Wednesday, September 14, 2016

Is Debt Consolidation Really Necessary?

Perhaps. It certainly can seem like the easy way out of the problem of too many payments every month. When credit card and loan payments add up to $900 every month, why not pay all of these debts off and have a nice easy payment of say, $300? There are two reasons why it may be a bad idea.

Why do you have too much debt? Entirely unforeseeable circumstances? That's rarely the whole cause. More often, when you have debt problems, it is because you buy too many things on credit. In other words, if you are looking for a consolidation loan it is probably due to bad financial habits.

What happens when you combine all those debts? You don't owe less. You may get a lower interest rate on average, but you still owe all the money, right? The consolidated debt is just easier to pay. It will be paid with one lower monthly payment stretched out over a longer period. That's easier, but what else becomes easier now? Having more debt.

Isn't this exactly what many people do? They get $900 in various payments rolled into a loan with an easier $300 payment, and now they have excess income again. Time to buy some things on credit. Debt consolidation can be a way to postpone reckoning with the real problem - bad financial habits. Unfortunately, when you put off dealing with the real causes of debt, the problem becomes much worse.

Debt Consolidation Is Expensive

Because of the lower interest rate, it seems like you are saving money with some consolidation loans. This isn't always true. Most often you are converting short-term debt into long term or longer-term debt. The problem here is that the more time you take to pay off the money you owe, the more you pay in interest.

Suppose you owed $6,000 on a credit card, with 18% annual interest. It would require a payment of $176.26 per month to pay it off in four years, and you would pay a total of $2460 in interest. Now suppose you rolled the debt into your 30-year mortgage on your home (many people do this), with only a 7% interest rate. This would add $39.92 to the payment. That's easier than $176, and a much lower interest rate, so how much total interest will you pay over the years? $8371 - more than the original debt!

Naturally there are debt consolidation loans shorter than 30 years, but you get the point. Even with a 15-year, 7% loan, which would costs $53.93 per month, you would pay at least 50% more in interest than with the 18% 4-year payoff. Converting your short-term debt into long term debt can cost you a lot more in interest.

The lesson? Try hard to make those payments and get rid of that debt sooner. You'll be glad you did. What if it is impossible to make those payments? This happens, but for a reason, so why not work at least as hard on changing your habits as you do on getting the best consolidation loan.