Why Debt Consolidation Doesn’t Work

Debt consolidation does work, but only as a short-term tactic to enable you to move towards a debt free financial position.

The idea behind debt consolidation is that where you have debt in more than one loan (or credit card), you combine them all into one loan, with a lower interest rate. The benefit is that you immediately reduce your monthly interest payments, which should give you some more breathing space to start to pay the loan amount off. It works particularly well where people have a lot of debt on credit cards as credit card interest rates tend to be a lot higher than standard personal loans.

Let’s look at an example:

John has $10,000 of debt as follows:

Loan: $5,000 at eight percent
Credit card: $5,000 at 18 percent

His monthly interest payments would be $33 (loan) + $75 (credit card) = $108

If he rolls the credit card debt into the loan (still at eight percent), then his monthly repayment would go down to $67. That’s a $41 monthly saving so well worth doing.

Consolidated loans can either be unsecured (i.e. just a standard personal loan) or they can be secured (i.e. rolled into your mortgage with the collateral being your house). Obviously, a lot of care needs to be taken before you secure a loan with your house. You need to be very confident that you can repay it; otherwise you could lose your house.

However, it is important to remember that consolidation should only be a short-term tactic. In the long run, it’s important that you change your attitude towards debt and pay it all off. The difficulty for many is that their monthly debtor payments becoming so high that it’s all they can do to make the minimum payments. That’s where consolidation may make a difference, but you still need to find a way to significantly reduce any outstanding debt.