Is Debt Consolidation a Good Idea?

Scrabble Series Debt

We can probably all agree that debt sucks.  Debt is a financial pit we should escape and avoid.  But often we don’t realize this until it’s too late and we’re already ensnared by its grasp.

When we find ourselves struggling with multiple high rate credit cards, car loans, and medical bills it’s easy to think that debt consolidation is the answer.  But is that really the case?

 

How does Debt Consolidation work?

Debt Consolidation is just what it sounds like.  It’s consolidating multiple individual debts into a single combined loan.  Instead of several monthly payments to multiple lenders, you now have one combined payment for all the consolidated debt.

Credit card balance transfers or Personal loans from a bank are primary examples. 

 

Is Debt Consolidation a good idea?

In theory a Debt Consolidation makes sense.  There’s a synergy to focusing on a single loan and often the new loan will carry a lower interest rate.  But does debt consolidation work?

In practice it works about as well as you do.  You see, personal finance is not always about the math.  If it were just about the math, you probably would not be in debt in the first place.  Instead, personal finance is about self-control and delayed gratification.  It’s about not making purchases until you can afford them.

The discomfort you feel as a result of so many little debts is actually good.  It gets your attention and pushes you to take action.  The key is taking the most appropriate action.  Doubling down on your payments, prioritizing debt smallest to largest, following a budget are all profound steps that come about through changes in your behavior.

On the other hand, a debt consolidation loan probably does more to self-medicate the pain than treat the underlying issue.

I recall several years ago getting a debt consolidation loan.  Again, on paper the benefit was obvious.  I consolidated most of my debt into a single loan with a lower interest rate and lower monthly payment.  And that’s the only thing that changed.  My spending patterns did not change, rather I felt empowered to continue my spending for two dumb reasons

    1. I believed that I had solved the problem
    2. I now had extra money each month as a result of the lower interest rate and monthly payments

This turned out to be pretty foolish as I found myself in an even worse position several months later.

However, that does not have to mean that Debt Consolidation is a universally bad idea.  Check the name on the site and understand that for me to write a debt consolidation blog article and not universally despise debt consolidation is somewhat blasphemous so I probably have a fine line to toe because I actually find truths on both sides of the discussion.

 

When is Debt Consolidation a Good Idea?

There are instances in which Debt Consolidation might be a good idea.  I’ll give two examples:

Debt Consolidation vs Bankruptcy – this is a no brainer.  I’ve written before here and here that I believe bankruptcy to be  a place you should be dragged kicking and screaming.  You should be forced into bankruptcy because all other options have been exhausted.  Restructuring your debt through Debt Consolidation or other Refinance vehicles are certainly options you should explore in this admittedly extreme situation.

Graduate Level, Ninja Debt Repayment – Debt consolidation should be at least the 6th step you take and only after you’ve mastered the following:  Make a Budget, Prioritize your Debt, Cut your lifestyle, Live on your budget, Progress in your Debt Repayment.  Once you are maximized your budget and experienced success, then perhaps you can squeeze a little more out of your debt snowball by consolidating debt and lowering interest rates.  But do this only with built-in accountability through automated payment systems and budget reviews with your spouse.

In most instances, by the time you’ve experienced behavior changes, the benefits (or risks) of the Debt Consolidation are not worth the efforts.  But I personally would not categorically rule it out in all cases.

 
Pros and Cons of Debt Consolidation

What are the Benefits of Debt Consolidation?

    • Immediate Relief – consolidating your debt can provide an instant relief to a strapped budget.  
    • The Math is Sound – it’s true, a lower interest rate is better than a higher one, as it relates to debt.  On paper this will help expedite your journey out of debt.
    • Consolidated is Easier – mental clutter is removed by having only a single due date to manage and payment to make.  Redundancies are removed and time saved.

What are the Cons of Debt Consolidation?

    • Numbs the Pain – Paying off your debt solves the pain while consolidating it only treats the symptom. 
    • Not a Behavioral Change – The key to your financial future lies in changing the behaviors that led to you being in debt rather than making being in debt easier to tolerate.
    • Can Lead to a Bigger Mess – learn from my experience.  I ended up in a bigger mess because I treated the symptom and not the root case.  I ended up with my consolidated debt payment AND a fresh batch of newer loans each eating away at my peace.

 

Personal Loans for Debt Consolidation

At this point, if you think Debt Consolidation is a SAFE option for you, then cruise over to my article on Peer to Peer Lending for an overview on a growing personal loan alternative that may be right for you.

 
Photo by StockMonkeys

What is Peer to Peer Lending?

e-commerce

What is Peer to Peer Lending?

Peer to Peer Lending (also referred to as Person to Person Lending, P2P Lending, or Social Lending), represents an internet enabled shift in the personal loan market place.  The easiest way to explain it is through an example.

Say our friend John wants to remodel his kitchen or payoff his high rate credit cards.  He goes to his local bank branch and applies for a personal loan with a 10% interest rate.  That’s traditional bank borrowing.While loaning funds to John at 10%, the same bank is promoting CD Rates of 1.25%.  That’s traditional bank savings.

Together, the traditional bank is profiting on the 8.75% interest rate spread, which is why the tallest buildings in your nearest downtown area are the bank buildings.

Peer to Peer Lending, as the name suggests removes the expensive bank from the equation and shares the formerly large spread with both the lender and borrower.

