I find that the closer we get to paying off our consumer debt completely the more I tend to reflect on debt management, how we handled debt, how to handle debt in general and could we have done something differently (understand ‘better’). I also have been much more inclined to interrogate well established personal finance mantras, like ‘you don’t get out of debt by taking on more debt’. This is a mantra usually used when someone asks whether they should consolidate their debt or not.
Yes, you do get out of debt! We started with close to £100,000 ($157,000) consumer debt two and a half years ago and are set to pay off debt, all of it, by February, 2013 latest; I hope that it will be all done by the end of this year or in exactly three years. We took more debt on; or to be precise we restructured our debt by consolidating nine credit cards in one big, fat and very scary loan.
Having got the mantra out of the way let me now turn to my main question: is debt consolidation really worth it? Is it worth choosing one large debt over many smaller ones; is it worth changing credit card debt to a loan? I’ll be honest here and say that at this moment I am thinking ‘yeah, of course it is; I’ll go with consolidation anytime’.
But this has certainly not been the case all the time and there have been many occasions when I have thought ‘if I only didn’t consolidate’. So I decided that tonight I’ll set the advantages and disadvantages of debt consolidation, as I see these, so should you think to apply for a loan there is some frame of reference to inform your decision.
On the plus side:
Taking out a loan usually saves interest: taking out a loan to consolidate many smaller debts usually saves rather a lot in interest payments. Currently credit cards interest, even the most favourable one, is running at about 20%; one can still get a bank loan at less than 10% interest. If one needs smaller amount it is well worth considering peer-to-peer landing arrangement – in some cases interest can as low as 7-8%. Of course, this is assuming that your credit score is decent; well, more than decent actually.
Taking out a loan ensures you are paying your debt down: loan repayments are calculated so that one always pays some of the principal rather than only interest. Keeping debt on credit cards always contains the risk that you will minimise the pain of changing your life and repayment by paying only the minimum amount. This is plainly dumb but at the same time it is a very successful business model for the credit card companies; which tells me that it is something many of us do most of the time.
Taking out a loan means that you are not exposed to interest rates increase: the contract that sets out the conditions of the loan also state the interest rate; so it is very unlikely that you will get a letter informing you that the interest rate on your borrowing just went up 3%. This happens regularly with credit cards.
Debt consolidation saves energy and bother: yep, I really mean this one. It would have really drained me to have had to deal with debt across nine different places. Having it all in one saved me loads of energy, worry and bother. It is really easy to follow progress as well – I have a lovely chart that keeps going down. I never thought that this could be so aesthetically pleasing – but I can admire it repeatedly.
On the negative side:
Taking out a loan usually entails collateral: what this means in simple terms is that because the bank wants to ensure you are going to pay back it asks you to put something down as security. Usually it is your home! This is a real problem if something goes wrong and you can’t pay back: if your debt is on credit cards the worst that could happen is that you will damage your credit rating, if it is a loan you could lose your home.
You are stuck with the interest rate: most of the time this works in your favour. However, if your credit rating is good and your borrowing to income ratio is not atrocious there are 0% interest rates on credit cards. During the last two and a half years this has been often a point of regret for me: consolidating meant that we could not take advantage of these deals.
Loans can stretch over a long period: in fact they usually do. Our loan is for ten years and I have to tell you that when we took it out I thought that this is the twilight of my life gone. Where we got it right is that we checked and double checked that there are no penalties for overpayment and early repayment; after that we attacked the loan with a vengeance and as a result we very quickly reached the point where the monthly repayment covered more principal than interest.
Repaying a loan is a long term commitment: so is repaying credit card debt, you may think. Not the same! Keeping your debt on credit cards (and paying it down) is like running a number of sprints – each run is hard but there is a positive emotion at the end; so you can take a breath and go for the next sprint. Repaying a large loan is like running an ultra-marathon – you just have to keep going; and when your head is telling you to stop you just keep going! You can’t afford to ‘hit the wall’!
I think that debt consolidation is worth it but you have to ask yourself the following three questions:
- Can you take the collateral?
- Do you have a strategy for overpayment of the loan and have you checked that its conditions allow this?
- What kind of runner are you? If you are a sprinter stick with many smaller debts; if you have the mentality of a long distance runner consolidating is for you.
Do you think debt consolidation is worth it?