Understand the myths and truths of debt consolidation

March 13, 2018
It is one of the most common pieces of financial advice: consolidate your debts so that you can pay them off faster. Is consolidation the best option? You have to look carefully to find out.
Understand the myths and truths of debt consolidation

This advice makes sense at first glance. Putting all your debts into one account will make them easier to manage. If some of your accounts have a higher interest rate than the consolidation loan, you will be saving money overall, right?

It is true that making a single debt payment each month is more accessible than making five or six different payments, but you may not be saving as much money as you think by consolidating.

Here is what you need to know about consolidating your debts:

First of all, to create manageable monthly payments, lenders will often increase the payback period (or “term”) of a consolidation loan. This means that you will be making payments for a more extended period.

Secondly, a lower interest rate is not guaranteed. If you have more than one credit card, chances are you are paying different interest rates on each account. Add a personal loan or auto loan into the mix, and the interest rate savings might be challenging to calculate. You can look at the monthly payments and term of your consolidation loan to figure the total amount that you will have to pay over the life of the loan.

Does the consolidation loan have a fixed or variable interest rate? You will be given one interest rate when you are approved for the loan, but that interest rate may change over time if you have a “variable rate” loan. This means that the interest rate that you get at the beginning might not be the interest rate that you have over the entire life of the loan.

Consolidation does not address the reason you got into debt in the first place. If you want to protect yourself from debt in the future, you need to change your budgeting plan or spending habits (or both). Otherwise, you will keep building new debt even as you are paying off your current debt.

Your first step, therefore, should be to create a plan for managing your debts. For example, if you need to borrow money in the future, do not opt for a credit card, go for an online personal loan instead. These loans have a few advantages. First of all, they are for a set amount of money, so you cannot use them for impulse buys. This also makes them easier to manage because you will know exactly how much you have to pay off. Also, you usually pay online personal loans off in instalments, so the payments and term are clear when you get the loan.

What are the alternatives to consolidation loans? Focus on removing your debt by targeting one credit card or loan at a time. Pay the minimum balances on the other loans until the first one is paid off. Then, you can move on the second loan or card.