Again, consider that now John’s loan is funded at 7% and the lenders earn as much as 6.5% on their ‘savings’ or investment.  John is pleased with the lower rate and the lenders are pleased with their higher yields.

An important note is that many lenders are involved.  John’s loan is not coming from a single person but it’s coming from 10s or even 100s of contributors each ‘investing’ as little as $25 into the full loan.  Think about that, if John has a $10,000 loan there may be as many as 400 individual $25 contributors each participating and profiting from the transaction.

At its core, that’s how Peer to Peer lending works.  Banks are replaced with internet-based brokers or facilitators who lack the cost structure of traditional brick and mortal banks.  For their efforts they participate in the transaction but at a much lower rate.  This enables loans to be made at lower rates and returns to contributors to pay at higher rates.  Everyone Wins!  Right?

 

Benefits of P2P lending

Well, yes. That’s certainly the concept and is mostly the case.  In fact, the Benefits of Peer to Peer Lending are compelling:

  • Lower rates to borrowers
  • Higher rates to lenders than CDs or Savings Accounts
  • Facilitated or brokered transactions
  • Lenders select the loans in which they want to invest (as little as $25)
  • Borrows are screened and tiered for lender review – credit scores, loan purpose, employment record, payment history are all scored to Grade the loan similar to Bond Ratings.
  • Payments to Lenders made monthly, part principle and part interest.  Compare this to long term CDs in which there is often zero access to funds without penalty prior to the full term.
  • There is a secondary market for loans from some P2P brokers, this increases lender liquidity
  • Easy diversification across loans and loan types.

 

 

Risks of P2P lending

In fairness, there are risks related to any type of lending, even traditional banks foreclose on loans on a regular basis.

  • Non-payment.  If a borrower fails to pay, the lender will lose on that individual loan
  • Loan positions are considered investments rather than bank deposits.  They are not covered by FDIC insurance so a lender can lose money.
  • Lender plays a semi-active role in selecting loans and reinvesting their returns as compared a CD which is hands off following initial purchase.

  

P2P Borrowing

As discussed, participating in the P2P market as a borrower is also an option.  In fact, this may be an easier decision to make than lending because your immediate upside is a lower rate, assuming a strong credit rating.

The downside is that your loan may not be accepted.  The leading P2P lenders turn away far more loans than they accept, which is actually a benefit to the lender community.  However, if you carry a strong credit rating and could score a loan from a traditional bank, then you should have no problems.

 

 

Leading P2P Lending sites

Prosper and Lending Club are the leading P2P sites in the US, but there are other entrants into the market.  Here I’ll break down the leading sites.

Prosper


 Launched in 2006, headquartered in San Francisco

$447,000,000 in personal loans funded

Over 1.6 Million Members

1, 3, and 5 year terms

7 Risk Categories with yields ranging between 5.49 and 12.46%

$25 minimum loan contribution

Borrow up to $25,000

Stats as of Feb 2013

 

Lending Club

Launched in 2007, headquartered in San Francisco

$1,348,306,700 in personal loans funded

3 and 5 year terms

7 Risk Categories with yields ranging between 7.54 and 22.57%

$25 Minimum loan contribution

Borrow up to $35,000

Stats as of Feb 2013

 

While there are other emerging participants in this industry, at this time I’d only consider doing business with one of the above companies simply due to their size and duration in the market.  As the new players grow their track record they may become viable alternatives.

 

Is the P2P Market right for you?

As a Borrower, I think the decision is easy.  If you can qualify for a loan with a traditional bank, then why not shop your loan in this market too?  You really have nothing to lose.  I say that with the understanding that I’m not a fan of debt, but if you’ve made the decision to beg a loan from the bank, then you should at least give this a ride.

As a Lender, I think this could be a part of a diversification strategy.  Under no circumstances would I transfer my entire nest egg into this market.  However, if I were feeling frisky I might consider moving a small portion of my emergency fund over for the opportunity for higher yields.  For example, from a 6 month emergency fund you might consider moving .5 – 1 month over.  Similar to my recent stance on Penny Stocks, I would start out by treating this as an entertainment venture and see how it goes.

 

My Experiments with Peer to Peer Lending

I must admit that during my research I’ve become intrigued with the prospect of making a higher return on some of the funds I currently have parked in a low rate savings account.  So stay tuned as I put Prosper and Lending Club to the test.  I’ll document my experience opening the accounts, making my investment selections, and tracking my returns.   

As I document my Prosper and Lending Club experiments the links below will become active, so be sure to check back in.

 

My Lender experience with Lending Club

My Lender experience with Prosper

 

Also, I want to let you know that some of the links above are affiliate links.  That simply means that if you join Prosper or Lending Club from one of my links, I may receive – at no cost to you – a small commission.  If you choose to do this, I’d be very appreciative.

 

Peer to Peer Lending in the News

Below are links to recent news articles on Peer to Peer Lending. These are interesting reading that I recommend checking out.

 

Wiki:  Peer to Peer Lending 

Business Week: Peer to Peer Lending – No Longer Just a Curiosity

Time: Taking a Peek at Peer To Peer Lending

The Economist: Peer Review

CNN Money: Will Lending to a Friend Take Off?

Yahoo Finance:  Peer To Peer Lending: Determining The Future of Banking

Photo:  ganderssen1

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