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The Myth of the Debt Consolidation Loan

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Senior Contributor

The Myth of the Debt Consolidation Loan

This post is a part of my "homework" links in my signature.  I'm writing it mostly to point people this way when they make new posts about the topic of debt consolidation loans.

 

What is a debt consolidation loan?

Most people are confused about why this loan exists.  In the most basic view, a debt consolidation loan is a loan that lets you take a bunch of debt payments monthly and pay those off so you have just one payment to make.  It sounds like it's the answer to all of those many credit card and student loan payments, right?  Unfortunately, that isn't the case.

 

Who is a bad candidate for a debt consolidation loan?

Anyone who is over their heads in debt will likely be denied for this loan, even with a cosigner.  If you add up all of your minimum debt payments on all loans and credit cards (call this dollar figure "Debt") and divide it into your monthly income (call this dollar figure "Income") and the number goes above 36% or so, you will likely NOT get approved.  This is because lenders know that a lot of people who pay off credit cards with loans end up running the cards back up before the loan is paid off.  

 

Worse, if your credit cards carry high balances -- typically if any ONE credit card has a balance over 48.9% -- you will also likely get denied because it shows you didn't manage your spending well, and if they help you pay it down, you will just be right back to that point and now you also have their loan to pay.

 

So who is a great candidate for a debt consolidation loan?

Generally someone with a bunch of credit card balances that aren't very high (under 48.9% individually on every card) and someone who isn't running high total utilization on credit cards (say, under 28.9% aggregate utilization) and someone who has a loan or two they want to turn into one payment, but who also isn't overextended in terms of debt-to-income ratio.

 

What should I do if I have a lot of credit card debt at high interest?

Not get a loan.  Don't apply for one in hopes it will magically save you.

 

The only answer in this case is you just need to cut your spending by any means necessary, including cancelling cable and broadband at home, downgrading phone service, not going to restaurants at all (not even for your birthday) and throwing everything you can at those credit cards reporting over 48.9% utiization.  It's possible that bringing those down may qualify you for a loan for the remainder, so it's worth doing the math to see how much you need to pay off to bring every card individually below 48.9%, and all your cards down to below 28.9% aggregate.

 

What about crowdfunded or peer-to-peer loans like SoFi, Prosper or LendingClub?

Probably also denied if your DTI is too high and your utilization is too high.  If you do get approved, you may have a very high interest rate that may or may not save you money -- you'd have to do the math to see.  Remember that many of these types of loans include an "origination fee" so you have to factor that in.  And the higher your utilization is, the worse these loans work out if you manage to slide in with an approval.

 

To close, it's also important to know that banks have weird underwriting variances between different types of loans.  A debt consolidation loan may actually be more difficult to be approved for than a loan for a home addition -- or even for a vacation!  Why that is continues to be a secret held by the banks, but it seems that people who want $10,000 for a debt consolidation loan might get denied but if the same person asked for a vacation loan or a loan to upgrade their bathroom to a jacuzzi, they get their $10,000.  Bizarre how that works, but someone who wants to go on vacation or get a nice bathtub seems to be 'mentally' a safer bet than someone who needs $10,000 to take care of their overspending.

 

This doesn't mean you'd get approved for any other type of loan, but the odd data points exist and some banks will work with you better if you aren't using the money to be more responsible but to use the money to be more irresponsible.

Message 1 of 12
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Super Contributor

Re: The Myth of the Debt Consolidation Loan

ABCD2199 great write up and information! Thank you as I wonder about it's use and see that it is more of a convenience than a way to "bail one's self out". The comment about pay off and running the credit cards back up sure makes sense. Good info!
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Message 2 of 12
Senior Contributor

Re: The Myth of the Debt Consolidation Loan


@wrote:
ABCD2199 great write up and information! Thank you as I wonder about it's use and see that it is more of a convenience than a way to "bail one's self out". The comment about pay off and running the credit cards back up sure makes sense. Good info!

It's not as useful here on MyFico because the question doesn't get asked often, but on other forums the question is too common because of Christmas debts and people freaking out about being denied.

 

It's a confusing loan name.  It really isn't for those who need it, it's just for those who don't need it for any reason at all.

 

The best person who can use this would be someone with a 0% balance transfer where they have maybe 30% left to pay versus the limit and aren't going to get there before the 0% runs out.  Maybe that person also has 2 other cards with 15% utilization and 19% utilization and they figure might as well just roll those balances into one loan.

Message 3 of 12
Valued Contributor

Re: The Myth of the Debt Consolidation Loan

This is all so very true.

 

Prior to my BK, I can't tell you how many times I got terrible 20% personal loans thinking I was somehow fixing things while I was only making them worse.

 

9 times out of 10, it's not a consolidation loan a person needs, but instead it's a budget!

