This chart from Business Insider is a bit outdated, but it shows why debt consolidation loans have become so popular. Credit card debt keeps growing while income, relatively, stagnates. No wonder more people are overusing their cards.
“Should I use a debt consolidation loan to pay off my credit cards?” If you owe large sums of money to multiple different creditors and it’s stressing you out, then this question has probably danced around your head plenty of times in the wee hours of the night.
On one hand, it seems so easy and obvious. With a debt consolidation loan, you could consolidate your debts and only have to worry about a single monthly payment, one that’s hopefully less than what you pay now. Seems like a win-win.
On the other hand, you don’t understand how a debt consolidation loan works. It sounds too good to be true, and you’ve heard that the industry is full of scammers disguised as debt consolidation professionals. Diving in doesn’t sound like such a great idea.
If you’re trying to figure out if you should use a debt consolidation loan to pay off your credit cards, keep reading. We’ll help you to make sense of the whole situation.
First off: where did your debt come from in the first place?
Why do people have so much credit card debt?
Spending on credit is what makes many of life’s greatest moments possible. For most, buying a car or home, or getting a college education, would not be possible without some form of debt or credit. We simply don’t have the cash reserve necessary to finance those types of purchases, and saving up for them could literally take a lifetime.
Credit spending isn’t all wine and roses, though. As often as it is used to finance legitimate purchases, credit is easy to abuse, usually to the detriment of the person doing the spending. Usually, this abusive spending comes in the form of credit cards.
“Living outside your means” is the term favored by the media to describe this kind of reckless spending, usually said with a mixture of moral outrage and disgust. However, who hasn’t had to live outside their means occasionally? Financing a car, home, or education are all “living outside your means” in the sense that you’re borrowing money to make a purchase to improve your life.
Maybe so; however, when most people talk about living outside one’s means, they’re often talking about credit card spending to fund a lifestyle that a person could not afford on income alone. They mean people who whip out their credit cards at the register to buy clothes, shoes, gadgets, and other luxuries that most would agree are largely unnecessary. If your life is full of beautiful things and crippling debt on a number of different credit cards, then you are most likely living outside your means.
Of course, buying the finer things in life is not the only reason people run up their credit cards. According to NerdWallet, rising levels of consumer debt in the United States have less to do with individual bad decisions and more to do with the disparity between cost of living and income growth. Vital goods and services, including everything from medical care to groceries, have become more expensive while income has largely stagnated. It’s no wonder people are turning to their credit cards more and more to make ends meet.
In fact, NerdWallet found that credit cards account for $779 billion in U.S. consumer debt. That’s an average of $16,748 per household. Credit card debt is a problem, it seems, for almost everyone to some degree.
Whatever your reasons for falling into credit card debt, we’re sure you want to get out, and you’ve probably at least heard of debt consolidation loans. How do debt consolidation loans work?
How do debt consolidation loans work?
Some talking head on a daytime TV commercial will tell you that debt consolidation loans are simple to understand. You contact a lender to get a personal loan equal to the sum total of all of your debts. You use that loan to pay down all of your debts, and then focus on paying off the loan. Since loan terms are usually a lot more agreeable than credit card terms, you end up paying less per month and less in interest over time, saving you money and helping you get out of debt faster. Since you’re a savvy consumer, you’ll say, “That has to be too good to be true, right?”
Right! Mostly. That is essentially how debt consolidation loans should operate. It’s just not the full picture. There’s at least one finer difference to understand first; namely, that debt consolidation loans can be secured or unsecured.
Secured vs. Unsecured Debt Consolidation Loans
Unfortunately, basic financial education is not part of most high school curriculums, and if it is, it doesn’t usually go further than basic budget management. Later in life, when people are researching loans, they have no idea about the difference between secured and unsecured loans. One sounds safer than the other does, but they can’t be all that different, right?
Wrong. There are huge differences between the two different loan types that can have a major bearing on which type of debt consolidation loan is right for you.
Unsecured loans are your run-of-the-mill personal loans offered on credit, from a lender to you. The lender checks your credit score, assesses your creditworthiness, and finds that you’re likely going to be able to pay back the loan with no issues. Therefore, the lender offers you the loan on credit, trusting you and asking for no more than your signature before giving you your money.
