Last week’s blog post about checking your credit report leads us to the next question I hear concerning debt consolidation. There are several credible companies and independents out there who can genuinely help. My recommendation is like any financial decision, large or small, get the facts and do your research! In many of my initial consultations the idea of debt consolidation seems to be the answer when debt overwhelms your monthly budget. At first it sounds like a great idea but read on……
You are not the only one burdened with debt. According to The Center for Microeconomic Data’s 4th quarter report on household debt and credit found that overall household debt increased by 1.4%, with steadily rising account balances over the last 5 years. In fact, overall household debt is 26.8% higher than it was just 7 years ago. With everything 2020 has brought us these figures are likely to be yet another surprise if the credit card was reached for even more than normal.
What is debt consolidation and how does it work?
Debt consolidation is a simple concept. Basically, you combine all your smaller, individual loans into one large loan.
Advantages of debt consolidation
Debt consolidation offers only a few advantages to the borrower. What most of my clients are looking for are lower monthly payments, and a debt consolidation loan will provide that. In addition, the interest rates are often lower as well. Your result is you have only one bill to each month instead of multiple bills.
Disadvantages of debt consolidation
This is where the disadvantages override the advantages!! Despite a lower interest rate, you may end up paying more in interest by consolidating your debts. How would this happen? If you stretch out the payments for a longer length of time than you would have had on your individual smaller loans, the total interest you pay may well be higher. So do the math before you jump into a loan that seems great on the surface. To start paying off your debt with the end goal to becoming debt free the mindset and momentum plays a major role here. If you have multiple smaller loans and start paying them off from smallest to larges you see progress faster and more often.
In addition, having debt on your balance sheet negatively affects your net worth. Many people are concerned with eliminating debt ASAP – and a debt consolidation loan will usually do the opposite as it keeps you in debt much longer.
How do you consolidate your debts?
There are a few ways to handle debt consolidation, but each has their own pros and cons. Let’s take a look at them.
- Transfer your balance to a credit card with a lower or zero interest rate
- Pro: Save money on interest
- Con: Usually has a fee associated with it (check this closely)
- Potential pitfall: The low/no interest rate period is usually temporary, meaning you must do this again when the period expires. If you transfer to a zero interest rate and it is only for 4 months and then increases to 23.99% you may end up with a higher than previous rate.
- Take out a home equity loan (the riskiest process)
- Pro: Usually available at a lower interest rate than most credit cards or unsecured loans
- Con: Only available to homeowners who have equity in their home
- Con: Usually has fees associated with it, including the cost of a home appraisal
- Con: If you sell your home, you will have to pay the home equity loan back immediately upon closing
- Con: Usually has a daily simple interest which means you are incurring interest each day
- Potential pitfall: Some home equity loans allow you to only pay the interest each month, which can give borrowers a false sense of security, leading them to accumulate more debt. Don’t fall into this trap!
- Potential pitfall: If you fail to pay the loan back, your home may be foreclosed on
Should you consolidate your debts?
There are a few things to look for when deciding if loan consolidation is the right move. First, the single monthly payment needs to be lower than the combined payments. Second, the interest rate on the new loan needs to be lower than the average of the interest rates on the other loans. And third, if you need to put up collateral, such as your home or car, make sure you can comfortably make those monthly payments. You don’t want to lose a valuable possession you have worked extremely hard for and in the case of your home, your biggest asset.
**this content is for informational purposes only and is not intended as tax, legal, fiduciary, or investment advice. If you are considering debt consolidation please consult your financial advisor or as your coach we can walk through all the steps. You want to have accurate information first!