just the first step
In an environment
of record low interest rates, much attention is rightfully given to debt consolidation.
Consolidating higher interest rate obligations at lower interest rates makes a
great deal of sense, and is especially feasible with interest rates this low.
it is critically important to focus on the overall objective -- saving money and
accelerating the process to becoming debt-free. Losing sight of this objective
exposes the borrower to the dark side of debt consolidation.
there has yet to be a prime time television special entitled "When Debt Consolidations
Go Bad," such a program would surely contain the following lessons.
first disclaimer to crawl across the screen would caution borrowers not to stretch
the payback period when consolidating debt. The measure of money saved is not
the difference in monthly payment, contrary to what many borrowers may think.
Borrowers comparing terms solely on the basis of monthly payment,
called "payment shopping," are especially susceptible to stretching
the payback period into a longer term. The temptation is that stretching out the
term of the loan can significantly reduce monthly payments. The problem is the
borrower ends up making more of those monthly payments, costing the borrower more
in the long run. For example, consolidating debt with three years remaining does
not generate any savings if the borrower stretches the term to four years or more,
despite the difference in monthly payment.
The overall objective
is to save money, measured not by monthly payments but by total interest cost
over the term of the loan. The ideal scenario is to consolidate for the same payback
period, or reduce the payback period if possible. In the example cited above,
a borrower able to refinance this debt at a lower interest rate without stretching
the term beyond three years is poised to reduce interest costs over the repayment
The second disclaimer would have to do with what behavior
needs to be modified after the consolidation is done. In our fictional "When
Debt Consolidations Go Bad," footage would be shown of these same consumers
in shopping malls, restaurants, fine hotels and luxurious resorts whipping out
the plastic to pay for these indulgences. All the while, the narrator warns, "Do
not try this yourself."
To truly save money and accelerate
the journey to becoming debt-free, the borrower must now employ a healthy dose
of fiscal restraint as the consolidation frees up extra room in the monthly budget
or makes additional borrowing capacity available. Restraint from both spending
this monthly windfall and charging up additional debts is necessary to make the
Incurring additional debt is of particular
danger as the borrower can end up in a more precarious financial position in the
future. Carrying a larger debt load and tying up assets as collateral are great
obstacles to future financial security. One example is consolidating high interest
rate credit card debt on a home equity loan, only to then charge credit card debt
right back up again. Further, any fees paid as part of the initial consolidation
are then effectively wasted, as is the opportunity for any interest savings.
what is next for borrowers that have dutifully followed all of the debt consolidation
rules, reducing total interest costs and not stretching the term of the loan or
incurring additional debt? They now enter the most important, but overlooked,
phase in becoming debt-free -- repayment.
Lower interest rates
are a great assistance to debt repayment as more of each dollar is applied to
the principal and less toward interest. With the wind at the borrower's back,
debt repayment efforts quickly snowball, reducing the debt more quickly. As more
of each payment is applied to principal and less toward interest, the balance
on which interest is charged the following month is further reduced, limiting
the interest charged the following month and accelerating the principal pay down.
This process rockets ahead if the monthly savings generated by the consolidation
is applied to the repayment effort.
Taking advantage of lower
interest rates to consolidate debt and reduce interest costs is a good move. But
it is only the first move. Borrowers must also refrain from stretching the term
and piling up additional debt, and must then engage in a diligent campaign of
debt repayment. Otherwise, you may end up on a prime time reality special.
Greg McBride is a senior financial
analyst for Bankrate.com.
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