Debt Consolidation
Debt consolidation loans can be another way to resolve debt and are often touted as an easy way to get out from under the burden of credit card debt. At first, it seems to make sense. Consumers use the equity in their homes to reduce the interest on money borrowed from 20-25% down to 6-8%. Additionally, consumers benefit from having one monthly payment on the new loan.
A consolidation loan, however, does not address the underlying issues that caused the financial hardship in the first place. You used your credit cards, and continued to increase your credit card balances until only the minimum payments could be made. Using a consolidation loan to resolve credit card balances suddenly leaves many consumers with too much available credit. The source of this new credit; THE OLD CREDIT CARDS THAT HAVE NOW BEEN PAID OFF…
Many consumers convince themselves that they will only use their credit cards for emergencies now that they have been paid off. Typically, this does not happen. Unchecked spending habits usually result in increasing credit card balances in a relatively short period of time. Suddenly, the credit card balances are right back where they were before the consolidation loan was taken leaving the consumer with the consolidation loan balance and maxed out credit cards. A recent study identified that nearly 2/3rds of consumers who applied for consolidation loans to resolve their credit card balances had the same or more credit card debt within two years!
You may think you can use willpower to resist the temptation of using credit cards for everyday purchases but willpower alone will not break this cycle. In order to put an end to the perpetual debt cycle, you must change the way you think about and use credit. Simply applying for a consolidation loan won't teach you what you need to know.
Even if you are one of the few who has "learned their lesson" and you close your credit card accounts and refuse to apply for more credit, there is another problem with consolidation loans.
You will still owe the same amount you did on your credit cards, and only a small portion of your payments will go to repay your balance. Although you've reduced the interest rate, your loan may span 15 or even 30 years. To get an idea of how this works, look at your mortgage statement. It isn’t until the last several years on a mortgage that the principal is reduced. This is due to compounded interest. An equity or consolidation loan works in a similar fashion. Instead of getting those cards paid off in a few years, you'll be paying off your loan for many years to come.
Perhaps the worst part of using a consolidation loan to resolve credit card debt is that unsecured debt becomes secured debt. Credit card debt is unsecured, meaning that the debt is not collateralized by property or assets. So if you default on a credit card debt, your creditor can call you, send threatening letters, and even obtain a judgment against you and, in some states, they can garnish your wages but they can't take anything away from you.
The risks involved with unsecured debts are nothing compared to the possibility of losing your home. If you pay off your credit cards with a consolidation loan, you have effectively traded your unsecured debt for secured debt. This means that if you default on your consolidation loan, the bank can levy and suspend your home and in some cases even force the sale of your property to repay the loan.
In other words, Consolidation Loans are NOT a viable solution for resolving credit card debt. If you are still considering a consolidation loan as an option, you should carefully research other options before committing yourself to a loan that may take several decades to pay off.
