Debt has become a way of life for most Americans. Monthly statements from student loans, credit cards, car payments, mortgages and unsecured notes fill the mailboxes of millions of consumers every day. In many cases, the monthly payments from these loans become more than borrowers can manage on their current income. One possible solution for this dilemma is to roll all these debts into a single new loan that allows borrowers to make one payment each month on the total amount they owe. But consumers need to think carefully and do their homework before using this strategy, because it can sometimes end up harming them in the long run. Here's how to tell what makes sense for you.
How It Works
Debt consolidation is a fairly simple concept. The borrower takes out a new loan that will pay off one or more existing loans, and the new loan usually requires a lower monthly payment than the monthly totals of the previous debt.
Example: John has $19,000 of credit card debt, a $12,000 car loan and $5,500 remaining on a school loan. His total monthly payments come to $1,175. A debt-consolidation lender offers to roll his loans into a single note that charges a lower rate of interest and reduces his monthly payment to $850. He gratefully accepts and saves $325 per month.
Methods of Debt Consolidation
There are several ways consumers can lump debts into a single payment. One is to consolidate all their credit card payments onto a single new credit card – which can be a good idea if the card charges little or no interest for a period of time. A second way, for those who qualify, is to get a debt-consolidation loan from a bank, credit union or debt-consolidation service. Home equity loans are a third, excellent form of consolidation for some people, as the interest on this type of loan is tax-deductible for borrowers who itemize deductions. There are also several consolidation options available from the federal government for those with student loans.
Another approach – especially for those who do not qualify for any type of loan – is working with a debt-relief organization or credit-counseling service. These organizations do not make actual loans; instead, they try to renegotiate the borrower’s current debts with creditors. However, these groups often charge hefty initial and monthly fees, and their tactics could lower the borrower’s credit score. A good debt-management plan will never do this except, perhaps, for a short time at the beginning of the process.
Before making a commitment, carefully research the organization and get feedback from current customers. Similarly, shop around for the best deal on consolidation loans; borrowers with decent credit may receive several offers. The best loans will charge lower rates with few or no fees, offer flexible payment schedules and may include other features such as budgeting services or tools.
Advantages and Disadvantages
Carefully think through whether to consolidate debts and which approach to choose.
You pay more interest. The previous example showed how John improved his monthly cash flow by rolling all his debts into a single loan. What it didn't discuss is the total amount of interest John will pay over the life of his new loan. Most debt consolidation lenders make their money by stretching out the term of the loan past at least the average, if not the longest term, of the borrower’s previous debt. For example, if the longest term of John’s previous loans was five years, the new loan might have a term of 90 months (seven and a half years). This allows the lender to make a tidy profit even if it charges a lower interest rate than any of his previous debts. Other types of consolidation raise further issues. Although borrowers can deduct the interest on a home equity loan, they risk foreclosure if they become become unable to make the monthly payment. Those who default on consolidated school loans will usually have their tax refunds garnished and may even have their wages attached.
Match the solution to your spending psychology. The factors that determine whether a debt-consolidation loan is appropriate typically center on the borrower’s financial habits and circumstances. Those who are struggling to make their current debt payments can improve their credit scores with a consolidation loan if they can comfortably make the lower payment and eliminate late payments and fees. Those who cannot control their spending, however, will only dig themselves deeper into debt. If having more cash drives them to overspend, rather than save, they may find themselves even deeper in debut – to the point where bankruptcy or other drastic action may be their only alternative.
Take advantage of the extra cash. Those who make an additional payment to principal beyond the minimum payment on their new loan can whittle down their balance faster. If John in the above example paid an extra $200 per month on his loan, he could pay off his loan considerably sooner and save a proportionate amount of interest. Another way to use a debt-consolidation loan is to save money for a house; it frees up cash flow for a down payment that will allow the borrower to start building equity.
Watch your debt-to-credit utilization ratio. Debt consolidation will affect the borrower’s balance sheet and debt-to-credit utilization ratio, regardless of the type of loan. Credit bureaus monitor this ratio closely. They like to see consumers use much less credit than they have available, as it is considered a sign of financial stability. So even though it sounds sensible, borrowers who close out their old credit cards after moving the balances into a consolidation loan can damage their credit.
Example: Sally rolls $16,000 of credit card debt into a new loan. She cuts up her credit cards, but leaves the accounts open. If she has no other debt, she has effectively cut her debt-to credit ratio in half, as she now has $16,000 of unused credit available on her credit card accounts, plus her $16,000 consolidation loan. If she were to close her old accounts, however, she would be using 100% of the credit she has available from her new loan, which would adversely affect her score.
The Bottom Line
Debt-consolidation loans can be a useful tool for responsible spenders who have a sound plan to get out of debt and can reasonably anticipate that their incomes will rise in the future. But it will only mask the problem for those who don't change their spending habits. These loans are a short-term solution that can turn into a long-term problem unless the borrower is able to use the money saved each month in a constructive fashion. For more information on debt-consolidation loans, visit your local consumer credit-counseling service or your financial advisor.