I get a lot of searches on this site from people looking for information about debt consolidation. Why do people want to consolidate their credit card debts, student loans, and medical debt all into one payment? Because oftentimes they think it is a magic wand of sorts – that it will cause all their debt problems to disappear. Unfortunately that's not the case, and in many instances people end up making their situations worse by signing up for a debt consolidation loan.
The reason I haven't written about debt consolidation until now is because in most instances I'm not a big fan of doing debt consolidation. Many of the debt consolidation companies that you'll find out there really aren't going to do much for you that you already can't do on your own – and they'll charge you an arm and a leg to do it. Other debt consolidation companies are just plain scammers looking to take advantage of people when they're down.
Still, there are situations when a debt consolidation loan can be the right thing to do. Just remember to be careful and consider some important things before jumping into a debt consolidation loan.
What Is Debt Consolidation
First things first. What is debt consolidation?
Debt consolidation is when you take several debts, and consolidate them into one loan in order to take advantage of lower interest rates, lower payments or the lure of having a simplified situation and one easy payment instead of several payments. Doing a debt consolidation loan should mean that you're moving into a better situation that is more manageable for you and your family. Unfortunately this often isn't the case.
Things To Remember About Debt Consolidation
When doing a debt consolidation loan there are a few important things that you need to consider. If you don't examine these things it may mean that you'll make your situation worse – rather than better.
- Even with a debt consolidation, the problem still remains. Debt: When doing a debt consolidation loan people often feel like they've fixed their debt problem, when in fact all they've done is move the debt around, and possibly improved their interest rate a little bit. Don't be lulled into a sense of security by doing a debt consolidation. You haven't truly accomplished anything until you've erased the debts and become debt free.
- Consolidating both high and low interest loans could mean you'll pay more in interest: Too often people will make their debt situation worse by doing a debt consolidation loan because they'll lump all of their low interest debts (like student loans) in with their high interest debts (credit cards), just for the sake of having one easy payment. Too often this means that the consolidation loan has a higher interest rate than some of the debts they've lumped in – and they end up paying more interest because of it.
- Consolidating your debt may mean you'll be in debt longer: Often people consolidate their loans because they want to lower their total payment and make it more manageable. That sounds great, but the problem is that this means they'll often be in debt for a longer period of time – and for a larger sum of money. Sure the lower payments are nice – but they come at a steep price. Debt slavery!
- By consolidating your loans you haven't fixed the source of the problem – overspending/undersaving: By consolidating your debt you're really just treating a symptom of the illness, instead of treating the illness itself. What is the illness? Overspending and undersaving. According to figures that Dave Ramsey cited, a full 78% of people who consolidate their loans end up creating new debt to replace any gains they've made. Change your behavior instead, put yourself on a budget, do a debt snowball and you'll be in a much better situation.
So as you can see there are a lot of reasons that doing a debt consolidation may not be in your best interest. Carefully consider these points before heading down this road – and make sure that you're actually addressing the underlying issues that have gotten you into the situation in the first place.
When Should I Do A Debt Consolidation?
Are there times when doing a debt consolidation is actually a good idea? Sure. You just need to make sure that you consider the points mentioned above, get yourself on a written game plan, and make sure that the debt consolidation loan is actually improving your situation instead of making it worse. That means you aren't lumping low and high interest loans together in a rate somewhere in the middle, you're not extending the debt out into the future, and you're not consolidating your debt without first getting yourself on a budget.
When can a debt consolidation loan be a good thing? Take the situation of my good friend Matt over at DebtFreeAdventure.com. He recently did a debt consolidation loan through Lending Club. He took several higher interest debts, anywhere from 10.5% to 19.5% interest, and consolidated them all into a lower 9.32% loan. He didn't extend the length of the loan, and he has gotten his family on a written gameplan to get out of debt. They've made a commitment to making more money, getting gazelle intense, and getting out of debt as fast as he can. His consolidation has improved his situation, and in the end should be a good thing. Unfortunately not many people are as conscientious as Matt, and just get themselves into more trouble after getting their consolidation loan.
To find out if a debt consolidation loan can improve your situation, check out a calculator like this one found on MSN Money Central: Debt Consolidation Calculator
So What Other Options Do I Have?
There are a host of other options out there when it comes to getting rid of debt. Personally my preferred debt elimination method is the debt snowball through Dave Ramsey's total money makeover program. You can read about Ramsey's 7 Baby Steps to debt freedom on this site, as well as his Financial Peace University class that we took. If you don't care to read the whole series of posts, here's a quick look at how the debt snowball works.
- Put all your debts in order from the smallest balance to the largest.
- After your necessities are paid, pay the minimum payments on all of your debts.
- Put any surplus money towards paying off the smallest debt first.
- Pay off your smallest debt, get a psychological boost from knowing you’re one step closer to being debt free!
- Once the smallest debt is paid off you roll the money you were paying on that debt over to the next largest debt.
- Wash, rinse, repeat until all your debts are paid off!
While paying off debts many people will choose to take on part time jobs temporarily to create new income – so that they can get out of debt that much faster. When they are disciplined and create a written game plan most people are able to get rid of their debt within 12-24 months. You can too!
What do you think about debt consolidation? Is it something you would consider doing? If you have done a consolidation, did it improve your situation? Were you able to get rid of your obligations and become debt free? What steps have you taken to improve your spending and saving habits? Let us know your thoughts in the comments.