Debt Consolidation Loans:
“Get Out of Jail Free” Cards
for Consumers?
Lisa E. Bolton, Ph.D., The Pennsylvania State University
Paul N. Bloom, Ph.D., Duke University
Joel B. Cohen, Ph.D., University of Florida
The full report entitled “Helping Consumers Respond Responsibly to the
Advertising and Availability of Debt Consolidation Loans” is available at
www.nefe.org/research.
©2013 National Endowment for Financial Education. All rights reserved.
Consumer Debt
in the United States
Carrying debt is a familiar but often unwanted burden for most Americans.
At the end of 2012, consumer debt totaled $11.34 trillion1 and the per
capita share of the total consumer debt balance was approximately
$36,000.
Certainly many families are able to meet their financial obligations and
repay their credit cards, mortgages, student loans, and other debts in a
timely manner. Many, however, are not.
The magnitude of overdue debt continues to hover near its peak. About
8.6 percent of consumer debt ­— $978 billion — was in some stage of
delinquency (overdue 30 days or more).2 Although total household
delinquency rates are trending slightly downward from the recent high
of 11.9 percent in 2009, they still are far higher than the 4.0 percent rate
enjoyed in 2003.
American households are stressed by large debt loads: 14.7 percent of U.S.
families had debt exceeding 40 percent of their income. Among America’s
poorest families it is even worse: one in four had debt exceeding 40
percent of their income.3
Federal Reserve Bank of New York, “Quarterly Report on Household Debt and Credit,” February 2013, http://www.newyorkfed.org/research/
national_economy/householdcredit/DistrictReport_Q42012.pdf
1
Federal Reserve Bank of New York, “Quarterly Report on Household Debt and Credit,” February 2013, http://www.newyorkfed.org/research/
national_economy/householdcredit/DistrictReport_Q42012.pdf
2
Board of Governors of the Federal Reserve System, “2007 Survey of Consumer Finances,” February 2009, http://www.federalreserve.gov/pubs/oss/
oss2/2007/scf2007home.html. Cited in the U.S. Census Bureau’s “Statistical Abstract of the United States: 2012,” p. 735, http://www.census.gov/
compendia/statab/2012/tables/12s1174.pdf. These are the most recent statistics available as of this writing.
3
2
What are debt consolidation loans?
Debt Consolitation Loans (DCLs) are marketed as a financial remedy for
consumers faced with mounting debt that they cannot pay each month.
The Bottom Line:
Debt consolidation
increases the time you
take to pay off your debt,
and that dramatically
increases your interest!
With a DCL, a consumer’s multiple debts are combined into a single loan.
Typically, these loans have a longer loan term, resulting in a lower monthly
payment for the consumer. Sometimes these loans also have a lower interest
rate. What many borrowers do not realize is that the stretching out of the loan
term leaves them with a greater overall debt burden, which must be endured
for a longer time.
Who Uses DCLs
Summary of Research Findings
Researchers in the financial capability field studied what effects debt
Financial pressures, illness,
consolidation loans (DCLs) and the marketing of such loans had on
and overspending contribute to
borrowers. A multi-phase study funded by the National Endowment
household debt that eventually
for Financial Education® (NEFE®)found:
exceeds the family’s ability to make
payments. DCLs often are viewed
as an easy solution to an immediate
crisis or as a way to combat
overwhelming feelings of financial
stress or hopelessness, particularly
in low-income households with few
other options.
When consumers use them as “get
out of jail free” cards, however,
• The DCL “boomerang”: borrowers who have used DCLs are
more likely to view them as “get out of jail free” cards and
subsequently incur more debt.
• DCL marketing messages appear to have widespread effects:
consumers who know DCLs are available are more likely to
consider higher credit card limits and holding multiple credit
cards acceptable rules of thumb.
• An intervention that is both loan- and lender-focused is more
successful than either one alone to improve consumer knowledge
and intentions.
• The dual-focused intervention reduces the likelihood of
consumers favoring or trying DCLs.
such products can contribute to
an undesirable debt/repayment
pattern that undermines household
financial stability. The way these
Lisa E. Bolton, Ph.D., The Pennsylvania State University; Paul N. Bloom,
Ph.D., Duke University; and Joel B. Cohen, Ph.D., University of Florida,
conducted the study, which began in 2008 and was completed in 2011.
products typically are marketed also
can lead uninformed consumers
into unwise and costly dept
repayment decisions.
1
Effects of DCL Marketing
Whether they have turned to DCLs out of desperation or deliberation,
borrowers are attracted to benefits such as:
The way DCLs are marketed
(particularly to low-income
households with few other
options), can lead uniformed
consumers into unwise and costly
debt repayment decisions.
