4 Problems with Debt Consolidation

As credit card debt continues to rise in our American economy, more and more people are looking for ways to manage the chokehold that debt has on their monthly expenses. One of the most popular products is the debt consolidation loan. While there may be legitimate reasons for using this type of financial product, there are several catches to their use. And recent statistics show that for 96% of people, debt consolidation doesn’t solve their debt problem. (www.forbes.com/advisor/personal-loans/debt-consolidation-loan-statistics).

What is Debt Consolidation

A debt consolidator aims to pay off the client’s debt while offering an attractive interest rate and a single monthly payment.  For someone with 10+ credit card debts and loans, this will be a welcome relief from the multitude of payments to track and manage during the month. Sounds great, but is there a catch? Yes, there four problems with debt consolidation to consider:

Problem #1 - The service is not free

Debt consolidation services are not charitable businesses. They are a very lucrative business and do a great job marketing themselves as a solution to debt by offering, well..debt. As with most sizable loans, a debt consolidation service will charge a closing fee. These fees are not well advertised and depend on the amount and type of consolidation loan you are pursuing. But expect to pay at least 3-5% of the amount you are borrowing, and maybe more.

Problem #2 - If your credit score is poor, your interest rate will be high

Since debt consolidation is a loan product, they evaluate the risk of a client based on your credit score. If you have struggled with debt and your credit score has suffered, then the interest rate you can expect to receive may not be better than what you are already paying with your existing loans.  This means you will pay more for your debt when you include the closing costs of the consolidation loan.

Problem #3 - Collateralizing debt to lower the interest rate

Most consumer debt is uncollateralized debt. This means that there is no personal asset tied to the borrowed money that could be used to compensate the lender in the event you default on the loan. This is why credit cards are so expensive – lenders assume more risk by allowing you to borrow the money without assets backing the loan. As a carrot to lower your interest rate on your debt consolidation loan, you might be asked to offer up collateral – such as your home, car, or life insurance policy. But be very careful – if you default on the loan, you could lose that asset to the bank.

Problem #4 - You lose the ability to make visible progress on your debt

A popular debt reduction tool is the debt snowball. The process takes each of your loan balances and sorts them from the smallest balance to the largest. With any financial margin in your budget, you focus your efforts on the smallest balance. Once that debt is paid off, you move to the next highest balance and pay it off quickly. When you consolidate your loans, you do not feel like you are making progress on the debt because there is one large debt and one large monthly payment. Over the years, this can feel discouraging and you could lose the momentum for getting out of debt.

While there are several problems with debt consolidation, there are a few reasons you might consider this product.

Reason #1 - All of your debt is high interest credit card debt

If you have multiple high-balance, high-interest credit card debts, this process might be able to lower your interest rate and lower your monthly payment. Sit down with your financial counselor or financial planner to run the numbers and confirm. And certainly, avoid debt consolidation for student loans or other lower-interest debts.

Reason #2 - Avoid bankruptcy

If you are on the verge of bankruptcy, I would consider debt consolidation to help stabilize your financial situation.

The Debt Consolidation Alternative

The best alternative to debt consolidation is financial counseling. Having a trusted partner to help keep you accountable to your financial plan is more important than moving money from one debt product to another. For most people, the problem with debt is behavioral, not analytical. You cannot solve debt issues with interest rates and attractive payment plans. Financial counseling can help you correct bad money habits.