A Debt Consolidation Loan
Advantages, Disadvantages And Alternatives
A debt consolidation loan will not get you out of debt. It merely "shifts" the money that you already owe from one creditor to the next. But that is not to say that loans to consolidate debt cannot be used successfully as part of a more comprehensive debt reduction plan. Here are some of the 'pros and cons' of debt loans if you will, along with some other debt relief options available to you that you may not have considered (or known about).
Debt Consolidation Loan Advantages
Lower Interest Rates
The most obvious (and attractive) reason to consider consolidating your debts with a new loan is the potential to reduce the interest rates you are currently being charged. And with credit card interest rates that can be as high as 20% or 30%, reducing the interest you are being charged each month can have a significant impact on how fast you can pay down your debts.
Lower Monthly Payments
If you are struggling to make the minimum payments on your debts
each month, the thought of being able to lower those payments is
tempting. And loans
for debt consolidation can lower your payments in two
ways.
First, by lowering the interest rate(s) you are paying, and hence the
interest you are being charged each month, it stands to reason that
your payments will decrease as well. Second, the longer you are able to
stretch out the term of the new loan, the smaller the
payments will be. Just be careful here though. Stretch out the
term too long and you could wind up paying a lot more interest in the
long run. Not to mention extending the amount of time that you remain
in debt.
If you are a homeowner, and you consolidate your outstanding debts with a new mortgage, a cash out refinance, or a home equity loan, the interest you pay on the new loan may be tax deductible. (Check with your tax adviser on this.) By making your debt payments tax deductible, you will receive a tax refund from the government which you can then apply to further paying down your debts.
Only Make One Debt Payment Each Month
How is this an advantage? In a word, convenience. If you shift all of your existing loans and credit card debts into one bigger loan, you have the convenience of only making (and having to remember to make) one debt payment each month. This may help you avoid being late with payments, which can in turn hurt your credit score and cost you in penalties. But in and of itself I would not recommend consolidating your debts for this advantage alone.
Debt Consolidation Loan Disadvantages
Taking On More Credit Often Leads To More Debt
Here is an example of a scenario that happens all too often when it comes to loans to consolidate credit card debt...
Let's say you have $25,000 in credit card debt, spread over 4 cards, with an average interest rate of 16%. You decide that you would be much better off "consolidating" the debt with a new debt home loan at 7%. You go ahead and take on the new loan for $25,000 secured against your home, and promptly pay off your four credit cards. Your monthly payments are now lower and your credit cards are all paid off.
Fast forward two years...
Because you didn't actually solve the real reason that you got into credit card debt in the first place, over the past two years you have racked up another $12,000 in new credit card debt. Plus you have only paid off $2,000 worth of the debt consolidation loan that you got two years prior. Now, instead of $25,000 in debt, you are now $35,000 in debt!
More credit many times leads to more debt. Remember.
You can't borrow your way out of debt!
Turning An Unsecured Debt Into A Secured Debt
The most common types of debt consolidation loans are home equity
loans or mortgages. In other words, loans that use someone's home as
security. By consolidating debt in this way, one is swapping unsecured
debt for secured debt, which in most instances is a bad idea.
For starters, you take the option of negotiating a settlement with
your creditors off the table. And secondly, if you do end up filing for
Chapter 7 bankruptcy in the future and you have used the equity in your
home to secure a debt consolidation loan, you may have just cheated
yourself out of that equity.
Learn more about the potential consequences of using
secured consolidation loans here.
Longer Term Can Equal More Interest In The Long Run
One attractive feature of getting a new consolidation loan to pay
off your
existing debts is being able to lower the monthly payments required to
service the debts. And one way people do this is to take out a loan
with a very lengthy term. The longer the term of a loan, the lower the
monthly payments. Of course, this can cause two things to happen.
First, there is a very good chance that you will end up paying more
in interest charges over the life of the loan than if you kept
the original debts in place. And second, by extending the term of the
loan, you will likely end up in debt for a longer period of time. Read
more one these pitfalls
of consolidating loans here.
Limitations And Warnings Re: Debt Consolidation Loans
The next few points are not really "disadvantages" of debt consolidation loans (or debt reduction loans as they are often called) as much as they are "limitations" and "warnings".
Difficult To Get An Unsecured Loan If You Already Have Debt Problems
If you are already having debt problems, chances are that your credit score and credit report have suffered. And if you don't have any significant assets to use as security, you will have a difficult time finding an unsecured loan for debt consolidation purposes, let alone one that has a low enough interest rate to make it worthwhile.
Difficult To Get A Loan Large Enough To Cover Existing Debts
This is an extension of the previous point. When you already have a lot of debt, it is difficult to find someone willing to lend you enough to pay it off.
Bad Or Poor Credit Equals High Interest Rates
As I mentioned above, if your credit is "less than good", and you can find a consolidation loan (even if it secured by equity in your home) the interest rate that you will end up being charged may be as high or higher than what you are paying now. And on that note, stay away from companies that are offering unsecured loans regardless of what your credit score is. These operations are usually just a scam to get you to pay an upfront "application fee" or "loan fee" only to be turned down for the loan.
And finally, (and I hesitate to even mention this)...
Stay Away From Payday Loans
Many of the same "come-ons" that are used in the loan fee scam are
also used by payday
loan lenders trying to get your business. And although it may seem
obvious that using payday
loans for debt consolidation is a big
"no-no", what might not be so obvious is how you might get
"sucked-in" to taking one.
