I regularly get emails from people asking for advice on whether they should do a debt consolidation. While I have written a little bit about bankruptcy, I haven’t written much about Debt Consolidation programs.
What is a debt consolidation?
Basically as the name implies, it is combining a bunch of smaller debts into one larger debt. Often times, in order to fetch the borrower a better interest rate, the unsecured debts (i.e. credit cards) will become collateralized in order to get a better interest rate. To explain this further – credit card interest rates are normally higher because they have no colatteral if the borrower doesn’t pay. Conversely, a bank has your house as colatteral for a mortgage loan, therefore they can offer a lower interest rate.
Wikipedia’s debt consolidation page goes on to explain even more…
“Debt consolidation entails taking out one loan to pay off many others. This is often done to secure a lower interest rate, secure a fixed interest rate or for the convenience of servicing only one loan.
Debt consolidation can simply be from a number of unsecured loans into another unsecured loan, but more often it involves a secured loan against an asset that serves as collateral, most commonly a house. In this case, a mortgage is secured against the house. The collateralization of the loan allows a lower interest rate than without it, because by collateralizing, the asset owner agrees to allow the forced sale (foreclosure) of the asset to pay back the loan. The risk to the lender is reduced so the interest rate offered is lower.”
So is it a good idea?
Generally, my answer is no, it isn’t a good idea. The vast majority of people in debt are not in irreversible dire straights financially. They can dig themselves out of debt with a lot of determination, hard work, and of course, Gazelle Intensity.
But most people don’t really want to work at getting out of debt, they just want a quick fix – and they think a debt consolidation will be the answer. These are the people who absolutely should NOT do a debt consolidation.
As Larry Burkett says, “the debt is not the problem; it is the symptom.” For most people considering a debt consolidation, excessive spending is the problem and the excessive debt is their symptom. Therefore, the spending problem is what needs to be fixed – not the debt. And as the spending problem gets resolved it will slowly, but surely, take care of the debt problem.
Enabling the spenders
The danger of a debt consolidation for people who still have a spending problem, is that it enables them to spend a lot more. Once the debt is consolidated, it provides “breathing room” which is great if they are going to take that extra amount and use it to pay off their debts faster, but the sad reality is that most people don’t. In fact, according to an insider, “78% of the time, after someone consolidates his credit card debt, the debt grows back.”
It works for some
Having said that, I have seen close friends who were greatly helped by a debt consolidation. Like I said before, the difference with them and the others who used a debt consolidation to their benefit, was that they didn’t have a problem with spending. They got their payments lowered via the consolidation and used every extra dollar each month to pay down the debt faster.
Bottom line, it comes down to personal responsibility. We are all accountable for our actions. We are all stewards of what we have been given, whether we like it or not. We need to be honest with ourselves and “make no provision for our flesh” (Romans 13:14).
So, to sum up my thoughts about it, If I were in debt up to my eyeballs right now I would follow the 7 steps to getting out of debt (which I did). If for some reason things were so terrible that after following those steps I still could not make progress I would get help from a debt management company who could help me manage my debts and help me with the lenders.