Consolidating debts

During the pandemic lockdown I racked up a total of $15,000 in credit card debt, spread across two cards and a line of credit. I’ve been finding it hard to keep up with the minimum payment on all three accounts. Lately I’ve been reading up on debt consolidation and its pros and cons. Also I’ve been seeing ads of debt reduction through consolidation. I feel like whenever someone is advertising something, there’s always a catch! Would consolidating my debt be a good idea for me?

Let’s talk a little bit about what debt consolidation means. Basically consolidating debt means paying off a whole bunch of smaller debts by taking out one large loan big enough to cover them all. For example, if you’ve got three credit cards with balances of $6,000, $5,000, and $4,000 then you could take out a single $15,000 loan to pay off all three cards at once.

Why would you do this, trade three small debts for one large one? The biggest factor when trying to get out of debt is the interest rate of your loans. When consolidating debt the idea is to trade multiple high-interest debts for one low-interest debt. The lower interest rate means smaller monthly payments and a shorter time to pay down the debt.

Let’s keep playing with the example of having three credit cards with $6k, $5k, and $4k balances. Credit cards typically have an interest rate in the range of 18% to 22%. This means a minimum monthly payment of around $250. Let’s say you managed to put $500 towards paying off your debts each month, then it would take just over three and a half years and cost $21,000 to pay down your original $15,000 of debt.

Now, let’s look at the situation if you took out a $15,000 loan at 10% interest. Once you pay off the credit cards, the new monthly minimum payments on your loan will be closer to $125. It will take three years to pay down the debt and cost $17,300. You’re saving about 7 months and nearly $4,000 with the lower interest rate.

This probably all sounds like good news – cheaper payments, faster debt relief, and more money in your pocket. So what’s the catch?

There are a few possible drawbacks. The big one is people who get themselves trapped in large amounts of credit card debt and then pay it off using debt consolidation now have credits cards with no balance on them. It can be a powerful temptation to spend again, viewing the cards as blank slates. This is a dangerous path which sometimes results in people consolidating their debts, only to rack up new ones. Then trying to consolidate again, digging themselves in deeper. If you do consolidate your credit card and line of credit debts to pay them off, have a plan in place to avoid going into credit card debt again. Lock the cards, lower the limits on the cards, or cancel most of them to resist the temptation to overuse them again.

The other potential drawback is the company offering to consolidate and wipe out your old debts might be preying on your situation. Debt consolidating is a real thing and a useful tool, when you know what you’re getting into. If you walk into almost any reputable bank or credit union they can help you set up a new, low-interest loan or line of credit to help consolidate your debts. They should be entirely transparent and up front about your options, interest rate, and the time it will take to pay back your loan. It’s in their interest to work with you because they’re going to make a small profit off your new debt’s interest. Not as much as the credit cards companies were before, but still it’s a source of small profit for them to help you.

However, those reputable banks and credit unions probably aren’t the ones flashing ads in your face and offering to make your debt vanish. The companies advertising debt relief might be above board and planning to help you gradually pay down your debt in trade for a small profit. However, some of them are looking to fast-talk you into signing a contract which will not benefit you in the long run. Maybe they’re offering super low interest rates today, but those will climb to much higher rates next year. Or maybe the interest rate stays steady, but there is an annual fee. Or maybe there’s no annual fee, but if you’re late on a payment it’ll double your minimum payment.

The point is, the companies advertising debt consolidation plan to make money on the arrangement somehow. Some are honest and reputable. Others are hoping you’ll sign a contract that will lock you into paying them a lot over many years with all sorts of hidden fees and penalties.

In short, debt consolidation is a real and useful tool for lowering your payments, saving you money, and getting you out of debt faster. It’s definitely something I recommend looking into. However, it’s important to take steps to avoid backsliding into debt once your credit cards are paid off. It’s also important to work with a reputable company to get out of debt. Usually your own bank will help you (or one of the major banks will help you) take out a personal loan to pay off high-interest debts. Feel free to shop around to find the best rate and terms.

Less reputable companies are out there also offering to wipe out your debt and their rates may sound too good to be true. Chances are there are terms in their contracts which will place you in their debt for a lot of money. It’s best to avoid these kinds of businesses and, if you do seek their services, make sure you have read and understood the terms of their contracts before you sign.