When you have too much debt, or too many credit cards, a debt consolidation loan can look like a good idea. It’s an opportunity to combine multiple loan accounts, and multiple monthly payments, into a single, more manageable payment.
Have you ever heard the saying “if it looks too good to be true, it probably is”? And so it is with debt consolidation loans. They can be a good idea and an opportunity, but they can also be a trap.
Before you consider taking a debt consolidation loan, first think long and hard about whether or not you can make it work.
The most fundamental problem – and the issue most likely to trip people up – is the fact that debt consolidation doesn’t actually payoff any debts. It merely rearranges them into a neater looking pile.
The rearranging can actually be an advantage; the problem is in how we see it. A single loan looks contained. It’s less threatening than several loans with various payments. That can make a debt consolidation loan seem almost benign.
It’s important to realize that, just like any other type of loan, the only way that a debt consolidation loan gets paid down is when you take action to do it. Your debt doesn’t magically go away simply because you move it into a prettier looking package.
One of the biggest advantages of debt consolidation loans is also one of it’s biggest drawbacks: a lower monthly payment. That can actually become a problem because once you lower your previous monthly debt payments, there’s a new measure of budgetary freedom that opens the door to taking on new loans.
For example, let’s say you have five credit card accounts with a combined monthly payment of $600, and a total balance of $20,000. You do a debt consolidation loan that puts all $20,000 in plastic into a single loan with one monthly payment of $400. There is now an extra $200 available in your budget.
In a perfect world, you would apply at least some of the $200 in monthly savings to payoff the debt consolidation loan ahead of schedule. But human nature being what it is, this opens up the possibility of taking on new loans.
Since your debt consolidation loan has all of your old debts safely contained, you sort of forget about it, and go back to doing what you’ve always done, and you start hitting the credit cards again. It starts slowly, then gains steam, and before you know it your debt situation is worse than what it was before you took the debt consolidation loan.
You know what revolving debt is – you borrow money, pay some back, then borrow some more. That’s essentially how credit cards work. The same arrangement can develop with debt consolidation loans.
You take a debt consolidation loan to consolidate several credit card accounts, then shortly after that, you start charging on one of the credit cards again. Within two years, you’re still paying the debt consolidation loan, but you now have balances outstanding on several other credit cards. What do you do?
You take another debt consolidation loan.
If the debt consolidation loan gets large enough, you might eventually try to pay it off with a second mortgage or a home equity line of credit. At the extreme, you might try to roll all of your debts into a new first mortgage, thinking that this will be the ultimate solution to your debt problem.
But it doesn’t solve the problem, because debt consolidation loans have become just as revolving as your credit card accounts. And once again, no debts are ever actually paid off – they are simply repackaged.
Remember at the beginning I said that debt consolidation loans can be a good idea? That IS true, but only if you make it such. A debt consolidation loan should be used as a chance to fix a problem so that you can move forward in life. In order to make a debt consolidation loan work in your favor you need to do the following:
1. Don’t borrow any more money until the debt consolidation loan is paid.
If you have an uncomfortable level of debt, a debt consolidation loan must be viewed as a second chance. It can be very effective at cleaning up past debt problems, but the only way for it to be truly effective is if you stop borrowing money after you take the loan. If you take a debt consolidation loan, resolve that you will not take on any new debt, at least until the debt consolidation loan is fully paid.
2. Pay off the debt consolidation loan as soon as possible.
Since debt consolidation loans typically offer a single monthly payment that is lower than the combined total of payments on several loans, you should use this as an opportunity to payoff the consolidation as quickly as possible. The debts that were consolidated into your new loan represent “past sins”. You should want those out of your life as soon as possible. Also, since debt consolidation loans tend to be fairly large, you don‘t want them hanging around too long anyway.
3. Cut expenses and/or increase income.
The problem of too much debt usually comes about because you are spending too much in relation to the income you are earning. A debt consolidation loan is like a “financial timeout”. It’s an opportunity for you to completely reorganize your finances, and that should include creating a more favorable balance between your income and your expenses.
Use the consolidation as a time to either reduce your expenses, increase your income, or both. Not only will those efforts increase your ability to payoff the debt consolidation loan more quickly, but they’ll leave you in a better financial position once the loan is finally paid. If you’re able to follow through with these principles in mind, then debt consolidation can be a good idea.
Have you used a debt consolidation loan in the past? If so, how did it work for you?
The articles are written by personal finance enthusiasts (not certified professionals) based on their personal experience. What works for them may or may not work for you, and you should always consult a financial advisor before making important financial decisions.
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