Debt consolidation is a tool that can be good or bad. So, any consideration of a debt consolidation loan should be used with caution.
The advantage of combining all of your debts into one payment is that it can significantly reduce the minimum payments that you make each month. Therefore, this tool can provide significant relief to your budget.
However, debt consolidation can also be a bad move for many people. A mortgage loan is often used to consolidate debts, and can often lead a higher cost over the long run. So, it can have you shout "Booyah!" for money saved, or make you pound your fist with rage! So, be careful.
For example, lets say the John has 5 different credit cards that total $45,500 and a home mortgage for $224,00. Without going into each and every interest rate, here are some possible options.
No consolidation. If John pays his debts as they are, he will have monthly payments of $2,410 and will pay a total of $587,561 over 30 years.
Consolidate all debts with 1st mortgage. In order to do this, John will have to refinance his home loan, and will include the additional $45,500 with the original mortgage. He nows has a mortgae of $269,500 ($224,000 + $45,500) and his minimum payments will be $1,793. You will see that this is $617 less than option 1. However, John will also pay a total of $645,476 over 30 years.
Consolidate credit cards into a 2nd mortgage. John leaves the 1st mortgage alone in this option. His second mortgage for $45,500 will have a payment of $439 (at 10% interest rate); so his total payments in this option will be $1,892. Over 30 years, he will pay $628,410 towards principle and interest.
So, in summary, John's consolidation options are as follows:
Options Payment Total Principle & Interest Paid
1 $2,410 $587,561
2 $1,793 $645,476
3 $1,892 $628,410
The above example shows that in this situation, John could reduce his minimum payments by as much as $617 per month by doing a 1st Mortgage debt consolidation loan. However, you will also notice that this option is the most costly as far as interest payments. This loan will cost this person nearly $58,000 more in interest than if they did not consolidate.
In addition, by using the techniques for reducing your budget, making extra payments, and the snowball technique; you might be able to pay your debts off MUCH faster, without ever needing a consolidation loan. So, be very careful be considering a consolidation loan. Is Consolidation Right for You?
First, list out all of your debts and the minimum payments that you are making. Then use a free mortgage calculator to see what it would cost you to consolidate these debts into one loan (there is a free mortgage calculator in the resources below). This will allow you to see if you could be saving money each month.
To determine whether a consolidation loan is right for you, ask yourself a few questions:
Can I afford my current monthly payments? (If not, consolidation may be a valid option.)
If I consolidate, do I have the discipline to save the extra money (without spending it)? If you do not have the discipline, you are better off not consolidating. If you spend the extra money you may have saved from a consolidation loan, you will be in a worse debt situation than before the loan.
Is there any other way that I can reduce my spending and get out of debt?
If you can use any other technique, you will probably save money in the long run.
Overall, if you would like to consider if a debt consolidation loan is right for you; contact a financial advisor. If you think a consolidation will make you say, "Booyah!", think twice. It could be a costly decisioni. Most importantly, consider all of your options before rushing into signing any papers!
Spencer has a BA in Finance, an MBA, and is currently a Commercial Banker advising Business owners on Business and Personal financial issues.
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