What is a debt consolidation loan?
Put simply, a debt consolidation loan is one big loan that a finance company will lend you to pay off all your individual debts. The word consolidation is used because your debts that are with multiple lending institutions, or on multiple credit cards, that require multiple payments, are all grouped into one loan and therefore only one loan payment would be needed going forward.
This is a scene that’s repeated day after day: A person goes to their mailbox hoping to get something good. Instead, they get nothing but bills and junk mail.
Does this sound at all like you? If so, you know you are in real trouble when you start looking forward to the junk mail.
However, every now and then, something catches your eye…a mailing with offers for loans for debt consolidation. Being curious, you open the letter and wonder if it could possibly be as good as it sounds. After all, you could get one loan and pay everybody off, and maybe save a little money every month on top of that.
Consolidation loans can seem like a real lifesaver, but are they?
Here’s the catch, you get the best rates on a debt consolidation loan when you don’t really need it, so if you want that loan badly chances are any offer you see in the mail is never as good as they seem. That’s because the less risk you are to a lender, the lower your interest rates will be; and the less you owe, the lower risk you are. In short, the more you owe, the more penalty you’ll pay.
Aha! But you owe a lot, and you have an offer that has a very low monthly payment?
At first glance, such an offer may look really good, but dig deeper and you may find you will end up paying more than double what you currently owe. How is this possible? Easy, some loans for debt consolidation take advantage of your situation by giving you a higher interest rate, but low payments that last several years longer.
So, while you may pay less per month out of pocket, by the time you’re done repaying the loan, you will be in worse shape than when you started. A loan that could have been paid off in 5 years or less is still not paid off after 9 years.
Let’s take a look at a quick example
Suppose you have unpaid debt totaling $12,000 (to several creditors) with an average interest rate of 14%, with 5 years remaining to pay it off. Such a monthly payment would work out to approximately $279.
Now, let’s say you get an offer to get a lump sum of $12,000 so you can pay everybody back at once, and all you have to pay is $201 per month. Awesome! You’ll save $78 every month, not bad, right?
But hold on. Reading the fine print you see it’s at a rate of 16% instead of the 14% you’re paying now. Still, that extra $78 would really come in handy, and it’s only an extra 2 percentage points. Turning to the fine print again, you find out why. Instead of making payments of $279 for 5 years, you will be making payments of $201 for 10 years!
Let’s compare the final cost of both loan arrangements.
The 5-year plan will cost you $16,753
The 10-year plan will cost you $24,120
To put it another way, that $78 monthly “savings” will actually cost you $7,367 in interest. That means you will actually be losing $61 every month for those 10 years.
Any savings on such a plan is only an illusion and an expensive one at that.
Having said that, to be fair, not all loans for debt consolidation are structured this way. The only way to know for sure is to read the fine print, ask questions to get clarity, and make an honest comparison. As long as you take the time to fairly compare your options, you will be able to choose what’s best for you.
Also, sometimes when you have multiple loan payments to make each month, you may miss payments unintentionally because you’re just not keeping track of them properly. However, because when you do debt consolidation, there’s just one payment, doing this could help you to save on interest charges and prevent the negative impact on your credit score that missing a credit card bill could cause.
But do remember that a lower monthly payment doesn’t necessarily mean you have extra money to spend, because chances are, the reason you are in debt in the first place is a result of you spending more than you earn.
So be smart, be diligent — read the find print — and if a debt consolidation loan is your best option to get out of debt, choose one that will costs you the least amount of interest, and pay it off earlier than the term specified if possible. Then stay out of debt!