Debt Consolidation vs Credit Counseling
If you are looking for a solution to help you manage your money and ease any financial pressure you’re experiencing, you may be wondering which of the available debt relief options you should use.
In this article, we’ll review both options to give you an idea of how they work and which one may be best for you.
Debt consolidation vs. credit counseling
|Debt Consolidation||Credit Counseling|
|What is it?||A debt solution that replaces multiple existing loans and credit cards with one new debt.||The process of working one-on-one with a financial professional to address multiple areas of your finances.|
|What costs are involved?||The cost depends on the fees associated with the new loan or credit card. Costs can include an application fee, origination fee, balance transfer fee, or prepaid interest.||It depends on your situation and your ability to pay. In some cases, there is no charge. In others, there could be a monthly fee.|
|When should it be used?||To reduce the amount of interest paid and lower the total amount of your monthly payments.||If you are behind on your bills and need help managing your finances, or if you want a holistic look at your financial situation.|
|What are the credit requirements?||You will need to meet the credit requirements of the new loan. Generally, a higher credit score will yield a better interest rate and terms.||There are no credit requirements.|
|Can you keep your accounts open?||Yes.||Yes. (If counseling leads to entering a debt management plan, you typically would need to close or suspend your accounts.)|
|How long will it take?||The length of time it takes to pay off the new debt depends on the terms of the new loan or credit card, the amount consolidated, and the monthly payments.||Credit counseling could last several sessions based on your needs.|
|Will you have to pay taxes?||Generally, no. There may be some scenarios that could result in a tax liability, for example, if you use a 401(k) loan to consolidate and it is not paid back as agreed.||No.|
|Will it hurt your credit?||Your credit may take an initial hit when the new loan is processed, but as you make on-time payments and reduce the balance, you should see your score improve.||Seeing a counselor will not have a negative impact on your score. If the counseling leads to entering a debt management plan, your credit score may be affected.|
What is debt consolidation?
Debt consolidation is when a consumer takes multiple debts and combines them by paying them off with one new loan or credit card, typically at a lower interest rate than the individual debts.
“It can be done a lot of different ways,” said Andrew Pizor, a staff attorney at the National Consumer Law Center. “Some people do [debt consolidation] with a mortgage, some people do it with an unsecured personal loan and some people do it through a credit card advance.”
Even though using your home to consolidate your debt is an option, Pizor said doing so is generally a bad idea because you’re taking unsecured debt and attaching it to an asset.
“If you don’t pay your credit card bill, the worse they can do is sue you,” he said. “But if you don’t pay your mortgage, they can take your house.”
One of the main reasons consumers consolidate their debts is to reduce the total amount of their monthly payments. But sometimes the monthly payment is lower because the term of the new loan is longer.
In that case, even if the interest rate is low, you could be paying more for the new debt in the long run. “[A lower monthly payment] can be important for an immediate need,” Pizor told MagnifyMoney. “But you really have to watch out for going from the frying pan to the fire.”
Consolidating debts can also streamline your finances and make things easier to manage since you will deal with fewer payments and fewer creditors. But Pizor said that alone should not be the primary reason to pursue debt consolidation.
Consumers who are considering debt consolidation should keep in mind that this strategy does not reduce the balances of your debt. It simply moves the debt to a new loan.
How does it work?
Consumers can use debt consolidation to pay off a variety of debts including:
- Credit cards
- Student loans
- Unsecured personal loans
- Business debt
- Medical bills
- Debts in collections
There are multiple ways consumers can consolidate their debts:
- Personal loan
- Credit card balance transfer
- Home equity loan
- Home equity line of credit (HELOC)
- Cash-out refinance on your mortgage
- 401(k) loan
Who is it useful for?
Since one of the perks in consolidating debt is to reduce the amount of interest paid along with lowering the monthly payment, consumers who qualify for a low rate on the new loan or credit card stand to benefit the most from this strategy.
Also consumers who can manage their payments on their own and are confident they will pay the new loan on time are good candidates for debt consolidation. It is not a good strategy if you are likely to run into trouble with the new loan.
How much does it cost?
Depending on what is used to consolidate the existing debt, costs can include a balance transfer fee, an origination fee, points, or an annual fee among other costs.
How long does it last?
The amount of time it will take to pay off the newly consolidated debt depends on what method is used for consolidation, the total amount of debt, and the size of your payments.
Consumers who use a personal loan to consolidate debt can expect their consolidation to last the term of the loan unless they pay it down faster.
When should you use it?
Again, debt consolidation is not a good strategy for consumers who have trouble paying their bills. But it can be advantageous for those looking to lower their payments and reduce the amount of interest they are paying.
What to watch out for
Debt consolidation comes with some potential pitfalls. Consumers should beware the following:
- Paying even more interest: If you take your no- or low-interest debts such as medical bills and consolidate them with your high-interest debts, you could potentially increase the total amount of interest you pay.