Short-term relief of their cash flow situation
Lower monthly payments
Convenience of one payment instead of several payments
No need to keep track of minimum payment amounts for
multiple credit cards
• Reduction in calls and hounding from creditors
•
•
•
•
The researchers’ initial qualitative
However, DCLs are not a good choice for most borrowers because of potential
analysis found few advertisements
pitfalls such as:
that mentioned higher interest
or longer term loans; instead,
the majority emphasized lower
monthly payments and made
“hassle-free” claims.
• Encouragement to pull cash out of the transaction, further increasing
the overall debt obligation and total interest paid
• Inclusion of hidden fees and penalties not detailed in the
advertisements
• Converting the debt from unsecured (such as credit card and student
loans) to secured, using the home or other assets as collateral
• Higher interest rates due to borrowers’ inability to qualify for advertised
low rates
• Damage to borrowers’ credit rating
• Subsequent interest rate increases on borrowers’ credit cards
• Loans that turn out to be difficult-to-terminate scams or bad deals if not
shopped for carefully
2
“Rules of Thumb” by Consumers Exposed to DCL Ads
#1 Having more than one credit card is okay
When DCLs
are available
65% say NO
When DCLs are
not available
73% say NO
#2 Maximum card limits over $1,000 are okay
When DCLs
are available
26% say NO
When DCLs are
not available
39% say NO
Results: When DCLs are available, more consumers think it is okay to have multiple credit cards and card limits over $1,000.
The DCL
“Boomerang”
The experimental results suggested that the promotion and availability of
DCLs causes consumers to be more likely to treat these loans as potential
“get out of jail free” cards that would allow them to continue their heavy
borrowing. They viewed debt consolidation as a future “easier” way out of
their credit dilemma and/or as a way to further increase their borrowing.
The net effect is a form of moral hazard or risk compensation: Why avoid
risk if a remedy exists to take care of the problem?
The DCL messages also appear to have widespread effects on consumer
beliefs and intentions. As their current problem credit card status
increased4, consumers exposed to DCL messages were more likely to
“Believing that debt
consolidation loans
are easy to get and
conveniently available
can actually lead
consumers to avoid
taking actions needed
to reduce debt, such as
cutting back on credit
card use and setting up a
workable budget.”
– Joel Cohen, researcher
judge various risks as less severe and were less likely to engage in financial
behaviors that reduce risk. The availability of DCLs also increases the
number of credit cards and the dollar limit on credit cards that consumers
believe are a good rule of thumb, irrespective of education and income.
As measured by self-report of risky credit card behaviors such as delinquency on current accounts
4
3
Counteracting the Effects of
DCL Advertising
Consumers Need Two
Types of Literacy
1. Loan literacy: how and why
Next the researchers focused on developing an information-
loans work, their advantages and
based intervention to help consumers better understand
disadvantages (e.g., the relationship
DCLs, particularly their risks and drawbacks. Results of the
between APR, loan lengths, monthly
preceding experiments provided some evidence that warning
payments, and total interest paid).
messages mitigate the boomerang effect of DCL marketing.
Provides information helpful for
The research team also pointed to the importance of creating
evaluating specific loans.
combined loan literacy and lender literacy (not one without
the other), for increasing the intentions of consumers to
manage their money wisely.
2. Lender literacy: how and why
particular lenders act as they do.
Provides information to help increase
Many people mistakenly believe that lenders are obligated to
scrutiny of lenders and their claims.
give consumers the best interest rate for which they qualify,
and that lenders approve only loans that the consumer
can afford to repay. Lender literacy educates consumers
that lenders are sellers who act in the best interest of the
organization they represent, and lenders often approve more
debt than the consumer can handle.
4
Testing Solutions:
The Video Intervention
The researchers tested a nine-minute video
presentation they created that covered both loan
and lender literacy, and found positive effects
on consumers’ intentions and risk perceptions.
For comparison, they provided basic financial
numeracy education to a separate set of
consumers and designated a third set as a control
group that received no intervention.
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5 years:
total interest
$5,500
10 years:
total interest
$19,000
Consumers Have More Positive Intentions After Seeing the Video
Consumers exposed to the
loan-and-lender-focused video
showed better intentions of
engaging in positive money
management, including being
more likely to save, avoid debt,
and budget finances carefully.
They also reported having a better
understanding of the importance
of the total amount of interest paid
when making loan decisions.
Self-Reported Intentions to Engage in Positive Behaviors
Ranked from 1 (least likely) to 7 (most likely)
Consumers Show Less Favor for DCLs After Seeing the Video
Consumers exposed to the loanand-lender-focused video also
showed a reduced likelihood of
favoring or trying DCLs.
Self-Reported Likelihood to Favor or Try DCLs
Ranked from 1 (negative) to 7 (positive)
6
Implications for Consumers
and Financial Education Practitioners
4
Tips for Understanding
Debt Consolidation Loans
1.
