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The tricks and traps of free debt consolidation

It's no easy fix. A free debt consolidation loan can actually multiply your debts and problems. Watch out for sky-high rates, hidden fees, costly add-ons and damage to your credit rating. People often ask, "What does it take to get me out of debt?" well now you have found an answer. Free debt consolidation or nonprofit debt consolidation is the easiest way to get you out of debt.

People with big credit-card balances often see free debt consolidation loans as a "magic bullet" solution to their problems. Instead of paying multiple bills, they can pay just one, perhaps with lower monthly payments.

Far from being a ticket out of debt, however, these unsecured loans can simply be a fast track to bankruptcy court.

The trouble with free debt consolidation loans is twofold:

This kind of borrowing typically does nothing to solve the problem that got the consumer in trouble in the first place: overspending.
The loans can be far more expensive than the debt they're designed to pay off, full of hidden fees, expensive insurance and other profit-boosters for lenders.

"The fact that people are led into this thinking they're going to be better off is sad," said Linda Sherry, spokeswoman for Consumer Action, a consumer advocacy group in San Francisco.

There are actually two types of loans that are typically used to consolidate debt: home-equity lending, which allows consumers to borrow against the value of their houses, and personal lending, which is usually not backed by a home or other collateral but essentially relies on the borrower's promise to repay.

I've written before about the potential dangers of using home equity to pay off credit cards ("The 3 worst money moves you can make"). This column, though, focuses on the hazards of using personal loans to consolidate debt.

You end up paying more

Personal loans offer interest rates of 14% to 15% for people with good credit. Those with heavy debts or troubled credit, however, usually pay more -- 18% to 21% and up. These borrowers may also face upfront fees of as much as 10% of the loan amount.

As with any loan, the devil is in the details. If borrowers can secure a low-rate, low-cost loan and pay their debt off faster than they might otherwise, then free debt consolidation can make sense.

Too often, however, consumers look for lower payments, rather than lower costs. Lower payments usually mean it will take you longer to pay off your debt, and they inflate the total amount you ultimately pay.

Many people compound the problem by continuing to run up credit-card balances after they've consolidated their old debt. By adding more to their debt loads, they're bringing themselves closer to the financial brink.

Lenders may be giving them a shove, as well. Many of the companies that offer personal free debt consolidation loans push expensive add-ons that can vastly increase how much you owe.

So-called "single premium" credit insurance is one popular way lenders boost their profits on personal loans. This insurance, which covers your loan payments in case you get sick, die or become unemployed, often adds $1,500 to $2,000 -- or more -- to the balance of a $5,000 loan.

The cost of the insurance is tacked on up front, so you wind up paying interest each month on the extra amount.

"We say, 'You get all this protection for just $45 a month," said one lending officer who works for a national finance company and who asked not to be named. "It doesn't sound so bad until you multiply it out for 48 months and then add interest on top of that."

Sales of single-premium credit insurance became so controversial in the subprime mortgage lending market that major lenders, including Household International and Citigroup, have promised to stop selling the insurance upfront on their home loans. (The subprime market targets people with troubled credit. Household lends to this market through two subsidiaries, Household Finance and Beneficial, while Citigroup's subprime lenders include CitiFinancial and Associates First Capital.)

Credit insurance: an expensive waste of money

But the companies continue to offer single premium credit insurance on personal loans. That angers consumer activists, who say the insurance is vastly overpriced and usually unnecessary.

"It's an abusive product, regardless of whether it's secured by your home or not," said Chris Saffert, acting director of the Financial Justice Center, a group that combats what it calls predatory lending practices.

Consumer advocates also criticize lenders for encouraging borrowers to refinance their personal loans -- often tacking on more upfront fees or insurance products each time the loan is reworked.

People who have fallen behind on their loans are often offered the chance to take a "vacation" from payments for a few months if they agree to refinance, the lending officer said. That's how he convinced one couple with a $6,000, five-year loan to refinance into another five-year loan one year later -- and to purchase more insurance.

"If they would have come in and paid off the debt," the lending officer said, "the payoff amount would have been $6,300. Now they owe us $13,254."

If you're considering a free debt consolidation loan, keep in mind the following:

Free debt consolidation loans can hurt your credit. The actions usually associated with such loans -- applying for a new credit line and closing old accounts -- can damage your FICO credit score, said Craig Watts, spokesman for Fair, Isaac & Co., the company that developed this leading credit score. The loan's benefits might outweigh the drop in points, but most people can find a better way out of debt that doesn't hurt their credit rating.

You may be able to lower your interest rate without a free debt consolidation loan. If you have good credit, your credit-card companies may be willing to lower your rate if you simply ask. You may also be able to transfer balances to a lower-rate card, but use this tactic with moderation: applying for too many cards can hurt your credit which eventually makes those good balance-transfer deals disappear.

Focus on paying more each month on your debts, not less. You probably don't need a free debt consolidation loan to get out of debt. The fastest way to pay what you owe is to make the largest payments possible on your highest-rate, nondeductible debt -- which is usually a credit card. Pay the minimums on all your other debts until this high-rate loan is paid off. Then take the same amount each month and apply it to the next highest-rate debt, and so on until you're debt-free.

If you do decide to get a free debt consolidation loan, shop around. Credit unions often offer the best rates on personal loans, but you should also check the rates surveyed by Bankrate.com (see link at left) to get an idea of what most institutions charge. If you're being offered a loan with higher rates and fees, be careful. Either you're so far in debt that you're considered a poor risk -- in which case you may need credit or bankruptcy counseling rather than another loan -- or you're in danger of becoming a victim of predatory lending.

Avoid the add-ons. Credit insurance is usually an expensive waste of money.

Stop charging. Whether you opt for a free debt consolidation loan or decide to pay off your debts on your own, you'll need to stop using your credit cards if you expect to make any progress. You don't need to close your accounts. Just cut up your cards or freeze them in a block of ice -- anything that will make it hard for you to keep spending more than you have.

free debt consolidation

The tricks and traps of free debt consolidation

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