Debt consolidation is the process of refinancing multiple balances into a single loan. You can take out one loan for the total amount of your current debt, then repay your existing debts with the funds from the new loan. Finally, you’re left with just the new loan to repay.
A debt consolidation loan can help make life a bit easier, reducing the amount of loans and debts you need to track. Making a single payment each month may even save you money in the long run if you can get a lower interest rate than your existing loan rates, and it can help you avoid sweeping a few bills under the rug (raise your hand if you’re renting in Boston, MA, or another pricey market and have felt the burden of a hefty rent in addition to student and car loans).
However, these benefits aren’t guaranteed, and what you save on your interest rate may be canceled out by origination fees and other charges. Consider these factors and be prepared to change the way you spend money before you consider a debt consolidation loan.
1. Debt consolidation won’t necessarily make things easier
The idea behind debt consolidation is a good one. You get to roll all your debt into one loan to focus on and repay. It makes your financial life simpler and may help you pay less on what you owe if you can get a lower interest rate.
But it doesn’t always work out this way. “I’ve worked with plenty of people pre- and postbankruptcy over the years,” says Jason Reiman, a certified financial planner. He’s the founder of Get Financially Fit!, a company based in Tucson, AZ, that helps people with their finances. “A leading indicator of bankruptcy, in my experience, is debt consolidation.”
Reiman says that consolidating loans (with the exception of student loans) usually provides you with a short reprieve. It’s often followed by taking on new debts outside of the ones you’ve already consolidated. Why do people do this? “Debt consolidation typically doesn’t produce the expected results simply because of mindset,” Reiman says. “As humans, we resist change and discomfort.”
And changing your financial habits to not rack up more debt after consolidation can be really uncomfortable. You must change how you behave with your finances, and that could mean going without the luxuries and the standard of living that caused you to get into debt in the first place.
2. Be prepared to learn and understand how you spend money
“Debt consolidation can look OK mathematically, but it has a tendency to ignore the emotional and psychological aspects,” Reiman says. And those factors do matter as much as — or more than — the numbers.
Your mindset and behavior are at the heart of any financial issue. While a debt consolidation loan can help some people, it won’t do anything for you if you’re not committed to changing your internal thought processes and switching up your spending patterns.
Reiman says that for any solution to be effective, you need to start with the real cause of the problem. Ask yourself a few important questions. “For example,” he suggests, “how did I get into this heavy debt situation in the first place?”
So if debt consolidation isn’t the answer for you because it doesn’t address the root of your financial troubles, what is the solution? Reiman offers one exercise to try. “Get out a piece of paper and a pen,” he says. “Divide the paper into four quadrants: physical, spiritual, mental, and financial. Jot down your thoughts and actions over the past three to five years which may have prompted you to add more debt to your life.” Reiman says we will remember times when things seemed to happen outside of our control. But by taking a look at how we thought and felt at that time, we can see patterns in how we acted and reacted.
“The purpose of this exercise is to help uncover the counterproductive actions,” he explains. “Only when you know how you arrived at your current situation are you able to make solid choices about changing it for the better.”
3. Clean up your finances before consolidating
If you feel that a debt consolidation loan is an important step in your journey to financial success, make sure you do everything you can to eliminate opportunities to create new debts in the future. Cut up your highest-interest credit cards and use a budgeting system you can stick to. Start building an emergency fund or a savings account with a cash reserve you can draw on if something comes up that your monthly budget can’t handle.
Then sit down and make a plan for how you’ll repay your consolidated loan. Will you cut back on your spending to help make those payments and avoid further debts? Will you work to earn more so you have more cash flow to put toward debt repayment?
4. Consider other options
Remember, a debt consolidation loan is only one strategy for repaying what you owe. “The process of eliminating small debts one by one, and achieving these small wins, is invaluable,” Reiman says. And he stresses the importance of simply having a plan and tracking your progress.
“If you have multiple debt accounts, consider using a free program like powerpay.org to crunch the numbers,” he says. The site will help you craft a plan of action that most likely doesn’t include consolidation. You can also use various debt payoff strategies, like the debt avalanche or debt snowball, to help you make progress.
“Get accountability and coaching and be open to change,” Reiman says. “It’s difficult but possible.” Your current level of debt might seem insurmountable, but don’t get overwhelmed. Take a deep breath, consider your options, and make a plan. Then dive in!
Have you taken out a debt consolidation loan? Share your tips for successfully paying off debt in the comments!