14
Debt-Consolidation Loans
Consolidation won’t make your debts magically disappear, but it can help you get a handle on them if you use it in the right way.
Gerri Detweiler, Debt Collection Answers
Consolidating debts is being widely touted these days as a life preserver for those who are drowning in debt.
Here is the way debt consolidation is supposed to work. You add up the total of all your consumer debts (credit card accounts, installment and personal loans) and pay them off with the proceeds from a new loan—either a new credit card or a home equity loan—that has a lower interest rate and a monthly payment that is less than the total of the previous payments.
In theory, debt consolidation is a terrific solution for a burdensome debt situation because it shortens the time you stay in debt and reduces the associated costs. In practice, debt consolidation usually offers an express lane from the frying pan into the fire.
Debt consolidation does not refer to a single type of loan but rather to any plan whereby the lender hands you a lump sum of money to pay off your smaller loans, leaving you with one single debt. A debt-consolidation loan can be either secured or unsecured. It can be a new credit card onto which you transfer all the outstanding balances from your other credit cards; a home equity loan; a loan from a retirement account, such as a 401(k); a new loan from a finance company; or a personal loan from a friend or family member.
Debt consolidation is not a panacea. On the contrary, it often represents a much more costly and eventually difficult situation than the problem it was supposed to relieve. I am not at all thrilled with the whole idea of debt consolidation for the following reasons.
Debt Consolidation Represents a Detour
Of course, there are occasional exceptions, but for the most part, debt consolidation represents at best a lateral move. It doesn’t pay down debt but only moves it around. It makes your debt situation more comfortable, but it doesn’t put you any closer to getting rid of the debt. Many times it does just the opposite—it reduces the payment but extends the payback time so far into the future that the debt grows considerably because of the interest that piles up.
I received a letter from Michele, who wrote with a question on debt consolidation. It seems she and her husband have a $25,000 home equity loan at a whopping 15 percent interest and a $3,900 signature loan at 23 percent with the same household finance company. She explained that the interest rates are so high because when they took out these loans years ago, their credit history was, shall we say, less than pristine.
She went on to say that the lender approached them with a preapproved offer to combine both loans into one new loan at a fixed rate of 13 percent, extending the payoff time to twenty years. The lender was even willing to increase the loan to give them a little breathing room or take that well-deserved vacation or add on to the house. She wanted to know if this was a good deal, since the monthly payment would drop considerably.
Before I even looked at a single number, I had my suspicions. I don’t believe there is a lender on the face of the earth who would approach a current customer with an offer for a new loan deal that wasn’t in the financial interest of the lender. What lender would volunteer to rewrite or consolidate debt if it benefited only the borrower?
That fact alone should be a clear signal that someone is about to go for a ride. Then add on the fact that the lender wants to lend even more money to this family, and you can see the proverbial handwriting on the wall.
After reaching into the tool chest at my website, DebtProofLiving.com, and pulling out the loan comparison calculator, I was able to come up with comparative figures the lender didn’t happen to mention to Michele.
I learned that given their current loans and payment schedule, they would pay $31,951 in interest on the home equity loan and $1,264 in interest on the signature loan, or a total of $33,215. The proposed consolidation loan, on the other hand, would, over twenty years, require interest of $52,360. The lender stands to increase his profit by more than $19,000 in this deal. Clearly, if Michele were to fall for this, she would be taking a major detour on her journey to becoming debt-free by tapping into her home’s equity and paying even more interest.
Debt Consolidation Prevents Personal Growth
When we keep putting Band-Aids on difficult financial situations, it is nearly impossible for us to learn the tough lessons about what got us to this point in the first place. For example, if you have ten credit cards, all of which are maxed out, and you transfer those balances to a new credit card that promises a lower monthly payment, you have in fact told yourself that new debt is the solution for old debt. That’s wrong. The solution for old debt is to discover what prompted the situation to escalate to this point and then to do whatever it takes to repay the debt—not simply move it around to a more comfortable position.
Debt Consolidation Has a Doubling Effect
If you’ve ever lost ten pounds and gained back twenty, you’ll easily recognize this danger.
Consolidation is a good theory. Transfer all your credit card balances with high interest rates to a single new credit card with a lower rate of interest. Your one monthly payment is now lower than the total of all your individual credit card payments. However, this is when the trouble begins.
