Insider's guide to debt consolidation

By Liz Pulliam Weston

When people write to me asking about debt consolidation, they're typically looking for a magic wand.

They want a solution that will swiftly lift them out of their financial chaos with little effort and few, if any, consequences. Plenty of unethical marketers are delighted to promise them such results, profiting from their ignorance.

Before you sign up with a debt consolidator, you need to know the following:

• Debt consolidation may not get you out of debt any faster, save you any money or reduce your payments. In fact, the opposite can be true on all three counts.

• Debt consolidation is often confused with other, radically different solutions for debt. If you misunderstand what you're getting into, you could feel the fallout for years.

• You might be better off consolidating your debt on your own or from a different kind of lender.

When you consolidate debt, you basically transfer your smaller piles of debt into one bigger pile. You get the convenience of one payment instead of many, but that payment won't necessarily be less than what you were shelling out before -- and if it is, you may find yourself paying for months or years longer than if you'd just paid the original bills.

It's not a magic bullet

In a minute I'll discuss your debt-consolidation options and how to make the right choices. Before we get into that, though, you should know that debt consolidation is different from the other approaches to resolving financial problems. Debt consolidation is not, for example:

Debt management or credit counseling. With debt management, you sign up with a (hopefully legitimate) credit counseling agency that reviews your finances and puts you on a repayment plan to retire your bills in three to five years. These agencies have agreements with credit card companies that can lower or eliminate your interest costs.

Entering a debt management plan can have consequences for your credit scores, but if you pick a legitimate counselor -- one affiliated with the National Foundation for Credit Counseling or the Association of Independent Consumer Credit Counseling Agencies -- the effects shouldn't be lasting. If you've already fallen behind on your payments and think you could get out of your hole if you could just get your interest charges reduced, a debt management plan might be a good option. (See "The consumer's guide to credit counseling" for more details.)

Debt negotiation or debt settlement. You stop paying your bills, thereby trashing your credit rating. Once your credit scores are in the toilet, you (or your hired representatives) offer to "settle" the debt with your creditors for less than you owe, sometimes for pennies on the dollar. You run the risk of being sued by your creditors or defrauded by the debt settlement outfit. For more details, read "Debt settlement: A costly escape."

If you really can't pay your bills, a better option may be:

Bankruptcy. This also devastates your credit scores, but if you can file a Chapter 7 liquidation case, you're typically able to erase your credit card debt and medical bills entirely, getting a financial fresh start that may actually help you rebuild your credit faster than other debt solutions. For more on bankruptcy and whether it might be an option for you, visit MSN Money's Bankruptcy Guide.

Debt elimination. Whoops, sorry, this one's a scam. The folks proffering debt elimination pretend you can legally erase your debt with documents you purchase from them for a hefty fee. Some of these con artists are the same ones who argued, spectacularly unsuccessfully, that the income tax was a myth.

Some debt consolidators veer into scam territory as well, either by collecting high upfront fees and then not making a loan or by making false promises to get your business. If you've fallen behind on your payments and your credit is awful, for example, you should bolt if a debt consolidator promises you a low-rate loan. It's not going to happen.

Do you really need to consolidate?

Before you turn to a debt consolidator for help, you should consider your other options. Such as:

Credit cards. If you've got a credit card with a decent rate and a high credit limit, you might consider transferring your other balances to it. Your issuer might even help by giving you a lower, promotional balance-transfer rate or raising your credit limit to accommodate the extra debt.

You should be aware of the pitfalls to this approach:

• Your rate could change. There's no such thing as a true fixed rate with credit cards. Issuers can change terms at any time with 15 days' notice. So you run the risk of your rate spiraling higher.

• You'll need to put the card away. You should be careful not to use this card for purchases until you've paid off the debt because those new charges will accrue interest at a much higher rate, and your payments will go toward paying off the low-rate balances first.

• You'll need to be disciplined about paying down the debt. Revolving lines of credit such as credit cards don't force you to pay off much of your principal, so you could still be in debt decades from now. If you opt for this solution, you should make hefty payments each month, not just the minimum.

• You could damage your credit scores. Lenders and others use these three-digit numbers to gauge your creditworthiness.

The leading credit-scoring formula, the FICO, rewards you for having wide gaps between your balances and your credit limits on your accounts, particularly your credit cards. The score's creator, Fair Isaac, says it's typically better to have small balances on a number of cards than a big balance on one card.

Continued: When is a balance too big?

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