Make Consolidation Loan Work

Jul 29, 2014 by

handling debtsPurely by coincidence my friend Travis at Enemy of Debt published a post titled “We’re Getting a Debt Consolidation Loan, and I’m OK With That” on the same day I published on Money Counselor “Debt Doesn’t Cure Debt” in which I dissed a LendingTree billboard urging people up to their eyeballs in debt to take out a (presumably consolidation) loan. The contrast I think creates great financial food for thought for readers of both blogs.

Why Consolidation Loans Make Me Queasy

As I noted in “Debt Doesn’t Cure Debt,” each situation is unique, but in general I think taking out a consolidation loan as part of a debt pay-off strategy often backfires. Why? Because debt-challenged people often, consciously or subconsciously, use a consolidation loan to postpone resolving, not tackle, their debt challenges.

Here’s what can happen with consolidation loans:

  1. Bruce has $25,000 in credit card debt on three different accounts at an average APR of 18%.
  2. Bruce gets the bright idea (likely instigated by clever LendingTree-like advertising) to take out a $25,000 consolidation loan at, say 12%. His plan is to use the proceeds to repay the credit card debt. His life will then be simpler and cheaper because he has one monthly debt payment instead of three and, because of the lower interest rate and longer pay-off term, his monthly debt payment is less. Relief!
  3. Bruce does pay off the $25,000 in credit card debt with the consolidation loan. That felt good!
  4. But Bruce’s fundamental problem—he spends more than he earns—continues as always.
  5. Three years down the road Bruce still owes $20,000 on the consolidation loan, and he’s again maxed out his three credit card accounts by borrowing another $25,000. His budget is tighter than ever, and his debt load is $20,000 higher compared to three years earlier.

Whether knowingly or not, Bruce has used the consolidation loan to extend his economically unsustainable lifestyle. He’s made his debt challenge much worse, not better. The likelihood he’ll be forced into bankruptcy one day is higher than ever.

Why Travis’ Consolidation Loan Makes Sense

In contrast, Travis’ consolidation loan makes financial sense for his family. How does Travis’ situation differ from Bruce’s?

  • As Travis has described extensively on Enemy of Debt, he hit bottom with respect to debt and living beyond his means. He’s worked hard to tackle his challenges head on and understand why he felt compelled to spend more than he could afford. In short, he’s turned the spending corner, hard. That he repaid $109,000 in credit card debt over five years through a debt management plan vividly demonstrates his resolve to pay off debt.
  • Travis used the proceeds of his consolidation loan to pay off two lines of credit. He’s closing these two lines of credit after paying them off, eliminating any opportunity to re-borrow. That’s smart, and again sends a clear message that his plan is part of a debt resolution, not postponement, strategy.
  • Travis set up his consolidation loan so that he’ll be obliged to pay it off sooner than he’d be obliged to pay off the two credit lines. With the consolidation loan’s lower interest rate, the monthly payment difference won’t put any additional strain on his budget. This self-imposed discipline again says Travis is aiming to repay debt easier (with less cash) and quicker, not just move debt around.

Bruce, on the other hand, has not grappled with his core problem: a compulsion to spend more than he earns. As a result, his consolidation loan predictably turned into just another way to help him live beyond his means a few years longer.

Before You Take Out a Consolidation Loan

If you’re thinking of using a consolidation loan to help get out of debt, your plan should have these features:

  • Close all accounts you pay off with the consolidation loan’s proceeds. If you need to keep open a single credit card account, call the issuer and insist that the limit on the card be cut to $1,000 or less.
  • The consolidation loan’s term should be as short as possible so that the payment fits in a tight, debt payoff mode, household budget.
  • Your consolidation loan should allow early payments without penalty.
  • If you have not taken serious steps to stop spending beyond your means, you’re not ready for a consolidation loan. Do you have a household budget? Are you saving money each month?

Your Thoughts?

Do you have anything to add to the checklist above for people thinking of getting a consolidation loan?

Have you successfully used a consolidation loan to repay debt? Or is your story more like Bruce’s?

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