Consolidating loans can allow you to significantly reduce your debt payments each month, but it comes at a significant price: it will take you much longer to pay off your debt, ultimately requiring you to pay much more! Sometimes, however, it may be your only viable option. This is a guide to determining whether or not to consolidate your loans.
Step 1: List your debts
. Add up the required monthly loan payments for all of your debt. Do not include utilities but if you don’t have a mortgage and you pay rent, add in your rent. While you’re at it, list the remaining balance. If you lease a car, include the payment and treat the approximate value of the car as the balance owed.
Step 2: Calculate the percent of your income required to service the debt
. To do this, simply take the total of your monthly payments from step one and divide that into your total gross income (the amount of your combined paychecks before all the deductions your employer makes). If your month debt payments are $2,000 and your income is $5,000 then your debt service percentage is 40 percent.
Step 3: Apply the test
If your debt service is greater than 40 percent, you have a problem. It is unlikely that you can pay all of your bills each month without borrowing a bit more each month. You may not even notice it, but your mortgage balance and your car loan balance are dropping, but your credit card balances are likely rising. You may need to consolidate. If your debt service is below 40 percent, you may be miserable, but you should be able to make all of your payments without borrowing.
Step 4: Sell stuff
. If you have cars, boats, ATVs, expensive art, a second home or other assets that are not essential to life or that could be replaced with something much less expensive, consider selling those things to reduce your debt before you consider consolidating your debt. If you sell stuff to pay off debt, you will be much better off than if you consolidate.
Step 5: Apply the test again
If you sell stuff and reduce your debt, calculate your debt service again. If your debt service is below 40 percent, skip to step 7. If your debt service is above 40 percent, proceed to step 6.
Step 6: Consolidate debt
. If you have good credit and a home, it is likely that you can consolidate your debt easily and inexpensively. You can read more at FamilyHow to learn how to do it. If you don’t have good credit, it may be impossible to consolidate your debt. Working with a nonprofit consumer credit counseling agency you may be able to do something similar, but it will further damage your credit. If the total of all your debts substantially exceeds the value of your assets and isn’t mostly or entirely made up of student loans (which generally cannot be discharged in bankruptcy) you should talk to a lawyer about bankruptcy.
. Now, in order to avoid finding yourself in this pickle again, focus on not borrowing any money. Don’t buy a new car on credit. Don’t use credit cards to make purchases you can’t pay for when the bill comes. Next, apply about 1 percent of your income to your smallest remaining loan each month until it is paid off. Each month thereafter apply the 1 percent plus the amount you were required to pay on the old loan you just paid off to the next loan in order from smallest to largest. Continue that practice over the years to pay off all of your debt.
By following this process, you can quickly assess whether you are a good candidate for a loan consolidation and then focus yourself on getting out of debt. By doing so, you’ll better prepare yourself for a comfortable retirement without a lot of debt hanging over your head.
Devin Thorpe, husband, father, author of Your Mark On The World and a popular guest speaker, is a Forbes Contributor. Building on a twenty-five year career in finance and entrepreneurship that included $500 million in completed transactions, he now champions social good full time, seeking to help others succeed in their efforts to make the world a better place.