What About Consolidation Loans?
by Keith Rawlinson
Volunteer Budget Counselor
I couldn't even count how many times I've spoken with people who want
to use consolidation loans to deal with their debt problems.
Since these loans are so easy to do, and so easy to find; and
since there are so many people out there who seem to think that
consolidation loans are a good tool for dealing with debt, let's
discuss whether or not you should consider using a consolidation loan
to deal with a debt problem.
The word "consolidate" means to bring together. To make many
separate things into one. Therefore, a consolidation loan
means
taking all of your debts and using a loan to combine them into one big
debt. A consolidation loan usually means fewer payments to
make
each month, since all the individual debts are now one, and a smaller
payment. If you can reduce the number of checks you have to
write
each month, and get a smaller payment at the same time, isn't a
consolidation loan the way to go?
Well, not really. First of all, when someone is deeply enough
in
debt that they are even thinking about doing a consolidation loan,
having to write fewer checks each month shouldn't even be a
consideration. Getting out of debt is a long, difficult
process.
It generally takes years to get deeply into debt, so it is
only
fair to expect it to take a few years to get out. If you are
seriously considering a consolidation loan so you don't have to write
so many checks and make so many payments, then you are a long way from
actually dealing with, and solving, the debt problem. Let me
explain why.
Your debt problem is not being caused by having to spend time writing
checks each month. The problem is being caused by spending
more
than you earn and buying things you can't afford. Even if you
reduce your monthly debt payment to writing only one check each month,
these other problems are still there. You are still spending
more
than you earn, you are still buying things you can't afford, and you
are still going deeper into debt. How much time you spend
writing
out checks each month is the least of your problems, so don't use that
as an excuse to get a consolidation loan.
What about the
lower interest rate?
It is true, you can usually lower the interest you are paying on your
debts significantly by taking on a consolidation loan; but, that
reasoning isn't sufficient to justify the loan. Why?
Because the interest rate you are paying on your debt is not
likely what's causing the debt problem. Overspending, having
no
savings, and buying things you can't afford are. I think an
example here will help. Let's say that you are $23,000 in
debt
not counting your home. Let's also say that the average
interest
rate you are paying on this debt is 18%. If you are given
four
years to repay the balance, your total payment might be around $675 per
month. Let's assume your
budget is stretched and you can really only afford about $200 in debt
payments. In this example it is the difference of $475 per
month
that is plunging
you deeper into debt, not the interest rate.
Now, let's say you manage to get the interest rate on this debt down to
13%. Your payment is now around $617 per month. You
now
have a difference of $417 per month between what you are paying and
what you can afford to pay. That difference is still plunging
you
deeper into debt. The reduced interest rate didn't really
help
much. Yes, it is better than what you were paying with the
higher
interest rate, but it still doesn't solve the problem and get you out
of debt. Look at it this way: with the
consolidation loan,
you have reduced your payments by $58 per month. If I were to
just send you $58 each month, would that solve your payment problems
and get you out of debt? Of course not. $58 per
month won't
make a big enough difference. Well, neither will the reduced
interest rate of a consolidation loan; so, reduced interest rate is not
a good enough reason to get a consolidation loan.
What about the
reduced payment?
First of all, you need to understand that with a consolidation loan,
you are not paying off your debt. I've heard people say "I
got a
consolidation loan and used it to pay off my debt." The debt
is
not paid off--it is not gone--it was just moved. Got it?
With a
consolidation loan you do not pay off your debt, you just move it all
into one big debt with a large balance.
Now what about that reduced payment? Well, the
payment is
reduced for two reasons: One is the reduced interest rate,
which
we've already discussed, and the other is the term of the loan.
In this case, term refers to how long it takes to pay off the
consolidation loan; in other words, how long you will have to make
payments on the loan. If you read my article Eliminating Debt Completely,
you will see that it is possible to be completely debt free, except for
the home mortgage, in less than four years (often much less).
