People who have accumulated a substantial amount of debt from a number of creditors may consider obtaining a debt consolidation loan, a loan that will pay off most or all of their existing debt, and that will normally result in their making a smaller monthly payment on the single consolidated loan than they were previously paying to service their various debts. Although debt consolidation is a very good idea for some debtors, particularly those who have a lot of high-interest debt, consolidation is not always a good deal.
A debt consolidation lender provides a loan that pays off some or all of your existing debt, and replaces that debt with a single loan with a single payment. The goal is to replace a number of loans that carry higher interest rates, such as credit card debt, with a single loan that carries a lower total monthly payment.
At first blush, it may appear that there is no downside to debt consolidation. After your debts are consolidated, you end up paying less money each month to service your debt and thus have more cash on hand at the end of each month even as you continue to pay down your debts.
However, depending upon how the consolidation loan is structured, you may find that you are paying less money per month toward the principal balance of your debt than you did prior to consolidation. That is, over the life of the loan you may end up paying a lot more interest on your consolidated loan, and it may take a great deal more time to pay off your debt than if you were instead to keep paying your present individual debts.
There is also a chance that obtaining a debt consolidation loan will hurt your credit. Depending upon the scoring used, your income and the details of your credit history, obtaining a new line of credit and paying off existing loans may result in your being classified as a greater credit risk than if you were instead to continue to carry a number of smaller loans.
Before you obtain a debt consolidation loan, you should ask yourself if you have the fiscal discipline necessary to benefit from debt consolidation. If you obtain a consolidation loan with a lower monthly payment, but immediately run up new credit card debts, you will almost certainly end up in a worse position than you were in prior to consolidating your debts. You can even end up in a cycle of obtaining "consolidation" loans, with the commissions, fees, and interest rates accumulating to put you deeper and deeper into debt.
It is not unusual for a debt consolidator to obtain a commission of 10% or more on your new debt consolidation loan. It is possible also that the consolidator will be able to obtain a rebate from your lenders when your new loan is applied to pay off the debts owed to those lenders, resulting in an even greater commission.
The opportunity for significant, easy profits may inspire unethical debt consolidators to encourage people to obtain consolidation loans that are not in their best financial interest.
Trading Early Payoff for Low Payments
In many cases, those seeking debt consolidation are having difficulty making the payments on their current debts. A struggling debtor will often fail to qualify for a low interest rate on a consolidation loan.
However, if a debtor obtains a higher interest consolidation loan, any reduction in monthly payments achieved through consolidation will often result from the structure of the loan, with the bulk of each monthly payment going to interest and little going to the principal balance of the loan. As a result, although the monthly payment is reduced, the debtor will make very slow progress toward paying off the loan and will likely pay a lot more interest over the life of the loan.
Before you obtain a debt consolidation loan, consider your alternatives:
Pay Down Your Debts - For people who are able, the best way to resolve outstanding debt is often to pay more each month to service their existing debt, making additional monthly payments toward the principal balance, and focusing first on paying down their highest interest debts with non-deductible interest, such as credit card debt.
Negotiate With Your Creditors - Sometimes if you simply call and ask, a creditor will offer you a lower interest rate or will waive certain fees associated with your accounts. Credit card companies tend to more receptive to this type of request.
Debt Management - Instead of refinancing your debt, you may be better served by using a debt management service, under which you deposit an amount of money each month with a service that uses the money to pay your bills for you. Sometimes creditors will work with a debt management service to offer reduced interest rates or to waive certain fees associated with your loan or account.
Using a Traditional Lender - If you qualify for a personal loan through a bank or credit union, you will normally get considerably better rates and terms than you can obtain through a debt consolidation lender.
Secured Loans - If you have equity in your home, you may benefit from refinancing your home or obtaining a home equity loan to pay down your other debts as opposed to borrowing money through a debt consolidation lender. Many debt consolidation lenders will use your home equity as collateral, but offer less favorable terms than might be available through a mortgage or equity loan, and without the tax advantages of a mortgage.
Bankruptcy - If all debt consolidation is likely to do is delay an inevitable bankruptcy, consider whether you will be better served by proceeding directly to bankruptcy. If you qualify for Chapter 7 bankruptcy much of your debt may be discharged, and under a Chapter 13 bankruptcy your debts are restructured over a repayment period, usually three to five years, under which most debtors will pay considerably less than the full value of those debts.
Some debt consolidation lenders promise not only to consolidate your debt, but also to provide you with insurance and perhaps even investments, while at the same time maintaining or lowering the total monthly payment you must make to service your debt. You should be wary of that type of promise.
Prioritize Paying Down Your Debt - If you were in a good position to make investments, odds are you would not be in the market for a debt consolidation loan. You will likely be better served by directing your money to paying down your debt, as opposed to making new payments for insurance of having some of your money directed to an investment.
Watch for High Commissions - The commissions associated with the investments and insurance policies offered by debt consolidators are likely to be high and may be extremely high. Remember that primary reason a salesman is trying to sell you an additional financial product is to earn a commission.
Low Value Products - If you examine the terms of coverage for an insurance policy, or the terms of an investment, you are likely to find that you are being offered a substandard product at a high price.
The best approach for most people who want to consolidate their debt is be to look for the best option for consolidating their debt, and to complete that consolidation process before purchasing additional financial services. In most cases, the best option will not be from a debt consolidation lender, but will involve a mortgage refinance, home equity line of credit, or personal loan from a traditional lender. Once they settle into the new loan and payment structure, they may consider their additional financial needs, and whether they can afford to invest a portion of their income.
Most people with a significant amount of money to invest will benefit from using a professional financial planner, as opposed to buying insurance or mutual funds from a loan salesperson who has little actual knowledge of investment, and who offers a much smaller range of investment options. For those with less money to invest, the best option is normally a no-load index fund, a type of investment the loan salesperson is unlikely to offer.
Some debt consolidation programs are sold through multi-level marketing programs, with participants in the programs urged to sell loans or financial services to people they know. Although there may be a certain comfort level in purchasing a financial plan from a friend, co-worker, or relative, consider this: What are the odds that this person truly is an investment professional? Odds are you're getting a packaged sales pitch from somebody who knows little or nothing about financial planning.
Most multi-level financial schemes offer very few options to the customer, and all require very high commissions for the salesperson and the salesperson's upstream - those who sponsored the salesperson into the organization.
You should treat a multi-level program like any other option. Investigate to see how it stacks up against your alternatives, then select the refinancing option that is in your financial best interest. Don't be taken in by the fact that you like the person who is selling the program, or the suggestion that you will be doing them a favor. Many of these programs promise the participants the potential of a six figure income, and your friend hopes to profit handsomely by convincing you and others to sign up for the service.