all of the costs of getting the loan. After doing all of the calculations, in some cases, the actual cost may be much higher than anticipated. Even so, the net result could end up with a better interest rate than your current average interest rate of the debts you intend to pay off—if that is what you intend do with the proceeds! On the other hand, depending on many factors, including your credit worthiness and equity, the cost of processing the loan and resulting monthly payments might not provide you with any relief at all.

The problem most debtors have—is not having enough equity in the first place. Traditionally, lenders use a formula for determining eligibility and how much they will lend. This is usually based on a percentage—from 50% to 80% of the current market value of the home, less the amount that is still owed on it. If the current market value is appraised at $100,000, lenders will typically lend $50,000 to $80,000 maximum—that is, if you own the home free and clear. If the amount owed is $75,000 and the home owner is able to find a lender offering a loan at an 80% loan-to-value ratio, he or she may get a $5,000.00 loan. After paying the processing fees and other costs, however, they would only get a portion of this amount.

The advantage of a second mortgage or a home equity loan is that the interest is tax deductible for individuals itemizing deductions. Therefore, one must take this aspect into consideration and analyze the net result after taking this deduction. It may prove beneficial to discuss this issue with an accountant.

Whether a home equity loan or second mortgage is right for you depend on many circumstances, but generally you need a fair amount of equity in your home to make it worthwhile. Also, as noted under “Debt Consolidation Loans” there are many risks and concerns that must be considered. In particular, should you default on the loan, you could end up losing your home. If the purpose for acquiring the loan is primarily to consolidate “unsecured” debt, you are well advised to give it serious thought.

A better option may be to just borrow enough to consolidate “secured ” debt, and perhaps certain unsecured accounts that are likely to result in legal action should the debtor default. This would lower the monthly payment and reduce the risk of defaulting on the loan. Should the borrower later run short, funds could then be taken from the budget allocated for unsecured debts. While this would place the unsecured account(s) in jeopardy, such action could, as they say, save the farm!

If a debtor has a significant amount of secured debt and unsecured debt, another option that may be available, is to obtain a home equity loan to consolidate “secured” debt and then enroll in a Debt Management Program (as described below) to consolidate “unsecured” debt. For heavy debtors this is a very viable option that provides a safety factor and could yield significant savings in interest charges, late fees and other charges.

Debt Consolidation Through Consumer Credit Counseling

For many consumers experiencing financial hardship, enrollment in a nonprofit Consumer Credit Counseling Agency's debt management program may be their best option for debt relief. A debt management program, however, is not designed for everyone. First of all, a lot depends on who the creditors are. Credit counseling agencies primarily negotiate unsecured debt, such as credit cards, installment loans, retail finance plans, medical bills and personal debts. Second, contrary to popular belief, credit counseling agencies cannot force creditors to accept their proposals. Although most creditors will work with these agencies to effect a workable solution, many creditors have minimum payments (based on the outstanding balance) that they will accept. Therefore, an applicant needs to have sufficient income to support the revised lower payment, as well as enough income left for their basic living expenses.

How Debt Consolidation Through A Credit Counseling Agency Works.

Most creditors offer special repayment plans to their customers who undergo financial hardship and enroll in a nonprofit consumer credit counseling agency's debt management program. Upon enrollment, creditors are then informed that their customer has entered a debt management program and are asked that they reduce the client's monthly payment, reduce or stop interest, stop late fees and overlimit charges, and to re-age past due accounts to bring them current. Because most creditors support the agency, these special repayment plans are usually accepted.

In the typical scenario, enrollment in the program will reduce the consumer's overall monthly debt service 15% to 40% and reduce the average interest rate significantly. In addition, once enrolled, correspondence from creditors regarding past due accounts are directed to the agency. In other words, in addition to the above benefits, the program puts an end to upsetting collection calls and, financially speaking, offers the consumer a new lease on life.

Unlike a lender providing a “debt consolidation loan,” when consumers consolidate their debt through a nonprofit credit counseling agency, the agency does not then become the creditor. In this regard, the agency is, in essence, a conduit for disbursing payments to their client's creditors. While the consumer's original creditor(s) retain all legal rights and may take legal action should the consumer default on the negotiated payment, the agency itself has no such rights, and in fact, has no interest in or desire to take legal action. Contrary, the agency works “on behalf of their clients” to prevent such problems from occurring.

The only way to determine if debt consolidation through a Consumer Credit Counseling Agency would benefit a consumer is by analyzing the consumer's current financial profile. The Center For Debt Management does this absolutely free of charge and without obligation. If qualified, applicants may elect to enroll in a debt management program offered by our longtime associate, Family Debt Arbitration and Counseling Services, Inc. The agency are a federally designated nonprofit charitable organization dedicated to assisting consumers with financial difficulties.

In summary, if you have been considering debt consolidation or are currently experiencing financial hardship, it is important that you weigh all of your options. We hope that this document has provided you a great deal of insight in this regard. If you are unsure which path to take, we invite you to fully explore our web site. You will discover a wealth of information relating to debt management. We happen to agree with one of our visitors, who remarked, “Your site...is an oasis in a financial desert.” We are proud of what we have achieved through the years and dedicated to serving you.

If you have concluded that one of the options outlined above is right for you, perhaps it's time to act now! Regardless of which option you elect, you may apply online right now. There is no cost to apply and in most cases, you will know within hours if you are approved.