For the person in debt, a debt consolidation loan is like a lifeline. But reaching for it without knowing exactly what it’s made of could be a big mistake.
The way it’s supposed to work: You pay off all your small, high-interest consumer debt with the proceeds of a new, low-interest loan whose payment is less than the total of the smallest payments.
In theory, consolidation is a terrific solution for a heavy debt situation. In reality, it can force you into even more dangerous waters.
There are three ways to consolidate:
No. 1: A new, low-interest (unsecured) signature loan from an individual, bank, or credit union. If you can get it, this type of debt consolidation is ideal.
No. 2: Transfer all balances to a new credit card. Beware of excessive transfer fees or other annoying terms buried in the fine print. Interest on credit cards is always likely to increase, even when advertised as a “fixed rate”.
No. 3: A home equity loan. It sounds great to pay off your high-interest debt with money borrowed from your home equity. But that only raises the stakes. Now, if you fall behind, the lender takes your home through foreclosure.
There is another significant danger that all of these consolidation loans have in common: I call it the “double effect”. If you’ve ever lost 10 pounds and gained 20 back, you’ll understand right away. Most people who pay off all their pesky credit card balances look at those zero balances with a sense of personal accomplishment. They did something remarkable. They didn’t pay their debts, but they liked to pretend. They say they won’t use these accounts anymore but don’t close them. They leave them to “build up credit” or to provide a cushion – just in case of an emergency.
Statistics indicate that the person consolidating a new loan will enjoy zero balances for a short time, but end up charging them at all-time highs. The average period is two years. This means double the trouble because of the debt consolidation loan.
So are all debt consolidation loans prohibited? No, but they must enter with extreme caution and great consideration.
Before proceeding with any debt consolidation loan, make sure you get honest answers to these tough questions:
No. 1: Is the total consideration of the debt consolidation loan (principal and interest), and not just the monthly payment, less than the combined consideration of all the debts it will repay?
No. 2: Are the terms reasonable? If, for example, the new loan or the new credit card carries significant penalties – such as you lose the attractive interest rate if you are late once or twice – this is not reasonable. If you have to pay large loan origination fees, that’s not reasonable.
No. 3: Am I mature enough to cancel accounts that will be refunded during the consolidation process?
Except in extreme cases, the best way to deal with a load of unsecured consumer debt is to stop adding to it, work out your recovery plan, then buckle up and get to work!
You will be amazed at how quickly you can reverse your debt situation once you know exactly when you will be debt free.
This is an update to a column originally published in 2014. Mary invites you to visit her at EverydayCheap skate.com, where this column is archived with links and resources for all recommended products and services.
Mary invites questions and comments at https://www.everydaycheapskate.com/contact/, “Ask Mary”. This column will answer questions of general interest, but letters cannot be answered individually. Mary Hunt is the founder of EverydayCheapskate.com, a frugal living blog, and the author of the book “Debt-Proof Living”.