Debt Constipation
Constipation and debt consolidation have a lot in common (besides sharing a few letters).
Think about it. You eat. Your food gets processed. And if you’re healthy, you get rid of it. Debt works the same way. You spend. You get the credit card bill. And if your financial health is in order, you pay the debt off sometime soon.
Debt Consolidation Syndrome is a particularly vicious blockage whereby your debt just won’t go away. Contrary to what the debt consolidation companies tell you, debt consolidation is not the panacea to paying off your credit cards. It is nothing more than getting a new loan to pay off old debt. The debt remains stuck in your system. What good is that?
Debt consolidation is helpful under two very narrow circumstances. The first is that interest rate of the debt consolidation loan is substantially lower than that of your existing loans or credit cards. The second is that your current debt payments consume so much of your cash flow that you can’t get by without cutting your monthly payment.
Many people mistakenly assume that because debt consolidation reduces their monthly payment, they’re saving money. What they don’t realize is that by the time the loan is paid off, they will have spent thousands of dollars more in interest. The repayment term for debt consolidation is often very long, which negates the interest rate reduction. It does you no good to cut your interest rate a few percent and lower your monthly payment if it means you’ll stretch your final repayment date out another 20 years!
My friend Greg is a textbook example of someone who was led astray by a debt consolidation marketing pitch. Greg owed about $11,700 on his two credit cards. On one card, he had a $6,300 balance at 14.99% interest. On the other card, he carried $5,400 at 16.49% interest. He was paying off his credit cards at $400 a month — an amount a little less than double his required minimum payment. He had good enough sense to use the Snowball Method. At this rate, he would have paid off his cards in three years. Between now and the time he paid off his debt, he would have paid about $3,100 in interest.
Two weeks ago, he was offered the opportunity to consolidate his credit card bills into a home equity loan at 8.50% interest to be repaid over 20 years. Although he was swayed by the lower interest rate and the tiny monthly payments, the loan rep clinched the deal for him when she told him that interest paid on his home equity loan — unlike his credit cards — could be deducted on his income taxes. Greg now pays about $100 every month on his home equity loan instead of $400 on his credit cards.
Just how did Greg fare in this deal? Poorly. Over the next 20 years, Greg will pay more than $12,000 in interest. After factoring in the tax breaks, his out of pocket interest cost will be about $9,000. That interest will cost him almost as much as the amount of his original debt! Worse, since he used his house as collateral to secure the loan, his creditors now have a stake in his home should he be unable to make his payments at some point in the future.
Greg would come out ahead by if he applied his original $400 to his home equity loan. In that case, he’d be debt free in less than three years and save about $1,600 in interest as compared to his credit cards. But unfortunately, he can’t pay off his home equity loan early without incurring a hefty prepayment penalty, which puts him right back where he started.
The Moral of the Story
Although debt consolidation loans come with lower interest rates and less painful monthly payments, they’ll hurt you in the long run with their extended repayment terms. If you do take out a home equity loan with the intention to pay off the loan long before its due, make sure that the lender will not sock you with a prepayment penalty. Otherwise, the debt consolidation loan will do you no good.
Finally, if you have good credit, it’s often possible to transfer your balances to other cards with a lower interest rate — often 0%. You won’t find a 0% home equity loan anywhere! (The catch is that you are charged the normal interest rate on any purchase you make. Your entire payment applies to the 0% balance transfer, allowing purchases to compound at the normal rate. For this reason, you should not ever use a card for both a balance transfer AND purchases.)
You can avoid all this by watching your spending. But if you do get into a debt problem, make sure you take the right medicine. Debt consolidation is usually not it.
