Debt consolidation is combining outstanding loans (debt) into a single package (consolidation). The debts therefore become one “new” loan, and instead of making several small payments on the loans you used to have, you make one larger payment on the new loan.
Occasionally people ask whether debt consolidation is a good, economically constructive solution to credit card problems. Usually, the answer is that it is not. Certainly not as a solution all by itself. This article discusses some of the drawbacks of debt consolidation.
Debt Consolidation Loans
Ideally and typically—and what has made debt consolidation loans popular—the new, consolidated, loan is secured by some asset, often your home. This allows you to obtain lower interest rates. Thus consolidation, in the final analysis, is the conversion of unsecured debt into secured debt in exchange for lower interest rates. It can reduce your monthly payments considerably, and of course that could be very helpful.
It also converts “old” loans into new loans, giving them a new statute of limitations (new life for loans that could be at or near their time of expiring). Consolidating debts you haven’t paid for quite a while is probably a bad idea for this reason.
Consolidation can even turn loans with short statutes of limitations into loans with long ones. This isn’t necessarily bad, but it does increase your general level of legal risk.
Why Doesn’t Debt Consolidation “Work?”
Debt collection is seldom the solution people hope it will be. If you hare having trouble paying your bills, it won’t necessarily make your life any easier. Why?
It’s a question of risk.
As a pure financial transaction, exchanging a lower interest rate for a security arrangement can be a very reasonable decision. Why then has it been such a disaster for so many people?
Most people entering into complex financing are not able to assess risk and account for it. This is particularly true when they are under economic pressure—which they usually are when they consider debt consolidation loans. Thus people systematically underestimate the risk that they won’t be able to make the payments on the new debt.
Additionally, since most people do not really want to go far into debt in the first place, large credit card debt suggests other problems, either too little money or a tendency to overspend. These issues are more likely to be made worse by the sudden reduction of economic pressure and the sudden, apparently greater amount of money or credit available to be spent. Loan consolidation, like winning the lottery, encourages reckless spending.
The Hidden Legal Risks of Debt Consolidation
In addition to these “systemic” issues, there are two other main hidden costs of consolidation you should consider: loss of flexibility, and the nature of secured debt versus unsecured debt.
Consolidated Loans are Less Flexible
When you have ten loans for different things, from automobiles to credit cards, you have flexibility if hard times strike. If you simply cannot make your payments, you can give up some, but not all, of the things you have purchased. You can let some, but not all of the credit cards go into default.
This is certainly not a happy thing, of course, but it raises the possibility of individualized debt negotiations, debt forgiveness, or even missed statutes of limitation. Again, these are not the choices and hopes of someone in flush economic conditions, but they are real options facing many people right now.
In order for a debt collector to start garnishing your wages, it must find and sue you, must win, and then find your assets. It is an expensive and risky process for the debt collector if you fight. They sometimes drop the ball, and there are limits to how much of your wages they can garnish.
If everything else fails for you, you can declare bankruptcy, where homestead exemptions are likely to allow you to remain in your home.
The Nature of Secured Debt
The risk of debt consolidation loans is the nature of secured, versus unsecured, debt. Remember that what powers the lower payments for consolidation is the existence of security—usually your home. Your home secures the debt, and that means that if you do not make your payments on the new debt, the lender can foreclose on your home and take it away.
Foreclosures are generally “expedited” proceedings, meaning that your defenses are limited and the time for asserting them is restricted. In many states foreclosure is not even a judicial proceeding, although you have some legal rights you could assert in certain circumstances.
And what all that means is that instead of facing the prospect of years of battling over high-risk debts and questionable payoffs that could be trumped by bankruptcy, the banks can waltz into court and emerge in a very short time with your house. Put a little differently, your debt consolidation loan could make you homeless almost before you know it. And bankruptcy often, if not usually, will do nothing to protect you from it.
Anyone considering debt consolidation should think about these risks very carefully.