The debt situation in America, where the average consumer holds around $10,000 in personal debt, may be grim, but it is reassuring to know there are many ways to limit the growth of debt and make it easier to pay back. The debt management industry has a large market to cater to, one where the total size of the debt stands at over $13 trillion (figures from 2018). There are plenty of ways for individuals to tackle their personal debt, such as getting credit counselling, making use of debt relief programs (a related article for student loan debt relief), or even applying for debt consolidation, which is what this post discusses. Debt consolidation has many benefits and drawbacks, which is why it is a controversial financial service. To understand its true nature we will look at what debt consolidation loans actually are, how they work and then move on to analyzing the advantages and disadvantages of debt consolidation.
What is Debt Consolidation / Credit Consolidation?
Also known as debt refinancing, this is when you combine all your loans/debts into one new loan, ideally with better repayment terms. You can do this with your unsecured debts, such as personal loans, student loans, credit card bills or even utility bills debt (which is why debt consolidation is also referred to as bill consolidation). Once the old loans are limped together by your debt consolidators, you will simply make one monthly payment to them in order to repay your loans. The debt consolidation firm will then make several payments to your original creditors on your behalf.
If you are interested in learning more about how to consolidate your debt, it is better to approach a reputed credit counselor who will look at various aspects of your lifestyle and debt portfolio to determine whether credit consolidation is best for you. The terms of the new deal will depend on:
- Your credit history and credit score – a lower credit score will mean a higher interest rate or extended repayment period of the new consolidated debt. That is not a good thing.
- Your repayment capacity – if your income is substantial or you have a good amount in your savings account, and you simply need to curb your wasteful expenses in order to successfully repay your debt, the terms of the consolidated loan may be pretty lenient,
- Different assets you own – if you own personal assets that can be sold in case you have trouble repaying the consolidated debt, the lending company may charge you a lower interest rate to reflect the lower risk. Of course, the same debt consolidation firm may ask you to ‘secure your new debt’ using those assets, but many financial advisers are against that, the reason for which we discuss later in this article.
Advantages and benefits of loan / debt consolidation
There are 4 major advantages of getting your personal loans consolidated. In an ideal arrangement, your new consolidated loan should lessen the debt burden on you through the following benefits:
1. Efficient loan repayment:
Prior to having your loans consolidated, you may have had to make multiple payments on different debts on a monthly basis. This would have included all credit card debt, outstanding student loans, utility bill debt, etc., and the process may have been complicated and tedious. When you get all your debt consolidated, at the end of each month, you simply make one payment to your new creditor (debt consolidation firm) in order to pay back all your debts simultaneously. You don’t have to manage different installments to different creditors.
2. A lower interest rate
Your outstanding balance, in the form of the consolidated loan, may be assigned a lower interest rate as part of the debt consolidation contract. As mentioned in a previous article, there are other ways to get a lower interest rate on your credit card debt.
3. Small monthly installments
Not only do you reduce the number of loan repayments/installments to one, you also get the size of the installment reduced to suit your budget. However, this may not necessarily be a good thing, because it could mean you end up paying more interest charges if the duration of your new consolidated loan is longer.
4. Lower principle amount
The new consolidated debt may have a reduced loan principle amount so even if the interest rate does not fall, your overall payments will be smaller.
While these benefits make credit consolidation a tempting debt solution, there are a few downsides that you should be aware of before making the decision. The truth is, debt consolidation may work for some, but it’s not the right credit solution for everyone, as we examine next.
Disadvantages of Credit / Debt Consolidation
There are few drawbacks and risks associated with debt consolidation that make it a bad option for getting rid of your debt. Read through this list to understand what pitfalls.
1. Lower credit score
Your credit score will most likely fall after you opt for debt consolidation because you will most likely make smaller monthly payments to your creditors and it is apparent you are struggling with debt repayment. There are several ways to improve your credit score, so that is not entirely a long term or permanent disadvantage.
2. It may take more money and longer to repay your debt
You may think you’ve received a good deal if your consolidated debt requires you to make smaller payments at the end of the month to your creditor, however, that is not necessarily the case. The smaller loan installments may come at the cost of a longer consolidated loan term (duration). This could mean that you end up paying more money in the long run to get rid of your debt after getting your loans consolidated. You must use a debt calculator or a spreadsheet to make sure you understand the new cost structure of the consolidated loan contract before accepting it. Alternatively, if you have been promised smaller payments, make sure they come with a shorter repayment period as well to enjoy the true benefit of debt consolidation.
3. Perpetuating the debt habit
If you lifestyle is dependent on debt, debt consolidation will only offer a short term solution because it tackles the symptoms of a larger problem of over-spending. The issue of poor financial habits is not automatically addressed when you get a new loan to pay off old loans. For this reason, Dave Ramsey, the financial guru is strictly opposed to debt consolidation programs. Ideally, debt consolidation should be coupled with credit counselling so consumers have the right skills, tools and motivation to get rid of debt and avoid it in the future.
Many consolidation firms offer services for free and many have a non-profit mission, but even though you may be tempted to jump into their customer base, you should thoroughly investigate the reputation and cost structure of your service providers.
4. Secured credit consolidation can put your assets at risk
A secured consolidated debt may require you to hold your house as collateral, which means you could lose your house or other assets used as collateral, if you fail to repay your consolidated loan. While the interest rate on such loans is lower compared to unsecured loans, the obvious downside to this is that if you do not meet your credit obligations, you’ll run the risk of losing your biggest assets, such as your house or some property your previously owned.
5. Debt consolidation loan for debtors with bad credit score
Many companies offer specialized loans for people with low credit scores. Debt consolidation for people with poor credit scores comes with higher interest rates, tighter control and the possibility that the consolidation firm will ask you to secure the new debt against a personal asset. In most cases, people with bad credit scores should not choose debt consolidation because their track record indicates they have trouble managing debt in a responsible manner. The higher interest rate and inclusion of collateral for the consolidated loan reflects the high probability that low-credit score borrowers may be unable to pay back the new loan and go bankrupt.
Should you choose debt consolidation to lessen your debt burden?
After reading through the various benefits and downsides of debt consolidation, one may wonder if is is the right way to repay the mounting, never-ending debt. The answer is simple – debt consolidation is the right choice for you if:
- Your current creditors refuse to lower your interest rate, despite all your efforts (we wrote a negotiation script for lowering your credit card interest rates),
- You are unable to to make room in your personal budget to make full payments on your loans.
- The new consolidated loan offers a lower interest rate, smaller payments and lower principal,
- You have the means to pay all your installments on time,
- You are not signing a secured debt consolidated contract,
- You have decided to adopt frugal living habits that ensure you do not depend on large amounts of consumer debt in the future.
Conclusion about debt consolidation
Just like any other financial tool, credit consolidation is a double-edged sword. When used carelessly, it has the potential to further push you into indebtedness, but when used responsibly, it has to ability to save you from bankruptcy and set you on the path to financial freedom.