When we were in debt we didn’t even have the luxury to ask when is debt consolidation a good idea. We had to consolidate because we had so much debt that simply paying the credit card minimum payments was pushing us further into debt. We didn’t stop to think, we simply picked up the phone and arranged a consolidation loan with our bank manager (yes, there were such people before banks started relying on algorithms and credit scores). As it happens it was the right decision for us because it simplified our debt payments and helped us pay our debt in record time.
It is a good thing we didn’t have the time or inclination to question whether debt consolidation is a good idea. We also hadn’t read enough on personal finance. If we had we would have come across some worn-out mantras like ‘you don’t get out of debt by taking on more debt’. This is one used when someone asks whether they should choose debt consolidation or keep debt on multiple credit cards and with many creditors.
Guess what? You do get out of debt using debt consolidation or put differently when you take on different, if not more, debt. We started with £100,000 consumer debt in January 2010 and managed to pay off debt, all of it, by February 2013. It took us three years and one week to pay off our debt using debt consolidation and restructuring our debt by taking out one big, scary loan and paying off nine scary interest rate credit cards.
Selecting debt consolidation we broke another rule of personal finance: never make unsecured debt into secured debt. That simply means that all debt on credit cards is unsecured – the worse that could happen if you don’t pay an unsecured debt is a lot of unpleasantness. On the other hand, if you stop paying a secured debt you lose your collateral; in our case, this would have been our house (or a large proportion of our equity in the house).
These are important rules! Still, we broke them and paid off our debt in record time. It could have gone the other way…maybe. Although I never allowed the possibility of failure and loss to enter my mind.
Here are the reasons why I still believe debt consolidation is a good idea and what you may wish to take into account so there are no nasty surprises. Because you see, just like there is no free lunch, there is no idea that is universally good.
Why you may consider debt consolidation?
There are conditions under which must consider debt consolidation and forget about the rules. After all, if life has taught me anything, it is that our life choices rely on probabilities, not absolutes. Here are the probabilities, mainly about paying off debt, for which you must account:
- Your debt is on high-interest credit cards and you are struggling to pay any of the principal off.
- You wish to save on interest.
- Your debt is large (or it is a large proportion of your take-home pay).
- You wish to speed up your debt payment.
- Your net worth is high and you can afford the collateral.
- You have a very clear plan for how to pay off your consolidation loan.
Now, please make a cup of coffee and sit down with pen and paper. Where do you stand on all these probabilities? Is debt consolidation necessary and appropriate in your case?
When is debt consolidation a good idea?
Debt consolidation is a good idea when you wish to save interest. Taking out a consolidation loan and using it to pay off much more expensive debt could potentially save you a lot of interest. When we consolidated our debt, the credit card companies changed between 19% and 27% annual interest. Our debt consolidation loan secured against the house came with 7% annual interest and while this was still a scary amount of money given the size of our debt, it made debt payment manageable. Today there are many borrowing options including peer-to-peer lending arrangements some of which are accessible even for people with far from perfect credit history and score.
Next, taking out a debt consolidation loan ensures you are actually paying down your debt. You must know that the loan repayments are calculated so that one always pays some of the principal rather than only interest. Keeping debt on credit cards makes it very tempting to try and avoid the pain of changing your life, and paying off your debt, by paying only the minimum amount. This is plainly the wrong thing to do but at the same time, it is a very successful business model for credit card companies; which tells us that it is something many of us do most of the time.
Taking out a debt consolidation loan also means that you are not exposed to random interest rate increases outside your control. Make sure that the contract setting out the conditions of the loan also states the interest rate; that way it is would be 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. (Please have a look at this post about the mistakes to avoid when taking out a consolidation loan. Our consolidation loan was with our bank and worked out very well for us.)
Debt consolidation will save you much energy and bother: Yes, 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 your debt payment progress as well – I had a lovely graph with an arrow that kept going down. I still cannot believe how aesthetically pleasing that is – but I still admire it sometimes.
To summarise, debt consolidation is a good idea when:
- You aim to save interest.
- You want to ensure you are paying down your debt.
- You want to firm up the interest on your debt.
- You want the save yourself the hassle of dealing with many creditors.
When is debt consolidation not a good idea?
Debt consolidation is not a good idea because:
- Taking out a loan usually entails collateral: this means 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 it 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 favor. 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: and 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’!
Now you know when is debt consolidation a good idea. To make it worth it, and as risk-free as possible, you must 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.