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If you’re in debt and seeking help, the first thing you’re likely to hear is to consolidate your bills.
That’s good advice, but it’s also just the start. All the credit consolidating in the world won’t help if you don’t end up with a lower overall payment. That comes down to what kind of loan you get.
There come in a variety of forms and names, but the feature that matters most is the interest rate. You’ve undoubtedly heard the term a million times, but what does it mean in real terms?
Interest is money you pay for the privilege of borrowing money. Let’s say a bank loans you $1,000 at a 6% annual interest rate. That means you’d pay an extra $60 if you pay back the $1,000 at the end of 12 months.
That’s called “simple interest.” Most loans utilize “compound interest,” where you don’t just pay interest on the initial $1,000 loan. You also pay interest on the accumulated interest.
The rate that debt grows depends on how often the loan “compounds,” or comes due. With credit cards, it’s typically once a month.
The bottom line of all this is as simple as it is obvious. When you take out a debt consolidation loan to pay all your bills at once, you need to get the lowest interest rate possible. Here’s a quick look at the type of loans and what they’ll do to your financial figures.
Interest rates typically range from 5 to 36%. And with all loans, you must factor in origination fees, transfer fees, late fees, early-payoff penalties and other charges. All are important, but none are likely to have as much impact as the interest rate.
Getting a low one is a two-pronged process. The first thing lenders do is look at your credit score.
You can get one free credit report from each of the three major credit bureaus (TransUnion, Equifax and Experian) once every 12 months at annualcreditreport.com.
There is no quick fix for poor scores, but you can improve your credit score by paying bills on time, setting up automatic payments to make sure you don’t miss one, keeping credit-card balances low and reporting any mistakes on your credit report.
Once your armed with your credit information, invoke the old Smokey Robinson song and “Shop Around.”
If the loan business were the weight-loss business, this would be like going to a diet clinic and being handed a bag of doughnuts. A consumer borrows a small amount at a very high interest rate.
They typically write a post-dated check in the amount they wish to borrow, plus a finance charge. The lender holds onto the check and cashes it on the agreed date, which is usually the consumer’s next payday.
Most loans are due in one to four weeks, and research shows 70% of borrowers take out a second payday loan before paying the first. If the finance charge is $17.50 per $100 for seven days, that translates into an annual interest rate of 900%.
Repeat – 900%.
A variation of the payday loan is the auto title loan, where the consumer puts up his or her car as collateral. If the borrower can’ t repay the loan in 30 days – and studies show that one in five can’t – they lose their car.
You put all your various debts on one card which has a lower interest rate than the combined charges your were paying.
Most credit cards companies offer very low introductory rates, but they revert to the standard rate after 12-18 months. Monthly interest rates on credit cards vary from high single digits to 36%.
It can be wildly higher, with one company charging 79.99% interest. But the average interest rate in 2015 was 13.66%.
It’s basically a second mortgage. You put up your house as collateral and secure a loan or a line of credit. Interest rates are usually between 3% and 8%.
You borrow money from your retirement account. You can take out 50% of the total or $50,000, whichever is smaller.
Interest rates are usually based on the Prime Rate plus 1 or 2%, so a five-year loan would have an interest rate of about 5.5%. But the interest is repaid to the consumer’s own account, so it’s not a loss.
There are a lot of loan options out there. Don’t choose one that will leave you worse off than you began.
Get at least three proposals banks or other lending institutions. If the best offer you can find is a payday loan, don’t eat the doughnuts. Instead of a loan, you probably need to completely overhaul your financial life.
That’s why it’s wise to get a proposal from a nonprofit credit counseling agency like InCharge. It can not only offer competitive interest rates on loans, certified counselors can advice you on an overall strategy to get out of debt forever.