Why debt consolidation loans are often financially irresponsible
We are well into the new year and the bills may be starting to bite. To ease the pain, some institutions encourage borrowers to consolidate all their loans into a “consolidation loan”, which has been described by one cynic as “consolidating all your hard-to-repay loans into one un-repayable loan”.
A case can be made for this strategy as it allows you to take advantage of a lower overall interest rate, but let’s remember that lenders rarely come up with a new product just because they think it will be good for YOU. . Usually, their thinking is driven by how it will benefit them…in this case, increasing their market share.
Think about this scenario. Borrowers have a home loan of $350,000 at $1,987 per month, a car loan of $25,000 at $635 per month, a personal loan of $20,000 at $425 per month and credit card debt of $5,000 requiring $200 per month. Total debt is $400,000 and overall payments are $3,248 per month. If they borrowed $400,000 to consolidate all that debt into the home loan, repayments should drop to $2,270 per month, saving $978 per month, or $225 per week.
Although consolidation can be a useful strategy in some situations, you need to understand the principles involved in all borrowing. First of all, it is the height of financial irresponsibility to take out a loan whose term exceeds the life of the property purchased with the loan. That’s why no one in their right mind takes out a 30-year loan to buy a car.
If financial problems are caused by poor money management, consolidation will often draw you into deeper problems. The example assumes that our borrowers are foolish enough to consolidate all of these loans into one 30-year loan at the current rate of 5.5%. Sure, that frees up $225 a week, but where will that money go? In almost all cases, it will be spent and credit card debt will begin to rise again.
In a year or so, the couple will likely struggle to meet their repayments again, but now their situation is worse as their home loan balance has fallen from $350,000 to $400,000, making it even worse. more vulnerable to future interest rate increases.
Instead of consolidating, a much better solution would be to call a family meeting, explain how serious the situation is, and find ways for the family to reduce their expenses or increase their income to produce $100 per week. If that extra $100 was applied to expedite credit card payments and no other expenses were paid to the card, it would be paid off in less than a year. It’s a big if, but once you learn this habit, it’s surprising how easy it becomes.
Once the credit cards are paid off, the $300 ($200 + $100) that is no longer used to pay off the credit card could be added to the $425 used to pay off the personal loan. At a repayment rate of $725 per month, he would be repaid in an additional 18 months.
Finally, once the personal loan is repaid, the additional $725 per month needed for these repayments could be used to accelerate the repayments of the car loan.