Debt Consolidation Pros and Cons

I keep hearing ads on the radio as I drive to and from work about how debt consolidation can help you "Reduce Your Monthly Payments by XX%!" or "Eliminate Your Credit Card Debt!" There are also the ads that claim that by letting some company negotiate with your creditors, they can help you get out of debt in 3 (or so) years! Hmmmmm ...

I was going to create an Excel spreadsheet that would calculate how much you can save by consolidating all your credit card debt, federal student loans, car loans, and other consumer loans into a single lower-interest loan. The idea was that with lower monthly payments you could take the extra money you have left over to get out of debt faster by paying more principle and less interest! Sounds great, right?

Then reality set in. The more research I did, the more I realized that it's not quite that simple. What brought me back out of this idealistic dream world was remembering human nature. How many of us really have the discipline, once our monthly payments are lowered, to pay off debt rather than spend the extra money and rack up more debt? I'm not trying to pre-judge here, I'm just trying to say that debt consolidation may not be the best cure to debt problems.

Let's review some of the pros and cons of debt consolidation. Keep in mind that I'm not an expert, this is just a summary of what I found as I did some homework.

Debt Consolidation - Pros and Cons

Pros

• Reduced Monthly Payments. A significant decrease in the monthly payment is probably the most attractive benefit. What are you going to do with the extra money? That is one of the big questions. Are you disciplined enough to apply the reduced monthly payment to your debt snowball?
• Reduced Interest Rates. You may be able to get a lower interest rate with a home equity loan because it is a secured loan. Don't get fooled by the word "secured." This does not imply safe for YOU. It means its safer for your lending institution. If your goal is to get out of debt faster, reducing interest rates makes sense mathematically.
• Tax Deductions. With a home equity loan, you may see some benefits from the tax deductions that come from paying interest on a mortgage. You can't get that with credit card interest.
• One Payment, One Creditor. Writing one check may be easier than writing multiple checks, and you only have one creditor to deal with. In my opinion, this is a pretty weak argument. See below for how "one payment" could also be a negative.

Cons

• Get Into More Debt. It may be tempting to continue to use the credit cards that you've paid off. This is one of the reasons why debt consolidation is not a cure for credit problems. In fact, it could actually make problems worse, by allowing a person to get into more debt than they started with.
• May Cost More Overall. Even though the monthly payments and interest rate might be lower, you can end up with a longer-term loan in which you end up paying more interest in the long run. This is an example of how consolidating can turn into a scam.
• May Take Longer to Pay Off. If you don't end up using the extra monthly savings to pay off your loan (and perhaps even if you do), it could take you longer to get out of debt.
• Could Lose Your Home. If you go the route of a home equity loan, the lower interest rate that comes from listing your home as security might not be that beneficial if you default on your loan and lose your home.
• One Payment. In some cases, it can be beneficial to pay off smaller loans with higher-interest rates first. Knocking out debts with a good debt snowball plan can be very rewarding. You don't have that option if you've lumped all your debt into a single loan.
• May not Qualify for a Loan. It's possible that with so much debt, you may not qualify for an additional loan. Or, if you do qualify, the interest rate might be high.
• Disreputable Debt Consolidation Companies. Not all non-profit debt consolidation services are looking out for your best interests.

I may have been a bit biased towards the cons, because even the pros have some negatives in them. I also found conflicting information about whether your credit rating is improved or hurt by consolidating debt (that may be something to look at in more detail).

Debt Consolidation Calculators

If you Google "debt consolidation calculators" you'll get a bunch of online calculators, many of which are provided by lenders who want you to apply for their consolidation loans or lines of credit. Many of these calculators are designed to tell you what your new monthly payment could be. As I mentioned above, be careful to avoid making a lower monthly payment the main goal of consolidating.

If your end goal is to reduce your debt instead of just lowering your payment so that you can get into more debt or increase your spending, then I would suggest that you use the free version of my debt reduction calculator to experiment with different debt snowball strategies.

To compare strategies, you could save one copy of the spreadsheet with your current debts and another copy with the high-interest credit cards consolidated into a single loan. In this case, the purpose of consolidating would be to reduce interest rates. If your total monthly payment remains the same for both cases, the math will show that if you lump higher interest rate debts into a single lower-interest rate loan, you can get out of debt faster and pay less interest in the long run.

Note: A credit counselor may be able to help you find other ways to lower your interest rates besides consolidation. If your debt burden is at the point where cutting your budget is not enough to even make minimum payments on your debts, and you've done all you know how to do to negotiate lower interest rates or lower payments, then it may be time for credit counseling, and a site like DebtConsolidationCare.com might be able to help (This is not an endorsement of their website, I only mention this to point out that there are other solutions besides debt consolidation).

Do Your Homework

I included a list of references below to articles that I found helpful as I looked into debt consolidation. The key to not falling for a scam or getting yourself into more trouble than you were in to start with is to learn everything you can, to do your homework, and to weigh all your options. Before you consider a loan of any kind, you should consider what it is going to mean for you in the future.

First, you should completely understand your personal finances. Where are you spending your money? Do you spend more than you make? Do you have a budget? How well are you following your budget? Can you predict to within $500 how much money you will have 6 months from now? I'm not saying that $500 is some magic number. The point is that if you are unable to make a good prediction where you will stand financially in the future, it will be difficult to make any wise decision about what to do about your finances now. If this is the boat you are in, download a budget spreadsheet, and start taking control.

Probably the best decision I ever made regarding my finances was reading "Personal Finances for Dummies." I don't know how much I paid for it, because ones of my kids tore the back cover off, but I still have it and still refer back to it now and then.

Back to debt consolidation. After getting a handle on your finances, you may be ready to look into whether debt consolidation is for you. After everything I read, I decided it wasn't for me. The balance between the pros and cons of debt consolidation seems tipped heavily towards the cons. It looks to me like it's all about the short-term remedy, and the risk is having it turn out to be a long-term scam.

Some Debt Consolidation Articles

• Debt help that isn't, by Lucy Lazarony, from Bankrate.com originally at http://www.bankrate.com/brm/news/credit-management/counselinga.asp. This was a great article discussing disreputable and reputable credit-counseling services. Not sure what happened to the article.
• "Debt Consolidation Refinance - Pros and Cons," at searchlightcrusade.com, posted by Dan Melson on Thursday March 16, 2006. Provides an example scenario using numbers, with the conclusion being "to not get distracted by the fact that your minimum monthly payment goes down, and see if you (and your prospective loan officer) can come up with a loan and a plan that really makes you better off down the line."
• "Debt Consolidation: A Sensitivity Analysis," by Kenneth P. Moon, Ph.D., and Christine A. McClatchey, Ph.D., Journal of Financial Planning, 2005 December Issue - Article 8. If you are really wanting to get into the details of comparing debt consolidation plans, this article should be on your list of must-reads. If anything, it will help you realize how complicated the analysis can be.