Debt consolidation loans are a commonly marketed product for debt management. The banks and debt management companies portray their consolidation loans as the way to wipe clean our debt situation. Sometimes this may be the case, but it’s not necessarily a one-size-fits-all solution.
Let’s discuss how debt consolidation loans work and some of the pros and cons of them. My take on it will be purely objective, as I receive no kickbacks from anyone for writing this. So you can trust that my perspective on this topic, as a financial coach, is unbiased.
How Consolidation Works
This is typically a process for people who have multiple debts, often credit cards and unsecured personal loans. It involves opening up a new line of credit and using that line of credit to pay off multiple debts at once.
Sometimes a personal loan can act as your own consolidation loan if you have the creditworthiness to take out a large enough amount. I have had clients effectively convert credit cards into one personal loan, which amounts to their own consolidation.
Some debt consolidation plans involve the use of a debt management program, where a third party takes over your accounts and negotiates with creditors on your behalf. This is a more involved process that a mere consolidation loan, and can involve some additional fees for the management of your debts.
The short of it is that consolidation brings your debts under one roof, with the idea being that there is more simplicity and a better chance of paying them off. Now that we’ve discussed how it works, let’s talk about the pros and cons.
Pros of Debt Consolidation
The new consolidation loan will have a set interest rate that is often below the average credit card interest rate. Credit card interest rates are exorbitant, frequently upwards of 25%. If you can reduce this interest rate to around, say, 8%, you will save money by paying less in interest.
There will also be one payment due for all of the accounts which you consolidate into this new loan. A difficulty that some people experience is keeping track of many types of accounts. Especially if you have a variety of debts, like credit cards, personal loans, student loans, etc., it is appealing to have one payment in one place.
A debt consolidation loan can also help your credit by paying off accounts that are late or in collections. As these debts become paid in full, your credit score will increase as you have a more positive credit history. Not to mention that you will also pay less in interest, penalties, and late fees.
A debt management program can help lower interest rates as well. These agencies, many of them non-profit, negotiate on your behalf with creditors to develop a plan to pay your debts off. The weight of creditor negotiation is off of you with these programs. These agencies typically have a fee for their services.
Cons of Debt Consolidation
As appealing as the above-mentioned benefits can be, debt consolidation is not without pitfalls. What I have seen many times is people using consolidation as a method to stop the bleeding without addressing the underlying problems.
Consolidating your debt can actually make it harder to become debt-free. The main program I counsel my clients to use for debt elimination is the debt snowball. This program has you pay off your debts from smallest to largest, building momentum in the process.
By consolidating smaller debt balances into a larger one, you remove the ability to snowball the debt. A bunch of small bullies turns into one really big one.
Especially when starting out, getting victories quickly is important. If it takes many months to get even one debt paid off, you may become discouraged and give up. I have seen this happen many times.
It’s easy to see debt consolidation as a permanent fix for your financial problems. And that’s how the banks and debt management companies market these products.
But without addressing the underlying reasons for financial problems (overspending, lack of vision, no budget, etc.), the problems can end up getting worse. Six months later, these folks often find themselves in a similar or worse situation because their habits and mentality have not changed.
When using a debt management program, there are also risks that these companies don’t fully disclose to their customers. These companies will frequently allow these accounts to go into collections and they try to negotiate settlements.
But the creditors don’t always want to play ball. I’ve had a number of people come to me over the years because creditors have filed lawsuits for the principal owed, plus interest, penalties, etc. These lawsuits have been small in some cases, less than $5,000, but up to $30,000 in others. It’s not a good place to be.
This type of program can help to stop the bleeding, or at least appear to. But again, this approach does not deal with the deeper problems. The last thing we want is to invest time and money, only for things to end up worse down the line.
My Take on Consolidating Your Debt
If you can’t tell, my view on debt consolidation is more negative than positive. That’s not because I oppose it in theory, but because these programs do not address the underlying problems that cause debt troubles. As a coach, I want to see these problems solved for the long haul, so temporary fixes are generally not my thing.
I have had client situations in which I have suggested a consolidation or balance transfer. But this recommendation has come alongside my guidance, ensuring that my clients do not view the consolidation as a true fix for something that really needs deeper work.
Personal finance is more about behavior and mentality than math. Consolidation does not address the habits that lead to debt problems. With consolidation, accounts can be brought back to current, interest rates lowered, and payments simplified. That’s all true.
But it’s at the deep level that real financial change takes place. Debt consolidation loans and programs are a superficial fix for a deep-level problem. That’s my main issue with them.
I want the best for you. I want to see you become debt-free and never pay another dime of interest to creditors. Imagine being able to earn interest instead of paying it, making the magic of compound interest work for you.
You can make this happen. But to get there, it will take more than just consolidating your debt. It will take a change of the heart and mind to see that financial freedom is possible. By making voluntary sacrifices, confronting our past, and creating a vision for our future, we can achieve it.
Helping people find financial freedom is my mission. I’m here to help you experience levels of freedom you have never thought were possible. My coaching is something that no debt consolidation loan can offer you—hope, encouragement, and accountability.
My client testimonials speak for themselves. Book your free Discovery Session today to start your journey to financial freedom!