Debt consolidation can work in one of two ways: the first is that you get a lump sum to pay off all your credit cards and the slate is wiped clean and you just repay the loan. The second is that the debt consolidation company will contact your creditors and negotiate a new rate of interest with them and you simply pay the debt consolidation company and they take care of paying your creditors.
If we take a basic example we can work out how much the potential savings are each month. If a person has $25,000 of credit card debt (which unfortunately isnt unreasonable) at a rate of 18% per annum and they are paying $500 a month then it will take nearly 8 years to pay off the debt and they will have paid over $21,000 in interest – almost as much as the original debt!
A debt consolidation company could offer a rate of 12% per annum for six years in which case the repayment is reduced slightly to $488 per month and the amount of interest paid is just over $10,000. Even when the charges and other fees are added its unlikely to be anywhere near as much as the credit card debt.
However, there might also be some scenarios where a debt consolidation loan ends up costing more than the original debt due to the long repayment periods. Take this example:
A person has a $15,000 5 year unsecured loan at 9% and a $10,000 2 year unsecured loan at 15%. The $15,000 loan costs $311 per month and the $10,000 loan costs $484 a month for a total monthly repayment of $795.
A consolidated loan company says they can reduce the rate to 8% over 7 years so you are only paying $390 a month. This means you have to pay $7,676 in interest over this period. However, if you continued to pay off the loans at the original rates you would only have to pay $5,276 in interest. The $2,000 difference is one of the ways the debt consolidation companies make their money.
Debt consolidation could be a tradeoff between lowering your monthly outgoings but increasing the length of time you remain in debt and increase the amount you have to repay so before you go ahead and sign up to a debt consolidation company make sure you have calculated exactly how much you could be saving.
Also remember that if you are consolidating your debt in to a loan then it is usually secured on your home which could be repossessed if you fail to meet the monthly repayments.