To the person drowning in debt, a debt-consolidation loan looks like a lifesaver. But reaching for it without knowing exactly what it's made of could be a severe mistake.
The way it's supposed to work: You pay off all your small high-interest consumer debts with the proceeds of a new low-interest loan whose payment is less than the total of the smaller payments.
In theory, consolidation is a terrific solution for a burdensome debt situation. In reality, it can force you into even more treacherous waters.
There are three ways to consolidate:
No. 1: A new low-interest signature (unsecured) loan from an individual, bank or credit union. If you can get it, this type of debt consolidation is ideal.
No. 2: Transferring all of the balances to a new credit card. Beware of excessive transfer fees or other troublesome conditions buried in the fine print. The interest on credit cards is always subject to increase, even when it is advertised as a "fixed rate."
No. 3: A home-equity loan. It sounds great to pay off your high-interest debts with money borrowed against your home's equity. But this only increases the stakes. Now if you fall behind, the lender takes your home through foreclosure.
There is one more significant danger that all of these consolidation loans have in common: I call it the "doubling effect." If you've ever lost 10 pounds and gained back 20, you'll understand right away. Most people who pay off all their pesky credit card balances look at those zero balances with a sense of personal accomplishment. They've done something remarkable. They didn't repay their debts, but they enjoyed pretending. They say they won't use those accounts again but fail to close them. They leave them to "build credit" or to provide a cushion -- just in case of emergency.
Statistics indicate that the person who consolidates to a new loan will enjoy zero balances for a short time but will eventually charge them back to all-time highs. The average time is two years. That means double the trouble because of the debt consolidation loan.
So are all debt-consolidation loans off-limits? No, but they should enter with extreme caution and a great deal of consideration.
Before proceeding with any debt-consolidation loan, make sure you get honest answers to these hard questions:
No. 1: Is the total consideration of the debt-consolidation loan (principal and interest), not only the monthly payment, less than the consideration combined for all the debts it will pay off?
No. 2: Are the terms reasonable? If, for example, the new loan or credit card carries significant penalties -- like you lose the attractive interest rate if you are late one or two times -- that is not reasonable. If you must pay a big loan origination fee, that is not reasonable.
No. 3: Am I mature enough to cancel the accounts that will be paid off in the consolidation process?
Except in extreme cases, the best way to face a load of unsecured consumer debt is to stop adding to it, develop your payback plan, and then buckle down and get to work! You'll be amazed at how quickly you can reverse your debt situation once you know exactly when you will be debt-free.