The Downside to Debt Consolidation

It is hard to turn on the TV, flip through a magazine or browse the Web without seeing advertisements for debt relief services. Typically, these ads tell consumers that their monthly payments will be low, their debt will be reduced, and that the loans are no-hassle. However, lenders often gloss over the fact that lower monthly payments may be achieved through longer loan lengths, especially for those with a lot of debt who don’t qualify for lower interest rates. While longer loan terms may lower monthly payments, consumers might face a significant increase in total payments over the life of the loan.

Their vulnerable state of mind, coupled with a fear of creditors, may lead consumers to downplay the negative aspects of debt consolidation. In order to help consumers better respond to marketing tactics used by debt consolidation services, research from a professor at the Penn State Smeal College of Business suggests that improved financial literacy combining a solid understanding of both loans and lenders is needed.

Lisa Bolton, associate professor or marketing, and co-authors Paul Bloom of Duke University and Joel Cohen of the University of Florida recognize that low levels of financial literacy are a matter of increasing global concern. Although most measures of financial literacy typically focus on very basic concepts (such as understanding inflation and compound interest), consumers are increasingly pressured to make complex decisions regarding cash flow management, credit, savings and retirement, and homeownership. As the number of financial products increase as well as their complexity, basic financial literacy may be insufficient to protect consumers from being seduced by the marketing tactics of loan consolidation services.

In order to develop a solid understanding of the advantages and disadvantages of loan consolidation, consumers should educate themselves on both how and why loans work, and also how and why lenders act as they do. To investigate this issue, the researchers designed informational interventions focusing on loans and lenders and tested how consumers’ views of debt consolidation programs changed after viewing the intervention.

The loan-focused intervention explained how stretching a loan repayment over time increases total interest paid and how consumers are sometimes persuaded into taking out additional money beyond what is really needed. Furthermore, the intervention explains how, once monthly payments drop, consumers may find themselves spending more, therefore ending up in more debt. The lender-focused intervention explained that lenders are not obligated to offer the best rate for which their customers qualify, despite what most consumers mistakenly believe. The intervention emphasized that lenders act in their own self-interest because after all, they are trying to sell a product.

The results suggest consumers view debt consolidation as “get-out-of-jail-free cards.” And when provided with only basic information on APR and loan terms, consumers still fail to evaluate the loan effectively, and may even exhibit more favorable attitudes toward loan consolidation. The researchers explain that this may occur because such information given is perceived as relatively neutral, more challenging, and less immediately relevant to the consumer.

In contrast, when presented with an intervention comprising loan- and lender-focused information, consumers show improved money management intentions and loan decision-making, despite the marketing claims offering lower monthly interest rates. Findings indicate that both types of information are needed to improve consumer understanding of debt consolidation.

“Loan-focused interventions provide consumers with the knowledge to evaluate loans more appropriately,” the researchers write, “but lender-focused interventions are also needed to help consumers deal with the marketing claims made by lenders.”

The researchers believe their findings can help to create and/or improve informational intervention messages given by advocates such as credit counselors and schools. They also believe that increasing an awareness of why and how consumers are seduced by the apparent remedy of debt consolidation may increase a willingness among third parties, such as universities and large employers, to provide financial education about loan marketing. The researchers hope that lenders might re-evaluate their own marketing messages when called out by consumers for underplaying the downside of their services. Bolton and her colleagues believe that lenders may consider more balanced marketing approaches to differentiate themselves from less legitimate competitors and also to gain broader support from policymakers and regulators.

The study, “Using Loan Plus Lender Literacy Information to Combat One-Sided Marketing of Debt Consolidation Loans,” is forthcoming in the Journal of Marketing Research. Financial support for the study was provided by Smeal and the National Endowment for Financial Education (NEFE).

The video below was put together by Bolton and co-authors to help consumers better understand debt consolidation loans and lenders. The video, a co-production of the authors and the Center for Excellence in Business Education (CEBE) at Duke University's Fuqua School of Business, received financial support from the NEFE.