Debt consolidation – Where is the catch?
On paper debt consolidation looks great. Take all your monthly debt payments and roll them up into one nice smaller monthly payment and hey presto you have just performed financial magic! Oh if only it was that simple. The realities of debt consolidation are not so magical.
As I navigate my way through the internet looking at various services offered on debt related sites it strikes me as strange the way that they use the terms Debt Management and Debt Consolidation interchangeably. This can lead to a lot of confusion. I know it has for me. In its true form Debt consolidation is simply taking out a large loan to pay off all your smaller debts and reduce your debt payments to one payment a month. Generally it is the case that people with smaller unsecured loans like credit card debt take out a larger loan to the value of their debt which secured against there house or some other asset. Then using this new larger loan they pay off all their smaller more expensive debt.
Take a person who has lots of unsecured debt for example credit card debt but they also have some equity in their home. Assuming that the bank is willing that person can withdraw some of the equity from their home or get a loan secured on their house. The person can then take this money and repay all of their smaller debts.
Creatures of habitDebt consolidation can work like a charm provided that once the existing debts that the loan is being used to repay are repaid and no additional debt is incurred. Now you and I both know that in the majority of cases what will happen will go something like the following scenario.
As soon as the small annoying debts are paid off and are rolled into one monthly payment the individual can, for probably the first time in years, see their financial situation clearly. They can see that they now have a reduced payment to make and have rid themselves of the financial clutter. They say to themselves – ‘Never again’. However after about two months the temptation becomes too great and they decide to make one little purchase on the credit card that they have kept for emergencies and so the spiral continues. In about eighteen months they are looking to consolidate their debts because it worked so wonderfully the first time.
Does debt consolidation make senseIt really depends on your current financial situation and what you are trying to achieve. The key attraction of debt consolidation is that it frees up cash flow, for example if you were paying $1200 in debt repayments each month and managed to consolidate your debt and only had to pay $750 a month then you are freeing up $450 cash each month. This additional cash flow can be used to increase your savings. The point is it takes the pressure off you to come up with $1200 because now after consolidation you only have to come up with $750.
The advantages and disadvantages of debt consolidation can be summarised as follows
Advantages of debt consolidation
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1. It clears the financial clutter from your monthly payments. You go from having any amount of monthly payments to service your debt to just one single payment.
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2. It is possible to reduce monthly out goings significantly.
Disadvantages of debt consolidation
- 2. The fees to arrange debt consolidation are usually quite high.
Debt consolidation is simple in theory and it often sold as the solution to all your problems. Unfortunately the reality is somewhat different. While there are certain advantages to debt consolidation there are disadvantages to it also. You need to be aware of these before you decide if debt consolidation is right for you. Do your homework and make sure that if you do avail of debt consolidation services that you thoroughly research the company that is providing the service. The same applies if you decide to consolidate yourself without using the services of a specialist debt consolidation company.
Posted in Intro to Debt Management
May 7th, 2008 at 10:49 pm
excellent post, I also highly recommend a debt consolidation loan!