Here's how this works.
A company advertises something like "Debt
Consolidation Loans Up To
$15,000, Bad Credit No Problem!" If you read this you might think,
"Wow, I've got bad credit and I really could use a $15,000 debt
consolidation loan!" The problem is that the ad is nothing more than a
bait and switch tactic. Sure, the company offers $15,000 debt loans,
but you will have to have very good credit to qualify. If you have "bad
credit" on the other hand, you can still get a debt loan, but with
"payday-loan-like" terms. Don't be sucked in.
What You Need To Get A Low Interest Debt Consolidation Loan
Securing a loan to consolidate debt is not enough. What you need to
do is secure a low interest
consolidation loan. And in order to do that, you will need to make sure
that you have a few things in order. More specifically, your credit
score, ability to pay the loan back and assets to offer as security for
the loan. Read more about securing low
interest loans
here.
Debt Consolidation Loan Alternatives
Whether or not you ultimately decide that a debt consolidation loan
is your
best debt relief option, you need to start your debt elimination
journey
with a thorough financial analysis as well as solid budget.
Successfully eliminating your debts will rely directly on how
well you learn to manage your own finances. And in order to manage your
finances properly, you need a budget.
Starting With A Budget
Regardless of whether or not you are in debt, you need a budget. And if you are in debt, regardless of which debt relief option you choose, you absolutely need a budget. You need a budget to help you get out of debt, and a budget to keep you out of debt in the future.Preparing a budget can be an eye opening experience. It not only forces you to track and curb your spending, it also helps identify areas in your spending where you can save money. Many experts claim that simply the act of preparing a budget can save you 10% in terms of your spending. And if you are struggling with debt, that extra 10% could be a lifesaver. For more advice on debt consolidation loans and budgeting click here.
The Debt Snowball Technique
The debt
snowball technique is an excellent way to build upon your
budgeting exercise. This debt reduction plan works by listing your
debts from
smallest to largest, and then focusing your efforts on paying off the
debt at the top of the list. (Note that I said the debt with the smallest amount owing and not the debt
with the highest interest rate.) Once you have paid off the
debt at the top of the list, you cross it off and move to the next one.
Etc. Etc.
This may sound simplistic, but it is probably one of the most
effective debt reduction tools that
you can implement. Why? Because it ignores things that are out of your
control (interest rates, terms, etc.) and focuses on things you can
control (your spending, your income, etc.). And in many ways this
technique is superior to a debt consolidation loan.
Credit Counseling
Alright, if I have convinced you that a thorough financial analysis
and the preparation of a budget is essential to your success, but you
just don't know where to start, don't worry. A professional credit
counselor can help you by not only conducting that financial analysis
and working with you to prepare a budget, but by also educating you on
basic money management issues to ensure you stick the budget and stay
out of debt in the future.
And when combined with a debt consolidation
loan, credit counseling can be extremely effective
debt solution.
Debt
Management/Debt Consolidation
As we have discussed above, debt consolidation loans, or "debt management loans" merely shift
your debts from one creditor to another, without actually reducing the
amount. The objective of course is to improve upon the interest rate(s)
and terms of your current debts. But what if you could accomplish this
without having to go out and get a new loan? In other words, what if
you could reduce the interest rates, lower your payments and eliminate
late fees and penalties on your current debt? Wouldn't that be easier?
This is exactly what a debt management plan (DMP) can do for you.
(Debt management plans are also referred to as debt consolidation
plans, but they are not loans and are very different than a loan.) By
enrolling in a debt management plan, a debt counselor will work on your
behalf to negotiate with your creditors to achieve lower interest rates
and lower monthly payments among other benefits.
Credit
Card Balance Transfer
A credit card balance transfer can be a great alternative to getting
a new loan for debt consolidation. Here's a summary of how it works...
There are credit card companies that offer low or 0% interest rates
on any balances that you transfer from existing credit cards. Some
credit card companies will also allow you to transfer other "non credit card"
debts to the new card through the use of cash advance checks. By
transferring your existing credit card balances (that presumably carry
high interest rates), to low or 0% interest cards, not only will
your interest savings be substantial, you will be able to pay down your
debt much faster as all of your payments will go straight towards the
principle.
One thing to keep in mind however is that the low and 0% interest
rates only last for an introductory period, after which you will have
to transfer your balances to a different credit card or face higher
interest rates. It is a bit of a hassle, but worth it.
Unlike a debt consolidation loan, debt settlement (or debt
negotiation as it is also known), is a debt relief option that actually
reduces the amount of your debt,
instead of just the interest rates.
Bankruptcy
This is a tricky (and complex) topic as you can imagine. And
bankruptcy should certainly be well down your list of debt relief
options. The repercussions of filing bankruptcy can follow you for many
years to come and should be avoided if possible. The reality is,
however, that for some folks bankruptcy is the best alternative. But is
bankruptcy an alternative
to a debt consolidation loan? Possibly.
A Final Thought On Debt Consolidation Loans
Under the right circumstances a debt consolidation loan can be an
effective debt reduction tool. Is it "the" answer to your debt
problems? Hardly. In fact, when used inappropriately, a consolidation
loan can make your debt situation worse.
A remember, first things first. Before you choose any debt help option make sure that you get to the bottom of the cause(s) of your financial problems. A thorough analysis of your income and expenses, followed by a detailed budget will go a long way towards helping you understand and correct your money problems.
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