The Dirty Little Secret Of Debt Consolidation Loans
If you're considering a debt consolidation loan, then there are a few things you should know. Don't consolidate until you've read this.
Online, March 30, 2011 (Newswire.com) - Want to know a secret about debt consolidation loans? They usually don't work. There's a lot of money to be made by promoting and arranging these loans, as well as the enormous hope that surrounds them, so you won't hear too much about how they don't work. Having worked in the mortgage business for many years, and seeing the process play out again and again, I can say on good authority that it usually doesn't work. Great idea in theory, but the reality looks radically different.
Nearly any kind of loan can work for debt consolidation - cash-out first mortgages, second mortgages, home equity lines of credit (HELOCs), unsecured loans, and even credit cards. But the problems usually aren't the loans themselves; it's the human factor.
We expect consolidations to make our debt go away, and to do so painlessly. If it were possible then no one would have debt problems. The truth is if you're not feeling some pain during the consolidation you're probably headed in the wrong direction!
Why Debt Consolidation Doesn't Usually Work
There are a few factors sabotaging most debt consolidations, and they usually include one or more of the following:
The debtor's primary concern is usually with getting his monthly payments under control. The emphasis is on making the consolidation payment much lower than the combined payments on his old debts rather than on actual debt elimination.
Because the new payment is often substantially lower than the combination of payments on the debts that were paid off, the debtor quickly falls back into the familiar patterns of consumption and money management that got him into debt in the first place.
Most lenders are more concerned with monthly payment levels than with overall debt as well, and offers of new financing flood in to the consolidator, who in many ways is addicted to debt.
Consolidation is the process of converting short term debt (credit cards, auto loans and consumer loans) into long term debt; if a cash out mortgage is used, the debt is effectively converted to permanent debt.
The long repayment terms that accompany most debt consolidation loans - to keep the payments low - increases the likelihood of incurring major expenses that might involve new debt. Life is still happening while the consolidation is sitting out there.
An Example Debt Consolidation
To give an example, the typical debt consolidation profile looks something like this:
Borrower has a $100,000 first mortgage, a $25,000 home equity line of credit, $20,000 in loans on two cars, and $30,000 on various credit cards. Total debt: $175,000.
The monthly payment on the first mortgage is $1,000 (including taxes and insurance), the home equity line is $200, car loans total $700, and credit cards add another $700. Total: a budget-busting $2,600 per month!
The borrower finds he can do a new first mortgage and consolidate all of his debts into one monthly payment of just $1,300 per month on a $175,000 loan. Wow, that was easy, wasn't it?
But the story isn't finished.
Two years later our borrower still has his new mortgage - with all of his old debts rolled into it - but he also has:
- a new home equity line of $30,000 (needed a new roof, remodeled master bath)
- a single new car loan of $25,000 (tax credit, zero interest, couldn't pass it up), and
- $40,000 in credit cards (braces for two kids, "once-in-a-lifetime" trip to Europe last summer, etc).
Do you see the pattern? I saw it all the time - anyone who works in the lending industry sees it all the time! A bullet was dodged with the consolidation and life went back to normal. If house prices were still rising the way they were a few years ago, he'd probably do another consolidation to make the new load of debts go away.
The Right Way to Do a Debt Consolidation
The situation just outlined is pretty typical, but if you want to do a debt consolidation this doesn't have to be your reality. You can make it work, but there are a few things you need to put in place to make it happen.
Make the highest monthly payment you can afford
A debt consolidation should be used to eliminate your debt not make it easier to live with. While it's okay to set the payment below the combination of the debts you're consolidating if you have to, you might be doing little more than moving your debt from one pile to another. You need to be steadily chipping away at the principal balance.
Make the term as short as possible
Five years or less is a visible horizon that anyone can aim for. If you have to extend it out longer (for qualification purposes), plan to make regular additional principal payments to pay it off in less. The longer a consolidation loan hangs out there the greater the chance that it will fail to do what you hope it will. One more thing: make sure the loan has no prepayment penalty.
Use a fixed rate loan
Any kind of loan can be used for debt consolidation, but some loans are better than others. Fixed rate loans have two major advantages: they have fixed monthly payments and are self-amortizing. Revolving loans like HELOCs and credit cards usually lower the payment as the balance falls. This keeps you in debt longer, as well as allowing you to add more debt. You don't want either of those options, even if they seem easier.
Cut your living expenses
Remember that pain thing I was talking about earlier? You most likely got into debt because your expenses exceeded your income for an extended period of time. Unless you reverse the pattern your debt consolidation will fail. The consolidation should be viewed as a financial time out. You get a break to learn to live on a budget and allocate any extra money to either paying off the consolidation loan or building up savings so you won't have to rely on debt in the future.
Increase your income
Getting extra cash early in the process may be the critical factor that makes the whole consolidation work. Get a second job, start a side business, or sell some of your unneeded possessions. This can help you to get a few dollars in the bank ensuring the long term success of your consolidation. You could also prepay as much of the consolidation loan as possible early on. If you're using a fixed rate loan any prepayment of principal will shorten the term of the loan - and that's what you want to do, any way you can!
There's an upshot to all of this too. If you can successfully implement these changes and make the consolidation work the way it should, you'll be better trained and prepared to deal with all things financial for the rest of your life. In that respect the effort is about much more than just debt consolidation.
Source: Moolanomy
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Think wealthy,
Morgan Kimble
Like this? Take a look at my last article: 13 Things You Should Never Buy Used