Secured loans are what happen when the lender isn’t sure if it can trust you or not, or if the total of the loan is large enough that the lender can’t afford to take your word that you’ll pay it back. We joked about secured loans sounding “safer,” and they are, at least for the lender.
With a secured loan, the lender asks that you put up some form of collateral as security for the loan. The idea is that, if you fall behind on your payments, the lender can legally seize and sell the collateral, making at least a portion of its money back on the loan.
Collateral can be almost anything, although in most cases, it’s a major asset such as your car or home. If you can’t keep up with your secured loan, then you have to say goodbye to one of the most important possessions in your life.
Why would anyone take a secured debt consolidation loan? Sometimes, they have no choice. If you have bad credit or a history of missed payments, then lenders will be far less willing to offer you an unsecured loan. A secured loan is much less risky for them.
Secured loans often have better interest rates and terms, since they reduce the amount of risk that the lender is taking on. These features can be attractive to borrowers, especially borrowers who are already struggling with their finances.
So, now you understand how debt consolidation loans work and what the different types are. Here’s the money question: should you use a debt consolidation loan to pay off your credit cards?
Paying Off Credit Cards with a Debt Consolidation Loan: Good or Bad?
As with most difficult quandaries in life, there’s no one right answer to this question. Whether you should use a debt consolidation loan to pay off your credit cards depends on the loan as well as your individual situation. You should ask a few questions first.
Could you pay off your debts on your own?
Have you made an honest effort to pay down your debts on your own? Debt consolidation loans and other forms of debt relief should not be a crutch that you rely on unless you really need them. Nine times out of ten, you’d be much better off trying to pay down your debt on your own.
First, make sure you’ve made and followed a strict budget. They’re not hard to figure out. You take your monthly income (estimated if you’re an hourly employee), subtract your monthly expenses (estimated for variable expenses such as gas and groceries), and then see what’s left. Whatever you have remaining at the end of the month is usable to pay down your debts.
Second, make sure that you’ve at least considered approaching your debt strategically. Most people just look at the sum total of their debts and start to despair, but it’s not as bad as that. By approaching your debts strategically, you can make steady progress toward making them disappear.
For most people, strategy means choosing a debt to focus on eliminating. You keep up with all of your monthly minimum payments and then pay extra on a chosen debt with the hope of eliminating it quickly. People tend to choose either the debt with the smallest balance (in order to eliminate a debt as soon as possible) or the debt with the highest interest rate (in order to save the most money in the end). Which one you choose depends on your circumstances.
If you’ve wisely budgeted and still don’t have much money left, or if you’re not seeing much progress even with a debt repayment strategy, then it may be time to weigh other options.
Is a debt consolidation loan the right debt relief option for you?
We don’t have time to weigh the pros and cons of every debt relief option under the sun here. However, you should at least be aware that there are more options out there than just debt consolidation loans.
Credit counseling, for instance, has helped many individuals struggling with debt to get back on their feet. Credit counselors are usually non-profit organizations that specialize in helping people sort out their finances and come up with a plan to get out of debt. Even if you’ve tried budgeting on your own and it hasn’t worked, a credit counselor may be able to help you find a solution.
Balance transfer credit cards also work well for smaller amounts of credit card debt. You find a credit card with a 0% APR introductory offer and use it to pay off all of your other cards at once. Then, you focus on paying down that card in full before the introductory offer ends, interest-free.
Debt settlement has also helped many people get out of debt relatively quickly. With debt settlement, you work with a company to negotiate with your creditors. Often, you stop paying your creditors altogether, paying into a savings account managed by the company instead. Once you build up enough money in the account, the company will take it to your creditors and use it to negotiate on your behalf by offering a lump payment now instead of the full amount of your debt over time. Many creditors will take the easy money.
Whatever option is right for you, make sure that you take the time to do your research. It’s an important choice to make.
Are you financially responsible enough to make a debt consolidation loan work?
Debt consolidation loans treat the symptoms of your financial problems, not the cause. At their best, they give you breathing room so you can get back on your feet and figure out a long-term plan for financial stability and security. They do not fix everything forever.
Think of it this way: once you get your loan and pay off all of your credit cards, you will all of a sudden have a huge amount of available credit. Will you be able to stop yourself from overspending on credit? Or, will you fall back into old habits? If you can’t exert some type of financial discipline, you’ll just end up in the same bad place within a couple of years.