The dark side of debt consolidation
By Barbara Craig, Attorney at Law
The expression “if it seems too good to be true, it probably is” never rang truer than it does with debt consolidation. This “cure” is oftentimes only an illusion of relief. While it is true that in some cases, debt consolidation has helped individuals with unmanageable amounts of credit card and other debt, in my experience, most people who attempt these strategies end up in the same or worse circumstances down the road.
Popular debt consolidation strategies
There are three primary debt consolidation options that involve combining all debts into a single monthly payment:
Home equity loan/line of credit (HELOC)
This option leverages the value of one’s home to pay off other bills. While this seems like a very attractive option because the interest is relatively low and tax deductible, all potential risks must be examined. While some people take comfort in the notion that this type of financing is merely loan or line of credit, the truth is that it is a mortgage and gives a creditor claim to one’s home.
For people who have lived beyond their means and accumulated excess credit card debt, this strategy can be dangerous if they have not gotten their spending in order and stick to a realistic budget. Otherwise, continuing the same bad habits could result in defaulting on the loan and losing the home. Finally, many people fall into the trap of borrowing the total amount for which they qualify instead of just what they need, increasing their overall debt load.
Balance transfer credit cards
Zero interest balance transfers have become a popular marketing tool for the credit card companies. With this type of offer, a consumer can transfer high-interest debt from one or more existing credit cards to a new card, and if the balance is paid off in a certain time frame, no interest is charged.
But there are no free lunches. The credit card companies can make these offers because they know a high percentage of consumers won’t get the debt paid off in time, and the typical 18% – 29% interest rate will then start accruing on the debt. Worse yet, many consumers fall into the trap of using the credit cards they just paid off and accumulating new debt. In some cases, I have seen people repeat this cycle a few times over several years, piling up total credit card debt which approaches their annual income, which would take as long as 50 – 80 years to pay off with the minimum monthly payments.
Debt consolidation/credit counseling agencies
Getting professional help to solve a big problem sounds like a good plan. Debt consolidation companies offer consumers burdened by debt the ability to combine all their debt into a single low monthly payment, plus in some cases, the prospect of settling some debts for only a portion of the amount owed. These companies will also typically offer credit counseling and educational resources – like instruction in budgeting – to help consumers get their spending habits under control and avoid repeating the same mistakes.
It all sounds good on paper. But in practice, this approach has many downsides. The biggest problem is that when debt is consolidated, it does not necessarily result in a change in behavior. According to experts, as many as 70% of individuals who participate in these plans end up with even more debt a few years later.
But even for the minority for whom debt consolidation does work, the attractive monthly payments stretched out over many years means that the total interest paid under one of these plans is often higher than it would have been without consolidation.
Bankruptcy as an alternative to debt consolidation
Many people are interested in debt consolidation to avoid bankruptcy, due to the belief that a bankruptcy filing will destroy their credit rating and impair their ability to get financing for a car or home in the future. But the truth is, most people who are considering debt consolidation already have severely damaged credit thanks to a history of late payments and high credit card balances. For many of these people, bankruptcy is faster, lower cost, and will actually help rebuild credit more quickly than debt consolidation strategies. With bankruptcy, it is possible to eliminate most or all debt in as little as a few months (Chapter 7) to three to five years (Chapter 13), and auto loans and home mortgages can be obtained as quickly as two to five years after filing.