Here is a classic lender’s problem. You get solicited for a debt consolidation loan to reduce $35,000 in credit card debt that you ran up when you had available credit line. You earned the points, lived the high life, but all of the sudden you find that you must pay nearly four hundred dollars a month as minimum due, with a 19% APR because the free interest period passed. And, by the way, paying the minimum due will take you well into the next decade.
Enter the consolidation loan. As the Federal Reserve Bank of Cleveland points out, the consolidation loan will often be approved, but you might end up being tempted to do one of two things. Even though you were well intended, and did plan to pay off all your debt once and for all, you might be tempted to use that check to further upgrade your lifecycle. While that is somewhat reckless, what will more likely happen is that you pay off your debt, decide to keep your cards active nonetheless, then before you know it, you have that $35,000 consolidation, and now, another $35,000 in debt. $35,000 in debt quickly became $70,000 in debt
Independent of the study itself, it should not come as a surprise that online “debt consolidation” loans fail to reduce a consumer’s debt.
By design, they can be used for any purpose at all. Lenders make no effort to force the borrower to use loan proceeds to reduce other debt and, even if the borrower pays down maxed-out credit cards with loan proceeds, that only means that the borrower now has a large new “open to buy” position on his or her cards.
Given this dynamic, it is also hardly surprising that many borrowers run into credit issues after re-levering with credit cards or other borrowing.
Since many of the online lending loans get booked as P2P rather than consolidation or second mortgages, some scoring systems assume the borrower has paid his bills. With a better score, more money comes available, and away you go, more debt.
Sometimes, you just need good old fashioned discipline; ironically, if you had that discipline, you probably wouldn’t have $35,000 in debt to begin with.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group
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