With average credit card interest rates being just over 20% it is easy to see how racking up $30,000 in credit card debt - at an annual interest rate $6,000, can become a burden in and of itself simply to meet the interest on the card. Paying it back can seem a fairy tale as you simply figure out how to make the minimum payments to avoid collection agencies and additional hits to your credit. Additional marks against your credit, ironically, can often raise your interest rate and thus make repayment even harder.
And then you see it - as an oasis in your desert of debt - a "Consolidate your credit", "get out of debt" sign or billboard audaciously placed by the side of a bus, during an infomercial or commercial aired between segments of Jerry Springer. This articles explains how they work, when they are useful, and how to avoid getting scammed.
How They Work:
The principal behind them is simple. Credit card companies are earning 20% or more interest on the money you owe them, but anything above a 6% return these days is considered good. Other investors (non-credit card companies) simply purchase the debt off the credit card company and now instead of owing 3 different cards - Visa ($5k at 14%), Department Store ($10k at 25%), MasterCard ($15k at 19%), you'll owe this new company $30k at 11%. Which makes your annual interest payments go from $6,050 per year to $3,300 per year, thus saving you $2,750 (superficially). Now you have a much better chance at paying the money back, and you'll be paying less money over all. At the same time, the debt consolidation company is now earning a 11% return on their investment, so for them it works out as well. In the case where everything goes according to plan these relationships end up being a win-win-win (including a win for the credit card companies because now they've been paid back).
When you should consolidate your debt, and when you should not
If a friend were to ask for a loan - a small sum that you could afford - a multitude of factors come into play that form the basis of your decision whether or not to lend them. Ignoring the friendship component, the most important item of consideration is whether or not you believe this person capable of paying it back. The same is true for both credit card companies and credit consolidation companies. Everyone wants to know that at some point they will get their money back, and will use all the information at their disposal to keep their educated guess as informed as possible. With a credit card company you generally have an information advantage over them. You know your personal situation much better than they do, but they do not have the resources to really investigate whether you can truly pay them back.
They ask for your income, but rarely require proof. They check your credit history but are unlikely to call you up for a personal conversation and ask you to explain any marks against you. Credit card companies due this because they know that the burden of a thorough investigation is more than the risk of a few mistakes in their credit calculation process.
With consolidation companies, they already know you are at risk of default, so much more personal attention is given to individual cases. This means the opportunity for hiding debts and/or personal income information is significantly less. The effect of this is that in general you are much more likely to be accepted by a credit consolidation company if you're actually able to pay them back, which is good news for you.
But being accepted and consolidating your credit can have a downside. By paying back the credit card companies you now have access to more credit. In the case example where you are maxed out and owe $30k to various credit card companies, by working through a consolidation company you'll know owe $0 to the card companies, and $30k to the Debt Consolidation Company. This means you can borrow up to another $30k and get yourself $60k in debt. If you cannot afford the $30k of debt than $60k will bury you. Which means before you accept their offer be prepared to change the lifestyle that got you into this debt in the first place. Moreover, Debt Consolidation companies have a much nastier reputation of harassing you the moment it may seem like you can't pay them back. They are in the business of working with those who cannot pay, so if you owe and miss payments be prepared to be harassed at work, wages garnishes, called all hours of the day and have people come by to speak with you.
Avoid Being Scammed
Those massively in debt are some of the most vulnerable in our society because they are looking for any means necessary to get them out of their financial rut. It's this same group that "Work from home" and "buy my CD's to make you rich" scams appeal to - those looking for a quick fix to their situation. With credit consolidation your first stop should always be to your bank.
Banks should always be your first and most trusted source because
a) They can often get your terms much lower than independent companies, and
b) They are unlikely to defraud you.
Avoid at all cost companies that charge an upfront fee for processing your application. Their business model is simply to make money off the application fees and would rarely (or in some cases NEVER) actually help someone get out of debt. Most provinces and states offer free credit counseling services that can help you figure out the best route, so take advantages of these. But again, NEVER pay money upfront for credit consolidation. The last thing you need is to be spending more money in a desperate attempt to get out of debt.