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The pros and cons of debt consolidation as a financial recovery tool

Anyone under financial strain should consider all their options with a trusted professional before making a decision on which approach to take, but debt consolidation may be a good option for some.

One option that sometimes makes sense for people facing financial distress is debt consolidation. Debt consolidation involves merging several individual debts into one, resulting in just one monthly payment that may be lower than the previous multiple payments in combination and at a better averaged interest rate.

Usually, consolidation involves credit cards, medical debt and other unsecured liabilities.

Over time, due to reduced interest and fees, consolidation may make financial sense and allow faster repayment. It may improve credit if the debtor is not getting multiple late payment reports to the credit reporting agencies.

Some sources recommend rules of thumb. According to NerdWallet, for example, if a person’s total debt (not including a mortgage) is more than 40 percent of gross income, debt consolidation is not normally a good option and bankruptcy should be considered.

However, there are many things to carefully consider before taking this step.

Prerequisites to consider

First, the debtor must have regular income or another source of funds to make the new, consolidated payment. If the debtor will not be able to make the new payments on a sustained basis, it probably does not make sense to take that route.

The debtor should be financially stable enough that if they consolidate, they can go forward making the one monthly payment without taking on new liabilities.

It goes without saying that to get a loan to pay off the smaller debts, which will then be the single payment going forward, the debtor must have good enough credit to qualify. The lender must be a safe and reputable source of credit such as a bank or credit union. Payday lenders or debt relief organizations may be shady and expensive – more on that below.

Interest-free credit cards are available for consolidation purposes, but they normally have no interest for a relatively short promotional period. If the debtor cannot make the payments with confidence before the promotion expires, this does not make sense because the interest rate that kicks in upon expiration is likely very high.

The debtor may have an asset to use for a loan like a 401(k) loan, home equity loan or paid-off vehicle to use for collateral. This may be risky though because borrower default could result in asset loss and penalties.

Red flag

Beware of claims by debt relief companies, also called debt consolidation companies, that may sound too good to be true – because they likely are not. These businesses are often based on scams and charge high and hidden fees for unsatisfactory results.

For example, they may tell a debtor to stop paying on their debts while the company renegotiates with the creditors, but this is risky. The creditors may not be willing to work with the company and failing to pay on the debts will hurt the debtor’s credit further. The company may succeed in getting the payments down or consolidated, but payments may balloon later without warning.

The bottom line is that any Tennessee or Mississippi debtor concerned about being underwater in debts should speak with an experienced bankruptcy lawyer as soon as possible to discuss all options.

The attorneys at Jimmy E. McElroy & Associates with two offices in Memphis help clients in west Tennessee and north Mississippi facing financial challenges to review their legal options for relief, which may involve debt consolidation, bankruptcy or other approaches. The lawyers then guide clients through their chosen legal remedies, including representation in bankruptcy or other legal proceedings when necessary. It should be noted that the law firm does not recommend any debt relief companies in Tennessee or Mississippi.