Debt consolidation is often one of the first ideas that come to mind when you’re overwhelmed by debt. But how does debt consolidation work, and is it a good idea to consolidate your debt?
How debt consolidation works
On the surface, debt consolidation seems simple. You take out a separate, larger loan and then use the money you get from that large loan to pay off your existing smaller loans. (Which are typically credit cards.)
The idea is that instead of multiple bills with a variety of interest rates, you get one bill and one interest rate.
It seems easier to manage, and the average interest rate may actually go down. The term may be longer too, giving you more time to pay off the new loan, and possibly also a lower monthly payment.
Is debt consolidation a good idea?
Depending on your circumstances and the type of debts you have, it may or may not be a good idea to consolidate your debt. Let’s talk about the pros and cons for the two major types of debt people often want to consolidate:
For federal student loans
There are a few pros if you’re thinking of consolidating federal student loans.
For example, you might be able to turn variable interest rate federal student loans into fixed-rate ones, which could be a good thing depending on future and current rates. If you have trouble making payments on time, reducing the number of late payments you end up making (by reducing the number of loans) would be beneficial. You also don’t need to pay a fee to consolidate them, because it’s done via the StudentLoans.gov site.
But there are also several cons for federal student loans.
You might end up paying more interest because you extend the time it takes to get them paid off. Or worse, you might lose borrower benefits or credit toward loan forgiveness.
Be sure you completely understand any potential downsides and their long-term implications before taking this step. You can read more about the pros and cons here.
For credit cards & other consumer debts
Put simply, it’s hardly ever a good idea to consolidate credit cards and other consumer debt. Here’s why.
Mathematically, it certainly seems like a good idea. Having fewer payments to worry about and a lower overall interest rate sounds like a no-brainer. It’s all very logical.
But that’s exactly the problem. When it comes to debt, we aren’t logical. If we were, we wouldn’t be in debt in the first place.
Illogical choices and borrowing
If I offered to sell you a sandwich for $10 today or for $14 tomorrow, would you choose to pay the $14? Of course not. It’s not logical.
But somehow we’re fine with swiping the card and paying “nothing” right this second, but $14 (or more!) later. Our emotions — our hunger for the sandwich or our desire to have something right now — override logic.
We don’t get into debt logically, and we can’t get out of it that way either — at least not at first.
What happens if we try to do so by consolidating debt too soon?
Often we end up even deeper in the hole than we were to start out with, because moving our debts around does nothing beyond giving us a false sense of relief.
We feel like we paid off the credit cards and car with our debt consolidation loan, and we may even joyfully tell people that “we paid off our car!”, but the truth is, we didn’t pay off anything. We still owe the same amount of money. We’re just paying a different company.
Why debt consolidation is an unfortunate bandaid
The really bad part is, we feel better. The debt is no longer pressing the way it once was, even though we still owe the same amount.
Let’s face it: most of us don’t do anything about a problem until we can’t stand it any longer.
So we don’t change anything about our behavior.
And the next time we need money, we do what we’ve always done. We borrow more.
The situation gets worse
Before we know it, we owe even more money. We’re right back where we started with multiple loans and multiple interest rates. Except this time it’s actually worse, because the total amount we owe is higher.
This is especially bad if we consolidated debt by taking out a home equity loan. In that case, we traded unsecured debt for debt on our home, making it possible for the lender to take our house if we aren’t able to pay for some reason.
We can’t see the future, so it’s a huge risk.
I know, I know. You’ve got more self control than that. You’ll be the exception. Except you almost certainly won’t be, just like I wasn’t.
On the plus side…
On the plus side, getting out of debt is not about self-control. It’s about changing the things you do and the way you view borrowing money — long term.
Make your changes first, and then consider a consolidation loan — if you still want to — once you’ve has at least a solid year of real debt reduction under your belt.
The first change to make is no longer looking toward debt for the answer.
Because the answer lies within you.