- Swapping a low payment for an extended loan term: You could be getting a lower monthly payment only because the new loan comes with a longer term, which increases the total amount paid towards the debt.
- Consolidating unsecured debt with secured debt: Again, if you pay off unsecured debt such as credit cards and medical bills with a home equity loan, HELOC or a cash-out refinance, you are putting your home at risk if up run into trouble paying the new loan.
- Running up your balances again: It is not uncommon for consumers who consolidate their loans to go deeper into debt by running up their balances again.
- Giving up your rights on federal debt: If you consolidate federal student loans, you will lose any protections and options associated with them.
What is credit counseling?
Credit counseling is the process of working one-on-one with a trained financial professional. Credit counselors can help consumers work through an immediate need or crisis or can provide a holistic look at their financial situation.
Credit counseling can offer guidance in the following areas:
- Establishing a budget
- Reviewing and understanding your credit report and credit scores
- Developing a plan to pay past-due bills
- Providing education and resources to help you manage your finances
- Helping you enter a debt management plan
How does it work?
Consumers who are interested in credit counseling would schedule an initial session. At that meeting, a counselor will take a look at your finances and determine your next steps, whether it’s to have additional sessions or to provide you with other resources.
A counselor may also recommend you enter a debt management plan, which is a program managed by the counselor to help you get (and stay) current with your creditors.
Credit counseling is offered by a variety of sources ranging from agencies to individuals. A few options include:
- National Foundation for Credit Counseling (NFCC)
- Financial Counseling Association of America
- Local community agencies
- Individual financial counselors or coaches
Who is it useful for?
“Credit counseling can provide very useful advice,” Pizor said. ”If you’re having trouble managing your money and you’re getting behind, it’s definitely worth talking to a counselor.”
Since credit counseling addresses a variety of needs, it can be a useful solution not only for those who are behind on their bills and need help but for those who are looking for education and resources on how to manage their money better.
How much does it cost?
There may be a cost associated with your counseling depending on your situation. Nonprofit credit counseling agencies are usually required to offer assistance regardless of a consumer’s ability to pay.
If your credit counselor suggests you enter a debt management program, there typically is a monthly fee associated with it, ranging from $25 to $35 at NFCC-affiliated agencies.
How long does it last?
Credit counseling can take place over one or several meetings based on your needs and financial situation. You and your counselor will discuss how many sessions you will need to have. If you enter a debt management plan, the average length is four to five years.
When should you use it?
Credit counseling can be helpful in the following situations:
- You are behind on your bills
- You have poor credit as a result of mismanaging your money
- You are overwhelmed by your financial situation
- You want to learn how to manage your money better
What to watch out for
When considering working with a credit counselor, keep the following in mind:
- Beware of disreputable companies: There are many trustworthy credit counseling agencies in both the for-profit and nonprofit sectors, but there also many that are not. Research any company you are considering working with thoroughly.
- Make sure the counseling agency is not pointing you toward a particular service: Some businesses might try to refer you to their debt consolidation partners or to get you to sign up for their debt management plan.
- High fees: Fees can differ from agency to agency, so be sure to compare costs.
Should you use a debt consolidation loan or credit counseling?
When considering which type of debt relief you should pursue, give some thought to your ultimate goals.
If you are looking for a one-time and immediate solution to paying your bills, debt consolidation may meet your needs. Keep in mind, though, that you will still be responsible for paying the new loan on time and consistently.
If you have multiple issues you want to address or are looking for long-term results and advice in managing your money, credit counseling is probably the solution for you. It can also help you work through an immediate crisis, but it is not an instant fix.
Pizor said it’s a good idea for consumers to consult a credit counselor even if they think they want to do debt consolidation or another type of debt relief.
If you decide you want to pursue one of these options, take the following steps.
Pursuing debt consolidation
- Research your options: Look into the multiple ways you can consolidate your debt. Review what products your current bank offers, and also look at credit unions, community banks and online lenders.
- Seek preapproval: Many lenders offer fast preapproval online.
- Compare loan terms and select your loan: Review the rates and fees of all the options you researched. When looking at loans side-by-side, examine the APR to get the most accurate comparison Choose the loan or credit card with the most favorable terms.
Pursuing credit counseling
- Research credit counselors: Pizor advised that consumers do their homework before deciding to work with a credit counseling agency. The U.S. Department of Justice also provides a list of approved credit counseling agencies.
- Ask questions: To determine a credit counseling agency with which to work, the Federal Trade Commission suggests consumers ask questions about how their program works.
- Consider the fees and other terms and choose a counselor: Compare the fees, as well as the terms of working with multiple credit counseling agencies, before moving forward with one.
Choosing your solution
Pizor stressed the importance of thoroughly assessing where you are and what your goals are before choosing any particular path. “Know your options and understand the situation before you give anyone any money,” he advised.
Regardless of the option you choose, remember that no debt relief solution will provide an instant or permanent fix. If you are attempting to solve or work through a crisis, make sure you take the precautions to avoid repeating the same mistakes in the future.
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