When set up properly, loans for debt consolidation can help you lower your monthly debt payment obligations, and hence take some of the stress off of your cash flow situation.
How does this happen? Let's have a look.
There are three key components that determine the monthly payment on a debt...
And by adjusting any one of these components of your debt, you will subsequently adjust the monthly payment amount.
Now, debt consolidation loans will not typically enable you to change the first component (the amount of the debt), but they can be used effectively in changes the other two components (interest rate and term).
The first objective that most people have when considering a debt consolidating loan is to lower the interest rates(s) on their current debt. Lower interest rate(s) equal lower monthly payments. Makes sense.
For example. Let's say that you have two outstanding loans, one for $4,000, and the other for $7,000. The first loan has an interest rate of 14%, a 7 year term (84 months), and a monthly payment of $136.71. The second loan has an interest rate of 12%, a 7 year term (84 months), and a monthly payment of $232.50. Your combined monthly debt payments are $369.21.
Now let's assume that you were able to secure a new debt consolidation loan for $11,000, enough to pay off both existing debts. And let's also assume that the interest rate on that loan is 7%, and the term remains at 3 years. Your new monthly debt payment would now be $339.65, or $29.56 less than you were paying before consolidating your debt.
Only $29.56 less even after we cut the interest rate almost in half?
Yes. And the main reason for that is that we didn't adjust the term of the debt loans. The shorter the term of a loan, the less impact that interest rates have on the monthly payments.
Although many people turn to loans for debt consolidation in order to lower their monthly debt obligations, they sometimes find (as we discovered in the above example) that just lowering the interest rate(s) on their debt doesn't have a huge impact. And it's at this point that they look at lengthening the term of the loan.
In order to see the impact that lengthening the terms on loans for debt consolidation can have on monthly payments, let's continue our example from above.
In addition to securing a lower interest rate on the loan (7%), let's assume that the new loan also had a term of 7 years (84 months). What would your new monthly payments be now? $166.02. Now that's quite a difference. Compared to the original monthly payments of $369.21, you are paying $200 less per month on your debt loans.
Alright, so we now have an idea of how loans for debt consolidation can help you improve your monthly cash flow by reducing your debt payments. But we have also come to realize that just lowering the interest rate(s) on your debt does not make a huge difference in your monthly payments. The big reduction comes from extending the term of the debt.
However, by extending the term of the debt you are doing two things. One, you are setting yourself up to be in debt for a much longer period of time. And two, in the long run, although your monthly payments will be lower, you will end up paying a considerable amount more in interest charges on the debt itself.
A final word of caution when it comes to loans for debt consolidation. Many people who take on a new loan to pay off existing debts end up taking on more credit. In other words, they now open themselves up to going further in debt. With their credit card debt now "paid off" with a new debt consolidation loan, they slowly (or not so slowly as the case may be) start building up the outstanding balances on their credit cards again. And in a short period of time, find themselves back in credit card debt in addition to now having a debt consolidation loan to pay off.
Why does this happen? The short answer is that loans for debt consolidation, although potentially a helpful debt elimination tool, do not address the underlying problems that got you into debt in the first place.