For someone who has multiple debts with high interest rates, consolidating into one loan with a single payment at a lower rate may seem like a great deal. Advantages can include saving on interest, having one payment versus several and getting out of debt sooner.
But is loan consolidation really a good idea?
On the surface I think it would be a tempting idea for those who owe to a lot of different creditors and are challenged with high interest rates. There is always a credit card offer with a zero percent interest rate for a set number of months. Who wouldn’t want to take advantage of 0% interest? Or, for others, securing a loan against the equity in their home with a home equity loan or a home equity line of credit (HELOC) is appealing. Although, such loans probably have more strict qualification rules these days.
I’ve also heard of some people around the personal finance blogosphere talk about consolidating with Lending Club. It has become a well known option for community lending versus taking out a loan with your local bank. People who have money and want to loan it out can seek borrowers based on their risk threshold. Borrowers can apply for loans online.
A dangerous game to play
While there are many options and certainly some benefits, loan or debt consolidation can be a dangerous game to play. When you consolidate your debt, you can feel a sense of relief. All of the sudden several debts have turned into one and perhaps the minimum monthly payment towards the debt has decreased. Psychologically, that can make someone feel like a weight has been lifted. It is almost a sense that there is some wiggle room again and the debt is no longer weighing you down.
So, the danger is the false sense of security. Sure, money is being saved, but did it correct the real problem of how the debt was created? If the reason why the debt was created is never solved, there is a temptation to open up another credit card and begin spending again. For many people, loan consolidation leads them further into debt.
Here’s what Howard Dayton says about loan consolidation in his book, Free and Clear:
If you haven’t solved the problems that put you into debt in the first place, you’ll end up worse off-and probably much worse off. You’ll jump from the frying pan into the fire. You are just digging yourself into a deeper hole.
He goes onto provide what I think is some solid advice. He recommends people wait until they’ve changed their spending habits and can consistently have a monthly surplus. If you’re still spending more than you make each month and making up the difference with a credit card, consolidation isn’t a good idea. But, if you can exercise control over your money versus your money controlling you consolidation may be okay.
I think the thing to remember is loan consolidation should never be the first step in solving a debt problem. The first step should be understanding what caused the debt and correcting the problem. Then, a spending plan should be set up and followed. The problem seems to come when loan consolidation becomes the first step. Just remember, getting out of debt involves a committment to hate debt and build a plan to pay it off. Taking out a loan will never be the answer to becoming debt free.
What do you think about loan consolidation?