The Pros and Cons of Debt Consolidation Loans

Most people who struggle with debt have more than one creditor to deal with, and possessing 4, 5 or 6+ credit cards is not uncommon for the average household in the western world.

The main advantage of getting a debt consolidation loan to pay off all your personal credit cards debt, is that the Annual Percentage Rate (APR) of a typical consolidation loan will be lower than the APR of your credit cards. If you do the math, you’ll notice that this can save you quite a bit of money in the long run and allow you to pay off your debt faster than you would be able to do otherwise. On top of that, you’ll only have to pay one creditor, instead of needing to deal with several bills, different due dates, minimums and so on each month. If you’re able to get a fixed rate term loan, you’re also guaranteed that the interest rate won’t increase over time – something that credit card companies are not usually able to promise you.

On paper it seems like a great plan: cheaper, faster and convenient. There are however a few hitches to keep in mind before going ahead with this plan of (debt) attack. The first issue concerns the lending institution where you get such a loan from. If your credit is excellent and the amount of debt that you have is relatively small, you can probably obtain a simple personal loan, which won’t affect your credit score too much. In most cases though, if you are heavily in debt, chances are that your credit score is not that great to begin with. If you apply for personal loans which in turn get rejected, you credit will be affected negatively, making your financial situation slightly worse off than it already is.

You may be able to obtain a loan for the specific purpose of debt consolidation by talking directly to your credit union or banking institution, or by first seeking debt counseling with any one of the many non-profit companies who specialize in this field. There are two inconvenient aspects however, if you opt to go this route though. Firstly, in most cases you will have to provide a co-signer or some form of substantial collateral such a car, as well as a budget that’s outlined to the last penny and which shows that you are able to handle the monthly payments. Secondly, and perhaps more importantly, a debt consolidation loan is a glaring red flag in your credit history. Taking out such a loan is not a decision which you should rush into lightly, it truly affects your credit and is best viewed as being something of a “last resort” option.

Perhaps the biggest problem with debt consolidation loans has to do with the psychology of the debtor (the person who is carrying the debt load). While such is not always the case, some people who are in debt are there due to poor impulse control and spending habits. What do you think it’s going to happen when the credit cards are freed (thanks to the consolidation loan) once again? You guessed it, many people end up accumulating further debt, because they haven’t broken free from their addiction to buying on credit yet.

These are all important aspects to keep in mind before proceeding to apply for a loan. There are times where debt consolidation is the only solution, short of filing for bankruptcy. Only you know your own personal financial situation well enough to be able to judge if this is the case. In many situations however, applying the debt-avalanche method, sticking with the goal of paying off your balances, and the determination not to rebound into consumer debt is what it takes to become debt free.

Photo credit: Lotus Head.