Debt Consolidation Loan or Borrowing Your Way Out of Debt?
For some borrowers, consolidating their debts or accounts, is a way to get a better handle on the accounts, and to see the light at the end of the tunnel; meaning getting out of debt.
Consolidation loans, or debt consolidation loans work like this:
You have three (3) or more accounts, such as credit cards, catalogues, store cards, personal loans, any unsecured type of loan or credit/debt.
These 3 account have various balances, but in total you owe £9,000.
You then take out a new and different unsecured loan for £9,000, which the intent and purpose of paying off the other three accounts.
At that point in time, instead of three (3) monthly payments for the accounts, you have one (1) monthly payment. So easier to manage.
In addition, in most instances, the one monthly payment is lower than the three previous monthly payments, and especially when consolidating credit cards, you have a date of no debt, a light at the end of the debt tunnel.
If you were to continue making the minimum monthly payment on a credit card, store card or catalogue, it can take many, many years to pay the account off and get out of debt.
The consolidation loan gives you a line in the sand, a specific point due to the term of the loan, when you know you will pay the loan off and be out of debt.
On the surface a consolidation loan is a good debt management tool, a way to get a handle on your accounts, see a way out of debt, and better manage your money and finances.
However, is a debt consolidation loan just borrowing your way out of debt?
How Did We Get Here?
While a consolidation loan is a great way to get a better handle on our accounts and debts by having just one (1) monthly payment, which can be lower than the three (3) previous monthly payments, we need to ask ourselves a couple of questions prior to entering into this.
What brought us to this point in our financial lives?
How did we get here?
For some the answer to this question is easy, we have a credit card, a personal loan and a store card that we use and pay on each month, and if we consolidate these we will save money each month.
The money we save each month we can pay towards the consolidation loan itself and instead of having the new loan paid off in 36 months (if it is a three (3) year 36 month loan), we can have it paid off in 30 months, or less.
Again, on paper and in theory, it looks good.
There are a couple of small caveats to this theory.
What brought us to the point or stage where we needed, or decided to get a consolidation loan?
If the loan is simply to better manage our finances, which consolidation loans do help with, then OK. However, if we are struggling with our monthly bills and the loan is to get a handle on paying the accounts, then OK, but we need to look closer at this.
If it is credit cards, store cards, catalogues, etc we are consolidating, we need to stop using the cards/accounts.
If we continue to use the cards and account after we pay them off, we then not only have the new loan payment each month, but we will then have the payments to the old accounts we continue to use each moth.
If we continue to use the accounts and cards, it is like trying to shoot a moving target; it is much more difficult.
If need be, close the accounts or cards. However, this in itself can pose an issue as it can affect our credit scores.
Credit Scores and Debt Consolidation Loans: If we follow the model used of credit scoring and what makes up our credit scores, (read more here), we know that the balances we have on our accounts, and the number of accounts we have can affect/change our credit score.
If we have three or more accounts and consolidate them to one account, in theory it should help or improve our credit score, and it does.
Instead of three accounts with a total balance of £9,000, we have one (1) account with a balance of £9,000, and three other open accounts with zero balances.
So for some, this can improve their credit score.
When we look at closing accounts we have paid off and no longer use, especially revolving accounts, such as credit cards, we need to be careful which accounts we close.
We do not want to close an old account, or one of the accounts we have that is one of our older accounts, and why?
The older accounts show when we first entered into the credit arena and first receive credit. This has an impact on our credit score, so we would not want to close an old, or one of our older credit accounts.
A fine line to walk to get out of debt and still maintain a good credit score.
Debt consolidation loans are a good debt management tool, but they also must be viewed in the light with an understanding of how and why you found yourself at the point of seeking out such a loan, and making sure you do not repeat the process.