Being in debt causes significant stress, both to your finances and to your psyche. There are a number of techniques that you can utilize in order to try and climb your way out of your financial hole. Consolidating multiple debts into a single obligation might make it easier to navigate your financial obstacles. However, is it a good idea to consolidate your debts?
It is essential to remember that debt consolidation is a means to an end, and by itself will not help you to unshackle yourself from your obligations. Whether it is an appropriate tool for you to utilize depends on both your financial situation, as well as on your individual inclinations.
What is Debt Consolidation and How Does it Work?
Debt consolidation is rolling multiple debts into one financial package. In other words, instead of owing multiple debts–with varying interest rates and repayment schedules–you would only have one debt repayment to make.
In practice, you would either take out a loan or use zero- or low-balance credit card to repay or transfer your debts. This alternative source of finance would then be used to repay your existing obligations. You will now be responsible for addressing this new debt obligation–either a loan or a credit card balance–that you have absorbed.
It is just as important to understand what debt consolidation is not. Debt consolidation is simply the reorganization of your finances, and does not constitute your repayment of these obligations. You must still work to repay your new commitment.
What are the Benefits of Debt Consolidation?
There are two principal benefits of debt consolidation.
The first is that you have simplified your finances. Instead of being responsible for multiple obligations, now you will only need to worry about meeting one payment schedule. Especially if you feel overwhelmed by balancing numerous obligations, only having one payment to make could provide you with some peace of mind.
The other main benefit is that you could potentially obtain cheaper financing, thus saving money over the long run. For instance, if you have two different credit card debts that charge 15% and 20% interest, securing a loan with an interest rate of 7.5% would allow you to save money on these interest payments.
Depending on the amount of outstanding obligations on your books and your credit score, however, you may not succeed in receiving cheaper financing. You also need to take into account any loan origination fees and the cost of transferring your balance to another credit card to understand whether or not the finances of debt consolidation will work in your favor.
What are the Downsides of Debt Consolidation?
The downsides of debt consolidation extend beyond financial considerations, and include psychological ones as well.
For starters, rolling all of your debts into one larger loan may not save you money. Interest rates depend not only on the larger macro economic environment, but also on your credit score. Those with high debts tend to have lower credit scores, and are thus considered riskier borrowers. For that reason, lenders charge them higher interest rates when borrowing money.
The math is straightforward, and performing a calculation comparing your current and future interest obligations will help you understand if consolidating your debts will bring you savings.
However, the larger downside, which is the false sense of having successfully addressed your debt obligations, is not quantifiable at all. For many, the act of falling into debt–especially those who have accumulated wealth-killing credit card debt–is due to behavior. Simply put, it is likely that you have spent money that you did not have the ability to repay.
Repaying debt is more than clever accounting tricks; it requires making a change in your patterns of consumption to spend less than you earn. Refinancing your debt into another obligation is not the same as repaying it.
The danger of debt consolidation is that it might make you feel as if you have taken credible action to address your debt obligations. This is simply not the case. Even if your original creditors have changed, you still owe the same amount of debt. Debt consolidation does not give you license to run up your credit card bill haphazardly once again.
Is Debt Consolidation Right for You?
Looking at your situation can help you determine if there is financial merit to consolidating your debt. If you can secure cheaper financing, it could allow you to save money on interest payments (and maybe even shorten the time it takes to pay off your obligation).
The trickier consideration is how consolidating your debt could impact your spending behavior. If doing so would provide you with a source of comfort and help you to stay on the right track, then it could certainly be a worthwhile step to take.
However, you should think long and hard about your spending inclinations, and whether or not you have the discipline to rein in your spending habits. If you are concerned that consolidating your debt could provide you with a false sense of accomplishment, then this is path is probably not for you.
Conclusion: Knowing Your Tendencies
Debt consolidation is a mechanism for facilitating repayment, not the repayment itself. It may help you save some money and simplify your finances, but it is not a solution to your debt.
The only long-term, sustainable fix is a change in your behavior. For most individuals, unhealthy patterns of consumption are the underlying reasons that they become indebted in the first place.
Until you have addressed that issue–your debts and the stress and anxiety that accompany it–will never truly go away.
Learn money management, and use data-driven stock insights with TipRanks.
