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Why Debt Consolidation Usually Makes Sense
Recently, I’ve heard from a few readers asking some very general questions about consolidating their student loans. Their questions mostly boil down to the fact that they’ve heard that it’s a good idea, but they don’t really understand why. What’s the benefit of student loan consolidation – or consolidating any loans for that matter? This is a great “personal finance 101” question, the type of question I already answer sometimes for my children and I expect to answer more and more as they migrate into adulthood.
Almost always, the reason you should consolidate is so that the sum total of everything you owe over the lifetime of your loan (or loans) is as low as it can possibly be, and consolidation is often a way to lower that total. The lower the total is, the less you’re paying in interest and the more you’re keeping in your pocket.
You can figure out how much you’re going to owe in total over the course of a loan by multiplying the monthly payment by how many months are left – often this is added up for you on the statement, but you can do it easily yourself with any calculator.
Let’s start off with a straightforward example.
An Example of Consolidation
Let’s say you have two loans.
With Loan A, you still owe $10,000, the interest rate on it is 6%, and you’re going to be making payments for the next 8 years. With Loan A, you’re making payments of $131.41 every month for the next eight years, and over the course of that time, you’re going to pay back your $10,000 along with an extra $2,615.77 in interest.
With Loan B, you still owe $15,000, the interest rate on it is 5.5%, and you’re going to be making payments for the next 7 years. With Loan B, you’re making payments of $215.55 every month for the next seven years, and over the course of that time, you’re going to pay back your $15,000 along with an extra $3,106.25 in interest.
If you don’t consolidate your loans, eight years from now everything will be paid off, but you will have paid your lenders an extra $5,722.02 in interest.
Let’s say that you have an offer to consolidate those loans into a 5 year loan at 4.5% interest. This will result in a monthly payment of $466.08 a month for the next five years, which seems bad at first. After all, with things as they are now, you’re paying a total of $346.96 per month. The lower payment is better, right?
The benefit with the consolidation is that you’re actually paying off your loans three years earlier than you would otherwise. When you hit that 60 month mark with your consolidated loan, it’s done. You’ve paid it off. Better yet, you’ve only paid $2,964.53 in interest!
Here’s another way to look at it. Before consolidation, all of your payments added together would be $25,000 (how much you owe) plus $5,722.02 in interest, for a total of $30,722.02. After consolidation, all of your payments added together would be $25,000 (how much you owe) plus $2,964.53 in interest, for a total of $27,964.53. You save about $2,800 by consolidating in this example, money that stays in your pocket, and all you had to do was consolidate your loans and thus change who you’re writing the check to and how much the check is each month.
It’s worth noting that not all consolidation offers are going to wind up with such obvious benefits as this one. Some consolidation offers are barely beneficial, while others will end up costing you more in the long run.
Here’s how to figure out which is which.
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The Decision to Consolidate
The decision to consolidate should come down to two questions, both of which need a “yes” answer from you.
First, will this reduce the total amount of all payments I’ll owe on my debts? If you add up the total of all payments on the debts you’re considering consolidating, the total of all payments on the consolidation needs to be lower than that or it’s not worthwhile.
So, for each loan you have now, take the amount you pay each month and multiply it by the number of payments remaining. Add the total for each loan together.
For the consolidated loan, rely on the quote that you’re given by the lender. Take the amount of your monthly payment and multiply it by the number of payments you’ll have to make. If this number isn’t lower than what you’re already paying, it’s not a good deal.
It is very important here to include all consolidation fees in this calculation. You will sometimes be quoted pure interest rates or payments that don’t include any fees. Make sure you include all payments and fees you will owe in this calculation.
Ideally, you’ll want to aim for the lowest payment total amongst consolidation offers. If you’re going to consolidate, it’s worth getting a few quotes before you do so, and the one that has the lowest total is probably the right one for you.
However, there is a second question that’s quite important: are you able to easily make that new monthly payment? Again, if you’re facing a monthly payment that you can’t easily pay, then consolidation isn’t a good choice.
Often, the offer that gives you the lowest possible total of all payments has some of the highest possible individual payments. That’s because many of the best offers are for a much shorter term. If you consolidate twenty year loans into 10 year loans, or consolidate 10 year loans into 5 year loans, you’re almost always reducing the total amount you owe by quite a bit, but at the same time, you’re almost always raising the monthly payment – you’re just going to be making a lot fewer of those payments.
You need to make sure that if your monthly payment does go up, you can handle it. The advantage, of course, is that you’ll eliminate that loan far faster after consolidation and you’ll pay far less interest and fees in total than you were paying before. In the long run, it’s a good move provided you can handle the monthly payments.
Everyone’s finances are a little different and I can’t universally suggest how much of a monthly loan payment you can handle. You have to assess that for yourself. In general, it’s a poor idea to have your total monthly debt payments and your monthly housing costs exceed 50% of your take home pay. If you’re in that situation, you’re walking a very risky financial tightrope and you should look at moving to a lower cost housing option and hold off on consolidation for now.
What you want to aim for is the lowest total of all monthly payments where you can handle the individual monthly payments. That’s usually the best option for consolidating loans and is probably the option you should go with.