The bad news is you’re drowning in debt and your credit score is under water.
The good news is there are lifelines out there.
If your credit score is still high enough (preferably above 640), a debt consolidation loan from a bank or online lending company could save you from high interest rates and overwhelming monthly bills.
If your credit score has gone south of 640, you may need to spend some time with a credit counseling organization and a Debt Management Program (DMP) to regain control of your finances. The good news is that a Debt Management Program can function like a Debt Consolidation Program, without hefty interest.
When your financial life starts spinning out of control, just keeping track of all those bills can be a job in itself. The average consumer has four credit cards, though many carry more. A California man is in the Guinness World Records for having 1,497 cards, though he said he actually used just one of them.
The number of cards doesn’t matter to credit-rating agencies nearly as much as the amount of debt you carry on those card. The average person seeking credit counseling has six cards and carries $17,548 in debt, according to the National Foundation for Credit Counseling.
The average interest rate for credit cards in December 2015 was 14.95% but it can skyrocket to as much as 29% for consumers with bad credit histories. The Premiere Bankcard has an eye-popping rate of 79.9%.
All those cards have differing balances and due dates. If they’re not paid on time, there are late fees and interest rates could rise. A consumer can get lost on that treadmill and never get off. That is where a debt consolidation loan comes in handy by grouping all those bills into a single debt. You make one payment, and the fixed interest rate should be lower than the fluctuating rates of credit cards.
Some banks and a variety of on-line lending sites offer consolidation loans. As with any loan, the terms will largely depend on the applicant’s credit history. Most consumers think first of their credit score, but lenders also scrutinize your debt-to-income ratio.
The debt-to-income ratio is determined by adding all your monthly debt payments and dividing that number by your gross monthly income. For example, let’s say you are paying $1,300 a month for your mortgage, $400 a month for a car and $500 a month in other debts. Your monthly pre-tax income is $5,000.
Divide the monthly debt ($2,200) by gross income ($5,000) and your debt-to-income ratio is 44 percent ($2,200 is 44 percent of $5,000). That would be a problem for lenders, who typically get skittish when the debt-to-income number climbs above 40 percent.
Lenders offer different interest rates, usually 5.99% to 32.99%, or other terms based on the risk that the borrower will not repay the loan. It’s known as “risk-based pricing,” and the bottom line is simple: The lower the risk, the better the interest rate terms.
Sometimes the “risk” is too great to qualify for a consolidation loan. For example, Prosper, an online lending company, requires a credit score of 640 or higher. Lending Tree, another online source requires a 660 or higher.
The average credit score is 695, but 19% of consumers have scores lower than 600 and likely would be turned down for consolidation loan. It’s a catch-22, but there are alternatives, specifically a DMP.
The process starts with a call to a non-profit credit counseling agency, which will ask questions about your income and expenses and determine if you qualify for a DMP.
The major benefit to you is that the credit counseling agency can help you get lower interest rates and try to get late-payment and other fees waived. Not only are your monthly interest rates reduced, credit counseling agencies can also help get debt collectors off your back.
The credit counseling agency also pays participating creditors on your behalf. You make one monthly payment to the counseling agency and they divide the payment among the creditors in an agreed upon manner.
As you make your DMP program payments, you will start reestablishing your credit through regular monthly and on-time payments. In a DMP, you generally will have to close most of your credit cards and be on a 3-to-5 year repayment plan. When you make your final payment, you are debt free!
Another option is debt settlement, but there are dangers involved here. A debt settlement agency asks you to stop making payments to creditors. Instead, the debt settlement agency asks for a substantial amount of cash from you or requires you to make monthly payments until you build a sum large enough to offer the creditor a settlement.
When the agency thinks it has enough money, it goes to the creditors and attempts to negotiate a one-time settlement, generally for less than the balance owed. The creditors recover a debt that otherwise might have been uncollectable, and they get to wipe an overdue account off their books.
The consumer walks away with a large debt not just reduced but cleared. It sounds good, but there are drawbacks.
There are substantial fees involved in the process. Debt settlements show up on your credit report and lower your credit score. You may also be sued by creditors in this process. It’s not an ideal remedy, especially compared to a DMP.
If you have poor credit and are in an ocean of debt, a consolidation process is often the best way to keep from drowning.
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