1. Weigh the downsides. Longer
Consumers in serious financial difficulty who are considering
DCLs may be vulnerable to current promotional practices,
especially if they are not very financially knowledgeable. Before
making any decision about DCLs, consumers – and the counselors
and practitioners who may be helping them –
should first explore other options to relieve
financial stress.
loan terms may decrease your
monthly payments, but they
increase the total amount of
interest you will pay over the
life of the loan. In addition, you
might incur hidden fees and
penalties.
2. Know the seller. Lenders are not
2.
obligated to give you the best
rate for which you qualify, so
4-Step Action Plan
1 Re-examine your current situation.
shop around and look carefully
at the terms. Also, just because
he or she is willing to sell you
a loan doesn’t mean you can
afford it.
3. Avoid the slippery slope.
3.
Don’t fall into the trap of
increasing the amount of a debt
consolidation loan to finance
additional purchases. You will
unnecessarily increase your
monthly payment and boost
your overall debt.
4. Establish a plan. The best way
4.
to get out of debt is to create a
financial plan and stick with it,
and to live within your means.
Is there a way you can make your existing debt payments
with your current income and expenses? When you know
the specific details of your finances you can make decisions
based on all the information available to you, rather than
reacting to overwhelming feelings of stress or hopelessness.
• List your monthly income, expenses, and debt. Use
paycheck stubs, bills, and statements for accuracy. Keep
a diary to track your spending.
• List 12 months of your income, expenses, and debt. Include
sporadic items such as income tax refunds, anticipated
holiday expenses, semiannual auto insurance payments, and
unexpected costs such as car repairs or medical emergencies.
• Do you have enough income to cover your expenses
and debt payments? Can you increase income, reduce
spending, or temporarily defer expenses in order to afford
your current debt payments? How much is the difference
between what you have and what you need for the year?
7
4-Step Action Plan continued
2
Examine lower-risk, more affordable
borrowing options first.
• Traditional bank and credit union loans
• Home equity loans
• Loans from family or friends
• Retirement plan loans
Compare loan terms (interest rate, monthly payment, length of loan,
collateral requirements) to evaluate which option is best for your
particular situation. Use an online “loan repayment” calculator to
test financial scenarios for each potential loan to help make the
decision. Consider other consequences related to these options, such
as putting your house in jeopardy for a home equity loan, or harming
personal relationships by borrowing from family and friends.
3
5
Questions to Ask a
Debt Consolidation
Loan Lender
1. Is there a fee to apply for
1.
this loan?
2. What is the interest rate,
2.
term, monthly payment,
and total amount of interest
paid?
3. What collateral is required
3.
Research debt consolidation loans and
compare them to your other borrowing options.
Financially stressed consumers with no other options may find
that DCLs are the only way to relieve the immediate crisis. In this
situation, consumers can arm themselves with basic facts about debt
consolidation loans and lenders in order to fully understand the
consequences of choosing this type of loan and a specific lender that
is best for them.
• Watch the “Facts About Debt Consolidation Loans” video for a
straightforward, understandable explanation of loans and lenders.
• Review “4 Tips for Understanding Debt Consolidation Loans.”
(previous page)
• Review “5 Questions to Ask a Debt Consolidation Loan Lender.”
(above)
• Collect information on at least three debt consolidation loan
offerings available to you.
• Compare the DCL loan terms to your other borrowing options to
determine the best solution for you.
• Seek advice from a trustworthy professional, advisor, or other
source as needed. Paying a small fee for professional advice may
prevent you from making a costly mistake with a DCL.
for this loan? What fees or
paperwork is required for
the collateral?
4.
4. Is there a pre-payment
penalty?
5. How does your firm make
5.
money on this loan?
View “Facts About
Debt Conslidation
Loans” video or
download it here:
www.nefe.org/research.
8
Financial educators,
particularly those
working with adults in
community settings (credit
counselors, schools,
churches, libraries, etc.),
can use the successful
video intervention and
research findings to help
their learners understand
and navigate their loan
options. Include DCLs as
a module in your program
or guide your counseling
clients through the
materials on an individual
basis. NEFE provides a free
workshop and resources
on this topic for your use:
www.financialworkshopkits.org.
4-Step Action Plan continued
4
Plan for financial recovery.
Once the immediate crisis has been addressed, consumers
can begin to make a plan to restore balance in their household
finances. The best recovery from – and the best prevention for –
DCLs is to make a budget or spending plan, use it consistently,
and update it as your financial circumstances change.
Additional Resources:
A good start to learning about DCLs is watching the intervention
video developed by this study’s researchers at www.nefe.org/research.
NEFE’s Smart About Money website provides a series of articles
on credit, debt, DCLs, and other repayment options, as well as
numerous other resources to help individuals and families manage
their household finances. Resources address financial goal setting,
setting up a spending plan, getting out of debt, and using a checking
account and credit card at www.smartaboutmoney.org.
9
www.nefe.org
©2013 National Endowment for Financial Education. All rights reserved.