If you are like most people, you look at the credit cards that now have zero balances and you feel a certain sense of delight. You’re quite proud of yourself because it feels like you’re debt-free (you aren’t really, but you enjoy pretending). You know for sure that you will never use those cards again (yeah, right), but do you close the accounts? No. You think that just in case you have some unforeseen emergency it would be nice to have the financial cushion these credit lines represent. You also reason that if you close them and then end up needing them in the future, you’ll have to reapply and go through that needless hassle. (I know you well, don’t I? That’s because I know myself.) You may even feel a bit like a savvy financial counselor as you instruct yourself to put the cards in a safe place so the balances will all remain at zero.
The truth is that regardless of whether those cards are in your wallet or stashed in the bottom of a vault in another city, available credit will haunt you. In the beginning, you’ll be terrified that you will have a reason to use some of it. Unfortunately, the feeling will go away quickly.
Before you know it, an “emergency” will show up, and that will be the beginning of the end. It is a strange thing how the availability of credit creates emergencies. And it does so in record time, particularly if you don’t have clear and concise personal criteria in place for what constitutes an emergency.
I can’t begin to tell you how many people I’ve heard from over the years who did the credit-card-balance-transfer thing—or took out a home equity loan to pay off all their credit card balances—and managed to get those credit card balances back up to their all-time high. And then they had double the debt to contend with—the consolidation loan plus all the credit card accounts.
When looking at a debt-consolidation loan, you cannot focus all your attention on the monthly payment. It is quite likely that while the monthly payment is less, the interest rate will be higher and the payoff time longer. You must look at the big picture, comparing the total amount of interest to be paid as well as all terms and conditions.
So is there ever a time when a debt-consolidation loan would be in order? Theoretically, yes. However, it is becoming more and more difficult to make it work—not only because of our weak human nature but also because of the credit industry. By the looks of the average person’s mailbox, low-interest credit card deals are quite plentiful. But don’t be fooled; carefully read all the terms and peruse each and every bit of fine print before you decide to apply.
Even the low-interest, fixed-rate cards are not all they appear to be. First, the interest rate may be fixed but only for a specific period of time. What happens at the end of the first year? If the rate climbs significantly or then becomes a variable rate tied to an index, watch out. Other offerings have very attractive interest rates and terms, but you need to pay careful attention to their penalties for paying late. Many deals provide that if you are late even one time during the introductory period (and that means missing the deadline by even five minutes), the rate immediately shoots up five or six percentage points. If you make that mistake twice, the rate on some of the more popular deals can go to 29.99 percent or higher. Clearly, that kind of deal makes a beneficial consolidation attempt nearly impossible.
If you are able to find a better deal and you can qualify to consolidate your debts in a less costly account—and you’ve done your homework and understand every aspect of the deal—make sure you cut up all the other credit cards as you pay them off. Even though you have “closed” the accounts as far as using them is concerned, they will be reported to the CRAs as having zero balances. Many open lines of credit will not necessarily help your credit score. You should proceed to systematically close the accounts at a rate of one every six to eight months.
Cutting the cards will go a long way to putting to rest the idea that those lines of credit are available to you and may very well help you clean up your credit report. Remember that in some cases, like qualifying for a real estate loan, too much available credit becomes a negative.
Debt-Consolidation Safety Rules
1. Do not tap into appreciating resources such as home equity or a retirement plan to consolidate or pay off consumer debt. It is not wise to use appreciating assets (your home equity and retirement plan are both growing in value) to pay for depreciating goods and services.
2. If you can successfully switch your credit card balances to a lower-interest credit card, keep paying the most you can each month. Never allow yourself to see the minimum payment as appropriate.
3. Completely close the paid-off accounts. Do this over a period of time, closing one every six to eight months to incur the least negative impact on your credit score. You must call the company with your instructions to close the account and follow up in writing. Do not consider the matter closed until you see on your credit report, “Closed at customer’s request.” These companies do not want to lose you, so be prepared. Breaking up is hard to do.
4. Do nothing to add to your total debt load. Used properly, a debt-consolidation loan should lighten your debt load, not create an opportunity to increase it. It should put you in a more favorable position, not further behind.
Instead of looking for shortcuts that may turn out to be costly detours, stop using the plastic, get busy putting together your Rapid Debt-Repayment Plan (chap. 7), and stop thinking of new sources of debt as the solution for existing debts.