The Truth about Debt Consolidation Programs

Debt Consolidation Programs

Under the right circumstances, debt consolidation programs can provide an excellent tool to help a family through a short-term economic crisis, and protect their credit scores.

When Debt Consolidation Programs Really Help

Consider the case of a young family with a mortgage, two student loans, a paid off car, and three credit cards. Over the years they have learned to budget their combined incomes carefully. They’ve set up automatic withdrawals from their checking account to meet monthly mortgage and student loan payments, and carefully schedule payments on the three credit cards to avoid late payment charges. They’ve also set aside money each month for savings so that they have the equivalent of three months household expenses in a savings account, and long term retirement savings accumulating in IRAs. They check their credit reports at least once a year, and have each brought their credit scores up to the high 700s

Then, all in the same month, the transmission on their car needs to be replaced, a pipe leading to a second-floor bathroom starts to leak, and a child’s illness requires that one of the parents take unpaid leave to stay home for over a week.

Rather than dipping into their savings account, they use their credit cards to pay for needed repairs and make up for the short-term lack of income. The result is that one of their credit cards reaches its credit limit, and the balances on the other two become so high that paying them all back down to zero will take months. They face the risk of both incurring substantial interest charges, and potentially damaging their credit scores. Aware of these potential problems, the couple heads immediately to the loan officer at their local bank. The loan officer suggests paying off the three credit cards with a secured two-year installment loan with no prepayment penalty. Security for the loan is provided by the couple’s savings account. Because the loan officer realizes that the couple would qualify for debt consolidation programs offered by any other bank or credit union, he offers the lowest available interest rate in order to secure their business.

The low interest rate and extended payment terms allow the family to continue their normal conservative use of their credit cards, and still make payments on their installment loan well above the required minimum monthly amount. In less than a year, the debt consolidation loan is paid in full, and the couple’s credit reports are stronger than ever.

Debt Consolidation Programs Don’t Always Work That Well

Consider the case of a second family. Though the combined family income of the second couple is actually higher than that of the first family, their ability to take advantage of debt consolidation programs is quite different for a number of reasons:

  • Unlike the first family, they have never sat down to develop a family budget to guide their spending, resulting in a high level of “impulse spending”;
  • Unlike the first family, they have not bothered to set up automatic payment systems for monthly bills that are the same month after month;
  • Unlike the first family, they have no regularly scheduled time of the month set aside for bill paying, and as a consequence have accidentally incurred late payment charges that have been reported to credit rating agencies;
  • Unlike the first family, they have not yet gotten around to opening a savings account or IRAs for their retirement years;
  • Because they have never checked their credit reports. They are unaware that their credit scores have been badly damaged by late payments and by allowing credit card balances to remain at high levels relative to each card’s credit limit credit;
  • And, because their higher income level has always allowed them to “muddle through” previous rough patches, they take no immediate action when confronted with the same set of misfortunes as the first couple. They depend instead on cash advances from the remaining available credit on their three credit cards.

When one of their credit card issuers notifies them that their credit limit will be lowered in 45 days, they suddenly realize that they have a serious problem which is about to become much worse. They have heard about debt consolidation programs, and see such a program as a way out of their current dilemma. Like the first couple, they head first to their local bank. They complete an application for the amount needed to consolidate their credit card debts, but to their surprise, they are turned down by the bank because their credit scores are below the threshold that is acceptable to the bank.

Feeling both frustrated and humiliated, the take no further action until they notice an advertisement included in their mail that promises them a quick solution to their debt problems – regardless of their credit scores and history. Since that’s exactly the kind of solution they desperately need, they submit the required forms. The loan they are offered comes with a much higher interest rate than they were anticipating, and must be secured with a lean against their home. Since the loan has a 60 month repayment period, the monthly payments are actually quite manageable, even though the total of all 60 payments is much higher than the current balances on their credit cards. At least all of their credit cards now have zero balances. You can imagine what happens next.

Final Thoughts

Debt consolidation programs can help you manage your family’s finances through a crisis situation. For them to do so, however, requires both having your financial “house in order”, and taking action early when a crisis occurs. Do you and your spouse have an agreed-upon family budget that controls impulse purchases and provides for developing a sufficiently large savings account? Do you and your spouse know what your credit scores are, and do you take the time to periodically review your credit reports? If you can’t confidently answer both of those questions in the affirmative, spending the time to seek help from a qualified credit counseling organization could be the most important investment you ever make.