How Debt Consolidation Loans Work

Nobody like to be in debt. Having to owe someone something is definitely not good for your longer term financial health. Every time you make an interest payment you are taking your hard earned cash that should be going toward your future and putting it into the hands of someone that lent you money sometime in the past. This is not the road to financial freedom.

Sure, some of us have gotten into debt through various means - not all of which are terrible. Some have taken out student loans, accumulating 10s of thousands of low interest loans that put them through fours years of drinking and partying. Other had so much fun they decided to stick around for 2, 3, 4, or even 7 more years. By the end of it all they have 100s of thousands of dollars in student loan debt but at least they make $100,000 a year. Many consider this an investment in the future, and for some people that is true, but for the vast majority of people who take on student loan debt they are just trying to live high on someone else's dime. They are simply have not yet grown up.

Then there is the more traditional consumer debt that plagues the US like the Israelites plagued the Egyptians. We buy cars, go on vacations, purchase houses, eat out, buy toys, go shopping, upgrade items needlessly, and fail to think long term with out purchases. The end result is that Americans are saddled down heavily by mortgages, automobile loans, and credit card debt up the wazoo.

Most people can effectively handle their level of debt. Sure, it isn't the most financially efficient way to build wealth - but a lot of people are content with working for someone else for their entire lives doing a task that doesn't really make the world a better place. Rather than spend time with their family and friends, they would rather site at a desk and type away in a grey, lifeless cubicle. Their life energy slowly dripping out their finger tips.

This type of person - the person who can easily handle the stupid debt that they have acquired - is not the type of person who would need to take out a debt consolidation loan. If this person eventually finds out that they are living their life the wrong way then they should adopt a different debt reduction approach: the debt snowball.

The type of person than needs a debt consolidation loan is the person who is way over their head in debt. They are so maxed out, they are having trouble making their monthly payments and just barely make ends meet each month. What is worse - there debt just seems to be getting bigger and bigger with each passing month and they are getting to the point where they are just barely able to make the minimum payments on their loans and credit cards.

This person has a cash flow crisis.

Debt consolidation loans can be an effective tool in your financial arsenal for stemming the bleeding that your debt is inflicting. If you get to the point where you can't even make your monthly minimum payments, how are you ever going to get out of debt? Even now that you are pushed to the brink, what will happen if you have a medical emergency? Or your car breaks down? Or something were to happen to your home?

The fallout would be pretty severe.

So what makes a debt consolidation loan a financial instrument that can help me break free from my debt and live a life that is free from financial worries?

Well, they do two things:

1. They make it so all your payments go to one person (company)
   
2. They lower the interest rate that you pay on the amount that you owe so your monthly payment is significantly lower

Making one payment is certainly one advantage of debt consolidation loans.  Who likes having to send one check to for your auto loan, one check for your student loan, one check for two of your credit cards, one check for three more credit cards, and one check for your mortgage?  Nobody, that's who!

It can be a nightmare just trying to remember who needs  a check when and if you are late you get saddled with ridiculous late fees and finance charges that leave you paying even more to your creditors.  This is not the way to pay off debt, especially if you are having a hard time making your regular payments.  A late fee here and there can really begin to add up.

With debt consolidation you just have to worry about one payment for all those current debt obligations.  No more writing 7 checks  a month - just one to your consolidation company.

The greatest money saver by far is the reduction in interest rates that your loan is going to achieve.  Monthly payment can be cut in half depending on the loan terms that you get when consolidating.  However, it is important to note that the reduction in monthly payment may actually end up increasing the amount of money that you pay to your creditors.

Whoa, you mean that by getting a debt consolidation loan I might actually be increasing the amount of money that I will end up paying?  That just doesn't seem right!

It may not seem right, but it is the truth - debt consolidation loans generally decrease the interest rate (APR) of your debt but they also increase the term of your loans.  This increase in loan term is directly related to how much you will have pay to your creditor over the life of your loan.

Example. A Guido owes a $100 to Anthony. Ricky owes a $100 to Anthony too. Guido has a 3% interest rate and needs to make monthly payments over the next 12 months or else Anthony will break Guido's legs. Ricky has a similar interest rate (3% APY) but has a term of 36 years.

Q: Who will have the larger monthly payment?

A: Guido - he will be paying $2.90 while Ricky will be paying $8.45.

Q: Who will pay Anthony more money?

A: Ricky! Despite paying Guido more each month, over the entire life of his loan Ricky will pay Anthony the most, a whole $3.05 more than Guido ($104.43-$101.38=$3.05)

As you can see, you should only increase the term of your debt payback and get a debt consolidation loan if you are going to benefit from the cash flow savings in gives you!