3 Myths of debt consolidation

One of the “solutions” many people take when they find themselves deeply in debt is a debt consolidation loan. On the surface this often seems like a good idea. I did it myself a couple of times back when I was struggling with debt. But is getting a debt consolidation loan really a good idea? Here are 3 myths of debt consolidation.

Myth: By consolidating my loans I can lower my interest rate.

Truth: This rarely works out. The problem is while people may be consolidating high interest rate credit card debt, all too often they are also including things like medical debt, low-interest vehicle loans, or personal debts to family members. The net effect of all that is frequently the interest rate on the consolidation loan is at least as much or more than what the proportionate rates were of the individual debts.

Myth: I can leverage the equity in my house to pay off my debt.

Truth: There are a number of problems with this idea. First and foremost, you are taking unsecured debt like credit cards or medical debt and converting it to debt secured by your house. So now if you fail to pay, instead of just being delinquent on your credit cards and perhaps getting harassed by debt collectors, by securing the debts with your home, if you don’t or can’t pay they will foreclose on you. Really, really bad idea!

This idea was really at the heart of the housing crisis that was a big part of the recession we are just coming out. The problem is people were living above their means and running up credit card debt. But on the flip side their homes were also going up in value, often at an unrealistc rate. The “good” news was once the credit card payments reached the level they were getting difficult to pay, then they’d just refinance that debt back into the house and then start the cycle all over again. Problem was housing values plummeted in 2008-2009. Now since all this credit card debt had been rolled into their mortgage, they had never made any real progress on paying down their mortgage.  When the house value went down they were underwater on the mortgage and they had credit card debt they couldn’t afford to pay. Nice recipe for bankruptcy and foreclosures. And that’s pretty much what we saw happen.

Myth:  Debt consolidation will give me one easy payment and is a good way to get control of my budget.

Truth: The reason it’s an “easy” payment is most generally because the term of the payments has been spread over a much longer time period. There is no magic that reduces debts other than living on less than you make and paying down the principle. If you spread those payments over a longer period of time you may have a lower payment, but that also means over the course of the loan you are going to be paying much more in interest.

This really gets to the real heart of the problem with debt consolidation. It gives you a false sense of having accomplished something. You can get a real good hint of this at the language people use when talking about it. “I got a debt consolidation loan to pay off some of my debts.” No! You haven’t paid off anything. You simply rearranged your debts.

You have to face  your debt

You simply can’t borrow your way out of debt. It’s like handing a guy standing in a hole a shovel and telling him to dig his way out of the hole. You just can’t do it.

There is only one way to really get out of debt. You have to attack it with a vengeance. Cut your life style. Sell things. Live on less than you make.  Do a debt snowball.

Getting out of debt has far more to do with behaviour change than it does with math. And that’s the biggest problem with debt consolidation. It is an enabler that allows you to continue along the path you are taking without really addressing your behavior. As a result what happens far too often is people consolidate their debts with the good intentions of paying extra. But they don’t change their lifestyle, continue to spend more than they make, and 5-10 years later they are right back in the same situation.

As I stated earlier I went through the debt consolidation process more than once years ago, but I never managed to get out of debt until I got serious about making the sacrifices needed to spend significantly less than I made and use the balance to attack my debt. I want you to take back control of your life. That will only happen when behaviors change. There aren’t any shortcuts. And yes it will be hard. Changing behaviors always is.  But it’s absolutely worth it.

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