There's a reason why it's best to pay off your debts smallest to largest with the debt snowball.
4 Minute ReadTopic: debt
Myth: Debt consolidation saves interest, and there’s one smaller payment.
Truth: Debt consolidation is dangerous because it only treats the symptom.
Debt consolidation is nothing more than a con because you think you're starting with a clean slate. But the truth is the debt is still there, as are the habits that caused it—you just moved it! You can’t borrow your way out of debt in the same way you can’t get out of a hole by digging out the bottom. Getting out of debt isn’t quick or easy, but it’s the first step to achieving lasting financial health.
Local experts you can trust.Find an ELP
Dave Ramsey’s trained financial coaches will never recommend debt consolidation to a client. Why? Because debt consolidation doesn’t work. Let’s find out why.Related: Read about more debt myths in Dave Ramsey’s best-selling book: The Total Money Makeover.
What Is Debt Consolidation?
So what is debt consolidation anyway? It simply means you’re taking out one loan to pay off a bunch of loans—or consolidating the debt to one payment. It’s typically considered for people who have high consumer debt.
But most of the time, after someone consolidates their debt, the debt grows back. Why? They still don’t have a game plan to pay cash and spend less. They also probably haven’t saved for all of the “unexpected events,” which will eventually become debt too. In other words, the good money habits for staying out of debt and building wealth aren’t there—their behavior hasn’t changed—so it’s extremely likely they will go right back into debt.
Debt consolidation seems appealing because, in most cases, there’s a lower interest rate on parts of the debt, and it usually includes a lower payment. But, in almost every case, the lower payment exists because the term gets extended, not because the debt is less. So if you stay in debt longer, you get a lower payment, but then you pay the lender more. Even worse, in some cases the interest rate is actually higher, meaning that you’re paying even more in the long term.
Debt Consolidation Example
Let’s say you have $30,000 in unsecured debt, including a two-year loan for $10,000 at 12%, and a four-year loan for $20,000 at 10%. Your monthly payment on the first loan is $517, and the payment on the second one is $583. That’s a total payment of $1,100 per month.
You May Also Like
The debt consolidation company says they can lower your payment to $640 per month and your interest rate to 9% by negotiating with your creditors and rolling the loans together into one. Sounds great, doesn’t it? Who wouldn’t want to pay $460 less per month in payments?
But they don’t tell you that it will now take you six years to pay off the loan. This may not sound that bad until you realize how much more you will actually pay in additional payments. You will now pay $46,080 to pay off the new loan versus $40,392 for the original loans, even with the lower interest rate of 9%. This means you paid $5,688 more for the “lower payment.” Not such a good deal after all.
The Real Way to Get Out of Debt
The answer isn’t the interest rate. It’s a complete change in how you view debt. You get out of debt by changing your habits. Commit to getting on a written game plan and sticking to it. Get an extra job to bring in more money, and start paying off the debt. Live on less than you make. And, finally, stay away from debt consolidation!
Need a plan to pay off your debt, but don't know where to start? Start with Financial Peace University! Learn More.