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Message 4 of 12
Regular Contributor

Re: The Myth of the Debt Consolidation Loan

This can be true. Especially for those who haven’t turned a new leaf over. Go right back to using credit cards. But people don’t just consolidate debt on credit cards. Some use it to get lower rates on loans they have. Car loans or other personal loans. It can be a great thing when used to lower interest rates while not extending payments over time. Or even to lower payments if one has say less income. They sacrifice time to make the payments smaller. I’m not a proponent of one size fits all for most things. People who raise their credit scores quickly this can be a godsend for. They can refinance their loans. No different than refinancing their house when rates go down enough. 



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Message 5 of 12
Senior Contributor

Re: The Myth of the Debt Consolidation Loan

Very true, and it can be a blessing, but sometimes it might not be.

 

I recently was working with someone in-person who had gotten a personal loan to knock out a different loan.  Their loan payment dropped from $400ish a month to $230 a month so they're "saving" $185/month on paper.  Except they're not because the $400 loan was almost paid off (14 months, maybe $5500 balance at 7% interest rate, $250 left in interest to pay) and their new loan was $5750 for 36 months at 9% interest (36 months, $5750 balance at 9% interest rate, $825 left in interest to pay).

 

After we went over their budget in my suggested 3 different ways, they were actually able to pay the original loan off much faster than 14 months with some small adjustments.  So they're going to do that now, but they also paid $250 in loan fees front-loaded.  Ouch.

 

I also know another family who refi'd their mortgage with 11 years left to pay into a 30 year note with a lower monthly payment but the interest they'll pay over time is hella higher.  And in their case, they weren't having trouble paying the original note, but they wanted more money for more Starbucks or whatever.  Lots of risk there.

Message 6 of 12
New Visitor

Re: The Myth of the Debt Consolidation Loan

We are hoping to get a mortgage on our house. We own the house free and clear now. The reason for the mortgage is to pay off credit card debts. Would you recommend that for a mortgage too, we do not tell the bank that it is for debt consolidation?

Message 7 of 12
Regular Contributor

Re: The Myth of the Debt Consolidation Loan


@Lively wrote:

We are hoping to get a mortgage on our house. We own the house free and clear now. The reason for the mortgage is to pay off credit card debts. Would you recommend that for a mortgage too, we do not tell the bank that it is for debt consolidation?


Pay off the credit card debts.  Dont put a mortgage on your paid off home.  I really wouldnt do that unless it was an absolute complete last resort.   I buy foreclosed houses at auction and I can not tell you how many times I have heard this exact story.  We wanted to consolidate debt, then they ran the cards again, or had a health issue or their kid had a health issue and now they cant pay their new mortgage and I end up with their house.  Whatever you can do, get another job for a while, sell your soul to the devil, whatever, just dont do it.  

 

Unless you are very old and are looking for a reverse mortgage and have spoken to a very specific type estate planner that can help with these types of mortgages, then you could be in a completely different situation. 


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Message 8 of 12
Valued Contributor

Re: The Myth of the Debt Consolidation Loan


@ABCD2199 

Who is a bad candidate for a debt consolidation loan?

Anyone who is over their heads in debt will likely be denied for this loan, even with a cosigner.  If you add up all of your minimum debt payments on all loans and credit cards (call this dollar figure "Debt") and divide it into your monthly income (call this dollar figure "Income") and the number goes above 36% or so, you will likely NOT get approved.  This is because lenders know that a lot of people who pay off credit cards with loans end up running the cards back up before the loan is paid off.  

 

 

 

What should I do if I have a lot of credit card debt at high interest?

Not get a loan.  Don't apply for one in hopes it will magically save you.

 

 


This is why I tell people not to take money out of their 401k to pay their credit card debts and never get a Home Equity Loan or the like to pay off credit card debts.


People think this is an easy way out. Maybe lower their monthly payment.  But what most likely will happen is you made no effort to change your ways.  You are just going to start using the credit cards again and charge up new balances as bigs as the old ones.  And now you have no 401k balance or huge mortgage with your credit card debt.  Making sacrifices is the only way that you will learn how to change your ways.

 

Now if your debt is too big to ever get out of then bankruptcy should be on the table.  But I also see people on here who declare bankrupty and the very same day are looking for credit cards.  Changins your attitude from long term outlook from short term outlook is the only way to get out of this mess.

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Message 9 of 12
Valued Contributor

Re: The Myth of the Debt Consolidation Loan


@Lively wrote:

We are hoping to get a mortgage on our house. We own the house free and clear now. The reason for the mortgage is to pay off credit card debts. Would you recommend that for a mortgage too, we do not tell the bank that it is for debt consolidation?


No No No No!!! I am not sure how strongly I can say this but never put credit card debt into your mortgage.  Credit card debt is unsecured.  If you lose your job or have an illness the credit card companies cannot take your house.  If you put the debt into a mortgage you put your house at risk.   If you don't have a mortgage you should be able to pay off your debts.  The only reason to add a mortgage to your house is to make home improvements to  your house that adds value to the house that equals  to or exceeds  the value of your loan. 

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Message 10 of 12