The concept behind a debt consolidation loan is simple: you get a loan at a low interest rate and use the money to pay off all of your high interest rate debts, like credit card debt. Sounds like a plan, right?
Not so fast. If you are deep in debt, perhaps carrying a combination of student loans, credit cards and maybe even a payday loan, debt consolidation may not be the best way to deal with that debt. Here are several reasons why consolidating your debt with a debt consolidation loan may not be a good idea.
Why Debt Consolidation Loans Don’t Always Work
You may not qualify
Yes, if you have good credit, and the ability to repay the loan, a debt consolidation may be a good solution. Unfortunately if you have a lot of debt, you may not qualify for a debt consolidation loan.
Or you may qualify, but only with a co-signer, which means someone else is now liable for the loan if you don’t pay. With a slow economy everyone’s job is at risk, and if you lose your job you may not be able to repay the loan, so it’s very risky asking a family member or friend to co-sign on your behalf.
If you have assets you can use as collateral, like home equity, that may improve you changes of refinancing with a debt consolidation loan but you are putting your assets at risk. This is especially true if you are taking out a high-risk, high-ratio second mortgage to consolidate debts.
Debt consolidation only shuffles debt around
There is, however, an even bigger problem with debt consolidation loans: A debt consolidation loan does not reduce your total debt. If you owe $50,000 on five credit cards it’s great to replace those five monthly payments with only one payment on a loan, but you still owe $50,000. Your total debt level remains unchanged. Lowering the interest payment is great, but unless that frees up enough cash to allow you to repay the loan in a reasonable period of time, you may not be better off; you may simply be trading one debt for another.
You may not save any money
We often meet with clients who first tried to consolidate their debt through a high-interest consolidation loan meant for those with poor credit. The problem with these types of consolidation loans is that you may not save much money. And it’s highly likely that your payments will be so high that they are not affordable in the long run.
Before you sign any contract, read the fine print. Many consolidation loans have hefty fees, some up-front charges and more often, penalty fees for late or missed payments. There may even be a clause that substantially increases the interest rate charged on your loan in certain circumstances.
Also be aware that if you consolidate through a line of credit, your interest rate can change at any time.
Debt consolidation can mean you will be in debt longer
There are two ways to reduce your monthly payment through a debt consolidation loan: get a lower interest rate or extend the repayment period. The second is a common option used by those with high debts to make their debt consolidation loan affordable.
For example, let’s say you consolidate $35,000 in credit card and other debts into a new loan at 8%. If you opt for a three year payment period, your monthly payment will be $1,096 a month. If you extend this to five years, your monthly payment will be $710. That sounds good but you are in debt for two extra years and you will pay more in interest over those 5 years.
You risk building up your balances again
A common mistake people make when consolidating multiple credit card debts through a new debt consolidation loan, is to build up new balances on their old credit cards. If you have several credit cards and you do transfer those balances to another loan, cut up those cards and stop using them. Keep one card only for paying, and pay that card of in full every month. If you don’t, you could find yourself facing double the debt in a few years.
Debt consolidation isn’t the same as debt relief
Mostly, debt consolidation is not the same as debt elimination. You have to pay back all your debts, plus interest. That’s fine if you can afford to, but of no help if you cannot. If you have a lot of debt, a debt consolidation loan doesn’t provide you with the lowest possible monthly payment.
What should you do? Compare your consolidation options. Try our debt options calculator (it’s free, and takes less than 30 seconds to complete). In our $35,000 example above, your monthly payments could be as low as $204 a month with a consumer proposal, much lower than any other debt consolidation approach.
If you don’t qualify for a debt consolidation loan, or if the monthly payments would be more than you can afford, it’s time to consider those other options. For many people a consumer proposal is the perfect alternative to a debt consolidation loan. Like a loan, you make one monthly payment, but unlike a loan there is no interest, and it is often possible to negotiate a settlement with your creditors where you pay less than the full amount owing. Paying $1,000 per month on a debt consolidation loan may not be possible, but paying $500 per month may be possible in a consumer proposal.
Of course that’s just an example; the actual amount the creditors would accept may be higher or lower in your case.
A consumer proposal is not right for everyone, but to find out if it’s a better consolidation approach for you contact us today for a free consultation.