The time it takes to pay off the consolidation loan will
probably
be more like ten years. That's the biggest reason why the
payment
is lower. Now, instead of paying on your debts for a few
years,
you have more than doubled it to ten years! Do you really
want to
double the time it will take you to get out of debt? You
might
say "but I'm going to use the difference to pay it off faster."
Well, if you could do that, you wouldn't need the
consolidation
loan in the first place. The whole reason you got the loan
was
because you couldn't afford your debt payments. The lower
payment
of a debt consolidation loan does not get you out of debt., it just
stretches the debt repayment out several more years.
Now, the biggest
reason why debt consolidation loans are a bad idea.
As I have already said, debt is caused by spending more than you earn
and by borrowing money to pay for things you can't afford. In
fact, these are by far the biggest reasons why most people in America
today are so deeply in debt. Does a debt consolidation loan
deal
with either of these problems? No, it certainly does not.
To get out of debt, you have to change your habits, your
lifestyle and the way you handle your money. To get
out of
debt you need
savings and you
need a plan.
A debt consolidation loan does not help you with any of these
things, so the money-mistakes that got you into debt in the first place
are still there. What this means is that, most of the time,
after
all the debts are moved into a consolidation loan, the debts start to
come back little-by-little, over time. Not only can this happen,
it is what usually does
happen. And yes, I know, I hear it all
the time, you're the exception--you're the one whose got it all figured
out. You're the one who can make the consolidation loan work.
Honestly, if you've really got it all figured out, then you
wouldn't be deeply in debt and you wouldn't need the consolidation loan
in the first place. Trust me, most of the time the debt comes
back after the consolidation loan.
Let's look at the effect of that: You are $30,000 in debt and
$15,000 of that is credit cards. You get a debt consolidation
loan and move that $30,000 of debt into the loan. Because of
the
lower interest rate and longer pay-back time, your payment has dropped
from $800 per month to $450. You now have $350 'extra' per
month
because of the consolidation loan. At first, you use it
wisely.
Then, you want a new CD player so you take $200 and
buy yourself a nice one.
Of course, there are a bunch of new CD's you want to go with
the
new CD player so you put another $150 on the credit card to buy the
CD's.. You figure
you can use the extra $350 next month to pay it off.
Unfortunately, the car breaks down and you need $800 to fix
it.
Since you have no savings, the car repair goes on the credit
card
too. $1,150 of your credit card debt is back already.
This
pattern continues and within three years your credit cards are back up
to $15,000. Why? Because you didn't change the way
you
handle your money. You had no savings and you had no plan.
So, after three years, you still owe $27,000 on the original
debt
consolidation loan and $15,000 in new credit card debt.
After three years, you owe a total of $42,000 thanks to your
debt
consolidation loan! If the average person were to follow the
advice here on Eclecticsite.com's Financial Page, they would most
likely be
completely debt free, except the home mortgage, in that same amount of
time. But not you--you're now deeper in debt than you were
before, all
because of a debt consolidation loan. You have to trust me,
this
is what usually
happens. I see it all the time in counseling.
Don't get a debt consolidation loan thinking you're the
exception and you can handle it. Believe me, it is most
likely that
you can't handle it and will be in worse trouble later.
What to do
instead.
The only time I might
even consider
advising someone to get a debt
consolidation loan, is if I don't see any other way, and if they have
already done all
of the other things I teach and have proven to me that
they have changed their habits, their lifestyle, have savings and a
plan. The funny thing is, after doing those things, people
usually
find that they don't really need a debt consolidation loan after all.
So, if eliminating debt
completely is something you want to accomplish in
your life, then you don't need a debt consolidation loan, instead
you need savings
and you need a plan.
Please know that all of the thoughts, information,
suggestions
and techniques given on this site are nothing more than the author's
opinion on
the matter being addressed. Do further research before making
any decisions.
This article copyright © 2007 by Keith C. Rawlinson
(Eclecticsite.com). All rights reserved.
This article may be copied for non-profit use including newsletters,
bulletins, etc.
as long as you
first get written permission from the author and full credit is given
which includes the author's name
and the name of this website.