Should I Consolidate My Debt?

Article by R. Joseph Ritter, Jr. CFP® EA

There is no one-size-fits-all answer to this question. However, you should consider a number of issues and factors before deciding to consolidate.

First, let’s ask why you are interested in consolidating debt? In a consolidation, none of the debt you owe is actually reduced. Consolidating simply moves the balance from one account to another, usually under one payment and interest rate. This may look tempting and might actually ease some of your strain. However, consolidating does not solve the bigger issue.

Let’s start with a few “don’ts.”

  • Don’t pay fees for consolidating your debt. You can do the same thing on your own, and paying a fee just adds to the amount you owe.
  • Don’t consolidate unsecured debt into secured debt. Unsecured debts include student loans, personal loans, and credit cards. Secured debt includes your home mortgage and vehicle loans. A common temptation is to tap your home equity with a line of credit, borrow against your home when refinancing, or using a title loan against your car. Although the interest rate on home loans may be lower, the length of time the mortgage is outstanding has a much larger effect than you may realize. Ultimately, you will pay many thousands more by tapping into your home equity than if you had left your unsecured debt alone. Also, unsecured creditors have no right to foreclose on your home or repossess your car. All they can obtain against you is a judgment. Combining unsecured debt with secured debt means that if you default on the loan you could lose your home to foreclosure or your car to repossession. And when you increase the amount you owe on your house or car, you are also increasing the chances of default. Unsecured debt is simply not worth putting your house or car in jeopardy. One other word of caution if you already tapped your equity to pay off unsecured debt and face foreclosure in the future is that many lenders are reporting any forgiven debt (the difference between what you owe and what the bank collects) to the IRS as taxable income to you. This means you could end up trading unsecured debt for tax debt.
  • Don’t consolidate low interest rate balances with higher interest rate balances. You’re better off negotiating interest rates.
  • Don’t get sucked in by high pressure advertisements promising low monthly payments and interest rates. Zero interest rates and low rates are introductory, and when they expire, interest rates soar to 19% or even 29% over night if you are late or miss a payment or can’t pay the full balance before the introductory period is over.

Now that we’ve looked a few don’t’s, let’s consider whether consolidating is the right choice.

Most people consider consolidating because they want to reduce their total monthly payments, can’t keep up with minimum payments, and want to get out of high interest rates. Most people also have a series of balances rather than one large loan. For example, a person with $50,000 of debt usually has some small credit card accounts, a personal loan, student loans, a car loan and at least one large credit card. 

If you consolidate all of these accounts (except the car loan) into one payment, your interest rate and payment will be level (fixed) for 3-5 years or more. Even as you pay down the balance, your monthly payment will not decrease. If you instead developed a plan to tackle your debts one at a time, each balance you pay off directly reduces your monthly payment. This frees up cash in your monthly budget quickly, which you can use to save a small emergency fund or put toward larger balances.

The majority of people who work with Zacchaeus Financial Counseling prefer this approach and are not interested in taking on the long-term commitment of loan consolidation payments.

But what about the interest rate? Most credit card companies are flexible in the interest rate on your account. All you have to do is ask.

Is it possible to reduce any of my payments? It might be if you can demonstrate financial hardship. Credit card companies especially have programs to help borrowers who are experiencing a legitimate hardship. Lenders would much rather modify the terms of your account than spend thousands of dollars in legal fees trying to collect.

Following these steps will help you accomplish at least the same, and probably better, results than a consolidation would have given you. Over time, your monthly payment will reduce even further, and you will have saved a lot of interest. You will also keep total control over the process and have the most flexibility too.

To ensure the success of your plan, start by trimming your budget as much as possible. If you have any extra money, put it on the smallest balance first. Why? Paying off a balance eliminates a monthly payment and frees up money to put somewhere else, and the quickest way to do that is by paying off the smallest balances first. Paying off the smallest balances first also gives you a much needed feeling of accomplishment, something you’ll never have with a loan consolidation.

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