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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.

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