Consolidation Loan: A lender lends you money to payoff your bills. You payoff all your credit cards and other debt, now your payments have all been consolidated into just one monthly payment to the lender, hopefully at a lower average APR than your current bills. You should close out all the accounts you paid off with your consolidation loan, so you don’t run up the balance again.
Consolidation Plan: A “bill paying service” that has the influence to work with your creditors to reduce or eliminate your interest and late fees, and agrees to send them your payment every month. You in turn pay the “bill paying service” a monthly payment equal to the amount of all your accounts in the plan, plus a service fee, and maybe interest if they could not get all of it removed. This should hopefully cost much less than your total payments before, since most credit cards will drop the interest rate to 0.
Notice that no one is lending you money, they are just restructuring your debt, which is safer. Don’t confuse these companies with lending institutions, or banks, they are not lenders. Usually car loans, home loans, and other secured personal loans cannot be brought into this type of plan because the bill paying service cannot get banks to relax the interest. This type of plan usually works best on credit cards, gas cards, and other types of credit.
The Proper Way To Use Consolidation Loans
Consolidation loans are not for everyone and can be dangerous if you aren’t careful. There’s a lot of people who don’t pay attention when they consolidate their loans. Sometimes the interest rate can be higher than the total APR on your current debt. Some unscrupulous lenders charge an enormous up front fee that they don’t go out of their way to tell you about. Some of these same lenders might even roll the fee into the loan payments. If the loan’s APR is higher than your credit cards, you’ll lose money and should not close on the loan.
Don’t consolidate just for the sake of consolidating. The word is misleadingly dangerous. Your brain tricks you into thinking that consolidation means less. Most people think a consolidation loan means they’ll pay less, but that may not be the case. Consolidation just means that the monthly payments from your creditors will be consolidated into one payment to one lender.
Basically you can’t just borrow your way out of debt, you must pay it off. A consolidation loan should only be considered if the interest rate is less than all the credit you owe AND you close out all of the accounts you paid off.
Consolidation loans are DANGEROUS for impulsive people because all you are really doing is shifting all your debt from one place to another, effectively OPENING ANOTHER CHANNEL OF CREDIT, while freeing up your credit cards. Some people then proceed to fill up their credit cards again, now they have double the debt they started with, and they are paying up to 22% on their consolidation loan because they weren’t paying attention to the APR when they signed up.
Some consolidation lenders are unscrupulous and make it appear they are eliminating your debt, when you are really taking on more debt. They might offer you a lower payment, but check their math and you might discover that it ends up costing you more than your original bills. Don’t fall for this! Always check their numbers.
Don’t let the lender trick you into thinking that lower monthly payments mean less interest. They could have a high APR and stretch the payments out over a long period of time, which is costing you more in the long run. Car dealers use this trick all the time on car loans. You pay more interest when your payments are stretched out to 60 months.