Debt Doesn’t Cure Debt!

Jul 21, 2014 by

head scratcher

Billboard message a head-scratcher.

While wandering the streets of Seattle last week a LendingTree.com billboard cried out for a Money Counselor head-scratching post. Unfortunately I didn’t have any camera with me, but the billboard’s message essentially was this:

Up to Your Eyeballs in Debt?

Take Out a Loan!

Am I the only one who sees some irony here?

What is LendingTree.com?

According to its website, LendingTree.com is “the nation’s leading online lender exchange.” In short, if you’re in need of a loan, you can apply through LendingTree and, in theory, receive competing loan offers from multiple lenders. This saves you time compared to applying to a bunch of lenders individually and may help you find the least cost loan.

Can Taking Out a Loan Help Cure Too Much Debt?

The unstated idea behind LendingTree’s recommendation is to take out a home equity or so-called consolidation loan, or to refinance your current mortgage and take cash out (like millions of now underwater homeowners did in the decade or so leading up to the 2008 U.S. housing crash), to pay off other, smaller but higher cost, debts like credit card or medical debt.

What’s wrong with this idea? Plenty. Everyone’s situation is unique, but in general:

  • Replacing unsecured debt—like credit card or medical debt—with secured debt like a home equity loan or refinanced mortgage is bad strategy. Unsecured debt usually has a higher interest rate than secured debt, but it also has one very appealing feature: it’s unsecured. That means if you can’t pay, you’re not going to be in jeopardy of forfeiting property like your home or car. While devastating to your credit, you can rid yourself of unsecured debt through bankruptcy if you cannot repay the debt and creditors are pursuing intolerable tactics like garnishment. If you can’t pay a secured debt, you’re going to lose to the lender the property you signed over as security. And you’re credit’s going to be trashed.
  • Many people who take out a consolidation loan for the purpose of repaying credit card debt do use the loan proceeds to pay off or down the high cost credit card debt. Then, their financial habits unchanged, they run the credit card balances up to the maximum again. In the end they’ve got all the credit card debt they started out with plus the consolidation loan. For most people most of the time, consolidation loans postpone resolution, and usually exacerbate, a debt challenge, instead of solving it. Be honest with yourself. A low cost consolidation loan can help repay debt, but to assure that’s going to happen, close all but one low-limit credit card account after you use the loan proceeds to pay off all of your credit cards. No cheating by opening a new credit card account until the consolidation loan is repaid!

We All Think Nothing Will Go Wrong

I know what you’re thinking. “Pooh on Money Counselor, I’ve got a good job and my house value has been going up. I’m going to take out a cheap home equity loan and pay off these credit cards at 18%. That’ll save me a bundle.

And you’re right; you may save a bundle, if none of these (or a lot of other stuff I won’t mention) happen:

  • Disability or health challenges that lead to an extended income loss
  • Layoff
  • You continue the bad habits that led to big balances on your credit cards in the first place
  • You want to relocate but find that the market value of your house is less than your mortgage + home equity loan balance

To Cure Debt: PAY IT OFF

With no close second, the best way to deal with a debt challenge is to adopt a plan to pay it off, not move it around. You can read more about my recommendations for dealing with debt here:

Options for Paying Down Debt

Pay Off Debt With a Debt Management Plan

Do-It-Yourself Debt Settlement

Do-It-Yourself Debt Payoff

What’s Your Story?

Have you taken out a consolidation or secured loan with the intention of paying off higher cost debts? How did your plan work out?

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  • I don’t normally do this sort of thing in comments….but I actually have a post today over at Enemy Of Debt putting forth the case when a consolidation loan is a GOOD idea. It’s not just pushing debt around, it lowered our interest rate and gave use a finite term in which the debt will be paid instead of the open endedness of a credit card / line of credit. I think the net is, every scenario is different, and needs to be evaluated individually….

    • Hi Travis,
      I appreciate your comment, and I agree consolidation loans can be helpful, IF the borrower has the discipline needed to use the loan as a tool to pay down debt, not to expand debt. Too often I’ve seen well-intentioned debtors take out a consolidation loan, use the proceeds to pay off a few credit cards, but then over time gradually build back up the credit card debt. In short, this type of debtor has not addressed the core issue: living beyond one’s means. Until that’s done, taking on a consolidation loan or any type of debt is a mistake. You used a consolidation loan the right way; many don’t, so caution is needed I think.

  • You are absolutely right. Taking money from Todd to pay Sue will not ultimately work out. There are a lot of variables which are hard to anticipate, like getting laid off as you mentioned. Paying off debt the first time really is the best way to go.

  • Travis Pizel

    I don’t normally do this sort of thing in comments….but I actually have a
    post today over at Enemy Of Debt putting forth the case when a
    consolidation loan is a GOOD idea. It’s not just pushing debt around,
    it lowered our interest rate and gave use a finite term in which the
    debt will be paid instead of the open endedness of a credit card / line
    of credit. I think the net is, every scenario is different, and needs
    to be evaluated individually….

    Here’s the link – if you’d rather not have the link here, feel free to remove:

    http://www.enemyofdebt.com/were-getting-a-debt-consolidation-loan-and-im-ok-with-that/

    • Hi Travis,

      I appreciate your comment, and I agree consolidation loans can be
      helpful, IF the borrower has the discipline needed to use the loan as a
      tool to pay down debt, not to expand debt. Too often I’ve seen
      well-intentioned debtors take out a consolidation loan, use the proceeds
      to pay off a few credit cards, but then over time gradually build back
      up the credit card debt. In short, this type of debtor has not addressed
      the core issue: living beyond one’s means. Until that’s done, taking on
      a consolidation loan or any type of debt is a mistake. You’re using a
      consolidation loan the right way; many don’t, so caution is needed I
      think.

      Readers, check out Travis’ post (link above in his comment) to see how to use a consolidation loan the right way–to pay off debt faster and easier.

  • Like you said, from Travis’ comment, there are exceptions and sometimes people can get an extremely low rate to consolidate. As opposed to paying all kinds of crazy rates, but…I like what you said: to cure debt: PAY IT OFF!

    If you really want to get rid of it, get disciplined and pay it off. That’s the bottom line.

    • Right on. A solid, disciplined plan to pay off debt can sometimes include a low-cost consolidation loan, as in the strategy Travis is using. But for many people–especially those with a history of living beyond their means–self-discipline breaks down and, in the end, debt grows instead of shrinks when they pursue the consolidation loan strategy.

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  • I think it depends on the circumstances — in the long run, which one will cost more, to pay off your current debt as soon as possible or try to consolidate your loan. Try to calculate different scenarios so you can make the best decision.

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  • Hmm. I have to say that I might agree that taking out a low interest loan as as self consolidation to pay off credit cards and then pay off the loan aggressively at a much lower interest rate is a good idea.. IF the person can actually stay out of any further debt. But they got themselves there to begin with so unless the behaviour is changed completely, there is the risk of the person just taking out more debt on their credit card.

    • Agreed. You’ve got to honestly know yourself and whether you’ve got the self-discipline to use a consolidation loan as a debt payoff tool.

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