Consolidating Loans

Don't Take Your Eye Off The Real Goal

Consolidating loans and debts with one new, lower interest rate loan is a popular technique used by people to lower the interest charges they are currently paying, to presumably help them get out of debt faster. I say "presumably" because many people fall victim to the temptations of these types of debt loans and actually end up in debt for a longer period of time and pay far more in interest charges than they would have had they not consolidated their debts in the first place.

What "temptations" am I talking about? As I said, one of the reasons people consider consolidating loans and debts is to lower the interest rate(s) they are currently paying. This in turn lowers the amount of interest they have to pay each month, and all things being equal, lowers the size of their debt/loan payments each month. One of the "temptations" however, is to make the monthly payments even smaller, by choosing to pay off the loan over a longer period of time. Stretching out the term of the loan reduces the amount of principal you have to pay each month, and will reduce your monthly payment amount.

What's wrong with lowering the monthly payments you ask? Well, before I answer that, let's take a step back and look at the big picture goal of consolidating loans and debts so that we don't lose sight of it. In fact, whether you choose a debt consolidation loan, or another debt reduction option, your main goal remains the same...

to get out of debt. Period.

Your goal is not to lower your interest rates. Your goal is to pay off your loans and get out of debt. Likewise, your goal is not to lower your monthly payments, your goal is to pay off your loans and debts as soon as possible so you can shift the funds you are spending on these into things like saving for retirement, saving for your children's college education or even saving for a nice vacation.

So let's go back to your previous question about lowering payments. Is that a bad thing? Here's the best answer I can give without knowing your personal financial situation. It's a bit of a roundabout answer so bear with me...

The first thing I advise people to do before they consider consolidating loans and debts (or consider any other debt relief option for that matter) is to do a complete assessment of their financial situation, and then complete a thorough personal or family budget that they can live with.

Preparing a budget and living within (or below) your means will do more for you financially and emotionally than consolidating loans will ever do.

Do what you can to clean up your own financial house first before you start looking for a maid so to speak.

Now, once you have this "big picture" plan in place, then and only then should you start to consider looking at consolidating loans and other debt and loan reduction options. And even then, don't expect these loan and debt relief options to do all the heavy lifting for you. One of the purposes of preparing a budget is to identify areas of your spending that you can reduce, thereby freeing up more money each month to pay down your loans and debt. This is not easy, I know. It will take discipline and likely force you to make some difficult decisions and changes in your life. And remember, never take you eye of the main goal of paying off your loans and debts as quickly and cheaply as possible.

Alright, lets' recap. You know your goal. You have a plan and a budget. And you are living within your means, thus freeing up money to pay off your loans and debts. Excellent. Now should you lower the payments on your loans and debt?

No! If anything you want to increase the amount that you are paying towards your debts each month. This is the only way that you are going to make any headway towards becoming debt free. Don't fall into the trap of keeping your same old lifestyle, lowering your debt payments by consolidating loans, and then expecting things to get better for you financially. They will not.

Let's pull this all together with an example of consolidating loans.

An Example

You have two $10,000 loans at 12% interest, each with a three year term. Your monthly payments for these two loans total $664.29, and over the next three years you will pay $3,914.30 in interest charges.

Now let's say you look into getting a new loan to consolidate the to $10,000 loans. You are given two options.

1. You can take a loan for $20,000 at 7% interest and a 7 year term.

2. You can take a loan for $20,000 at 9% interest and a 3 year term.

Let's compare these two options for consolidating loans:

Loan #1:

Monthly Payment: $301.85

Total Interest Paid Over Life Of Loan: $5,355.70

Time To Get Out Of Debt: 7 years

Loan #2:

Monthly Payment: $635.99

Total Interest Paid Over Life Of Loan: $2,895.81

Time To Get Out Of Debt: 3 years

The Results...

Loan #1 would allow you to reduce your monthly payment by $362.44 per month, and at the same time you are reducing the interest rate you are paying by 5%. However, in the long run it will take you 4 years longer to pay off your debts, and cost you $1,441.40 more in interest charges than if you had kept the original loans. Conclusion: This loan does not fit with your overall goal.

Loan #2, on the other hand, will only reduce your monthly payments by $28.30. Not a big difference. But, you will be out of debt in the same amount of time (3 years) and save yourself $1,018.49 in interest charges. Conclusion: This loan looks like it fits better with your overall debt reduction plan.

Consolidating loans and debts can assist you in reaching your main goal of becoming debt free. Just make sure that you prepare a budget beforehand and choose the debt loan that fits within your plan.