Get the Lowdown Before You Consolidates

Physician's Money DigestJanuary31 2003
Volume 10
Issue 2

With interest rates so low,many consumers are consolidatingtheir loans andcredit cards. And while consolidationcan be a good strategy, it's importantconsumers are aware of its dangers.If you're not careful, you couldfind yourself paying higher interestcharges or racking up bad credit. Sobefore rushing out to consolidate, it'sa good idea to figure out whether it'syour best option. If you decide it is,make sure you realize that how youconsolidate is just as important aswhy—and proceed carefully.


First, don't confuse loan consolidationwith debt consolidation. Debtconsolidation programs are designedfor people with severe debt problems.The debt consolidation service renegotiatesloan terms with creditors, andconsolidates the loans into a singlepayment through the debt service.Debt consolidation programscan hurt your credit rating.

Loan consolidations are generallyavailable only to people with goodcredit. And they take many forms.Among the most common loan consolidationsare home equity loans,home equity lines of credit, "cashout"home refinancing, student loanconsolidation programs, and personalloans through financial institutions.


Don't confuse lower paymentswith lower rates. Just because themonthly payments for a consolidatedloan are lower doesn't mean you'reactually paying lower interest rates.This is especially true with plansoffered by some debt consolidationprograms. The lower monthly paymentsoccur because the consolidationstretches out the life of the loan.

A similar mistake is transferringlower-interest-rate loans into a higher-interest-rate consolidation loan.To make bill paying easier, andbecause most loans can benefit fromconsolidation, a person may consolidateall of their loans. Yet, 1 or moreof the original loans may actuallyhave lower rates.

Undoubtedly the biggest mistakeconsumers make is when they confuselower monthly consolidationpayments with saving overall financecharges. The college loan consolidationprogram, offering its lowestinterest rates in history, illustratesthis point. Graduating students typicallyend up with multiple loans frommultiple lenders, so consolidationmakes paying easier. And the consolidationrates typically are lower thanthe rates for the original loans.

But there's a catch that escapesthe attention of many graduates: totalinterest payments. Say you have$20,000 in student loans. In 1 examplefrom a commercial lender, a consolidationloan would cost the student$222 a month for 10 years. Totalinterest payments would be $6644.The student could lower that monthlypayment to $143 a month by payingoff the loan over 20 years—tempting considering the tight budgetsof students just out of school.Yet, the total interest payments overthe life of the loan would be $14,389.



This same catch applies to otherloans as well. For example, a consumerwho consolidates their 5-yearcar loan into a 15-year refinancedmortgage or 10-year home equityloan may get more than they bargainedfor. Even at lower rates, they'llprobably pay more in interest for thecar than if they'd stuck with the originalloan, or refinanced the car loanitself for a 5-year period. Be sureyou consolidate a loan for no longerthan the period of the original loan.

In addition, by consolidating theircar loan into a refinanced mortgageor home equity loan, they're transferringmore loan risk to their home.And home bankruptcies right noware among the highest in history. Aworse situation occurs when peopleconsolidate their credit cards into ahome equity loan. By doing this,they're transferring unsecured debt tosecured debt—not a very good idea.

Hence, sometimes the best strategyis to live with the higher rates andpay the loans off faster with moneysaved either from earning extra incomeor by cutting expenses. However,if you're convinced consolidatingmight be a good idea, before youconsolidate, first make sure you'redisciplined. This may sound silly, butit's imperative you have discipline ifyou're going to benefit from consolidating.It's not uncommon for peopleto consolidate multiple loans, lowertheir overall interest rates and payments,and then go out and rack upnew debt—defeating the entire purposeof consolidation.

This column is produced by the Financial

Planning Association (, the

membership organization for the financial

planning community.

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