You’ve probably seen ads for loans that promise to reduce your debt, lower your monthly payments, and help you live a debt-free life.
And it will be hassle free, too, with counselors standing by to help you out.
Ever thought about these loans and wondered how they work? Maybe you’ve even considered getting one. Let’s take a closer look.
Imagine that you are a consumer with a pile of debt, credit cards, overdue bills, car loans.
Debt consolidation promises to take your pile of debts and consolidate it. Instead of multiple, little piles, you only have one pile.
Debt consolidation also promises to lower your interest rates and can give you more time to pay off your debts. The end result, just one lower monthly payment.
It sounds logical, right? You end the hassle of multiple monthly payments, and you get a lower interest rate, so you wind up with less to pay each month.
Unfortunately, this is a case where theory doesn’t always match reality. Here’s why.
First, debt consolidation may promise to reduce your high-interest rates, yet typically consumers with a lot of debt don’t usually qualify for those great low rates.
Without the lower interest rates, then all you’ve done is take a lot of separate piles of debt and made them into one big pile of debt, and you’re still paying hefty interest rates.
Wait a minute. That can’t be right. Debt consolidation loans promise lower monthly payments.
If interest rates are lower, then how can monthly payments be lower? Another way to lower monthly payments is to simply stretch out repayment over time, in some cases, a lot of time.
In other words, you pay less each month, but you keep paying and paying and paying. But smaller monthly payments would really help.
What’s so bad about that? Take a closer look at the totals.
The more time you take to repay a debt, the more interest you end up paying. You pay off the same principle or starting debt, but your total interest can go up a lot.
Here’s an example with some real numbers. Imagine that you owe $20,000 at an interest rate of 10 percent APR.
If you pay this loan off in five years, your monthly payment will be $425, and the total interest you pay will be just under $5500.
Now, let’s imagine that you pay this same loan off in 15 years. Your monthly payment drops. It’s now $215.
But take a look at your total interest. It’s now almost $19,000. Now, that’s a high price to pay for a lower monthly payment!
The bottom line is without lower interest rates, and most debt-laden consumers don’t qualify for those, debt consolidation just spreads out your debt repayment over time.
Your debt drags on and on, and you end up paying more in interest to pay off your debt. That sounds like a lot more debt, not less.
By the way, that’s why debt consolidation companies spend all their time bragging about lower monthly payments. They’d rather not talk about the rest. But that’s not all.
There are still a few more traps to watch out for when it comes to debt consolidation.
First, consolidators will sometimes convince you to take out a little more just in case when you consolidate your loans. These cash-back programs seem like easy money, but they add to the total principal that you owe, which adds to the interest that you owe.
In other words, they talk you into more debt while pretending it’s less debt.
Second, consolidators will sometimes convince you to take unsecured debt from credit cards, student loans, and so on and convert it into secured debt, and the most frequently used security is your house if you own one.
So now, if you don’t keep up with your monthly payments, you can lose your house. The bottom line on debt consolidation is don’t count on debt consolidation loans to ride to your rescue. When it comes to debt, these loans are not the solution.
The best way to manage your debt is to make a financial plan and stick to it.
Some consumers are surprised to learn the reality of debt consolidation and wonder whether these lending practices are legal. While it’s true there are shady lenders who are deceiving consumers and engaging in illegal practices, lenders aren’t necessarily breaking the law when they sell you a consolidation loan.
Let’s take a closer look at a couple of shocking facts:
- Lenders are really not obligated to offer you the best terms available. Treat loans as you would any other product and view lenders like sales people. After all, the lender is trying to sell you a loan.
- Many lenders do not look at your financial background to ensure you can afford to pay back the loan offered.
It’s true that lenders look at your financial background and adjust loans based on it, but just because the lender is willing to sell you a loan doesn’t mean you can afford it.
Lenders are perfectly willing to loan you more money than you can realistically afford.
They know over-extended consumers will probably forgo vacations, retirement savings, and even the essentials rather than default on their loans.
Same thing goes for credit cards by the way. That limit is just a number. It’s not a signal that you can afford to spend that amount each month.
And the same thing goes for mortgages. You might get preapproved for a certain amount based on your financial situation, but that doesn’t mean you should suddenly go out and spend your every last dime on your house.
Unfortunately, many consumers have recently had to learn this lesson the hard way.
Lenders are really sellers who are in it for their best interests, not yours. Ever heard the phrase “caveat emptor,” or “buyer beware”? Here are a some things to watch out for when dealing with lenders.
Lenders may hit you with fees, penalties, and hidden costs. Despite disclosure rules, you can still get tricked.
Lenders may pressure you into a plan or make guarantees without looking into your specific needs. Responsible lenders wouldn’t.
Lenders may masquerade as nonprofits, but funnel funds to for-profit companies and/or defraud consumers.
Consolidators may take the money and run by asking for payment up front and then not delivering on the loan.
The bottom line is, don’t count on lenders to ride to your rescue. After all, wasn’t it loans and debt that helped you get into trouble in the first place? The best way to manage your debt is to make a financial plan and stick to it.