Ditching the borrower's burden

Question: Does it makes sense to consolidate multiple credit card or student loan debts into one umbrella loan? 

Answer: The answer of whether you should consolidate your loans depends on a cost/benefit analysis between the terms of the existing and proposed loans. 

The loan terms that deserve the greatest attention include the interest rate, number of payments (loan length), loan amortization schedule (how rapidly does the principal balance of the loan decline) and fees. Before we go further, I need to introduce two terms: productive debt and unproductive debt. 

What is the difference between productive and unproductive debt? Productive debt is used prudently to purchase appreciating assets, while unproductive debt is used to purchase items that depreciate in value. The recent decline in housing prices is a warning that even “productive” debt can be dangerous, hence the warning in Scripture: “The borrower is the slave of the lender” (Prv 22:7). With that said, it can be reasonable to use debt prudently and in productive ways.  

However, it never makes sense to borrow for unproductive purposes, and if one has made that mistake, they should set a goal of eliminating it as soon as possible. Unproductive debt should always be short term. 

Common mistakes 

With that background, we can consider the question of whether it makes sense to consolidate loans.  

If the proposed loan lowers interest rates substantively, keeps the repayment of unproductive debt short term, and preferably doesn’t use a new asset for collateral, such a consolidation may make sense.  

However, a common mistake people make when considering loan consolidation is to focus on the promise of lower monthly payments without understanding what is causing the lower payments. 

Most often when loan consolidation is being considered, the borrowers roll credit card and student loan debt into their mortgage, either through refinancing or by adding a home equity line. While the decline in housing prices has made it more difficult to obtain such financing due to reduced equity levels, borrowers continue to look to their homes for relief from other debts. 

Borrowers are often pleasantly surprised when a lender tells them how much they can lower their monthly payment. What the lender doesn’t tell them is that much of the reduced payment is a result of an extended payback schedule — often 30 years. Unfortunately, the benefit of a lower monthly payment today is such a temptation for the borrower that they put blinders on and don’t factor in that they have just turned what should be short-term debt (five years or less) into very long-term debt. 

In addition to consolidation loans often turning what should be short-term debt into long-term debt, they also allow borrowers to cover up financial problems rather than truly solve them. Borrowers need to ask why their debts were created in the first place, often a function of spending beyond their means. Many people who consolidate debts never change their underlying behavior, with the result that a few years down the road, they accumulate additional credit card debts, but no longer have sufficient equity in their home to consolidate loan balances yet again.

Tackling underlying issues 

Rather than only dealing with the symptoms of excessive debt through loan consolidation, I encourage stretched borrowers to separate their debt into productive and unproductive categories, and focus like a laser beam on eliminating their unproductive debt as rapidly as possible. 

To do so will require the development of an annual income and spending strategy that allocates sufficient resources to eliminate the unproductive debt in a time frame that you choose. It will also require changes in behavior involving sacrifices — including taking on additional work to increase income and reducing discretionary expenses until the unproductive debts are repaid. It’s painful in the short run, but leads to true financial freedom in the long run. God love you! 

Phil Lenahan is the president of Veritas Financial Ministries (VeritasFinancialMinistries.com) and the author of “7 Steps to Becoming Financially Free” (OSV, $19.95). Submit questions for columns to askphil@osv.com.