Understanding the Risks of Debt Consolidation
Kevin is a former fintech coach and financial services professional. When not on the golf course, he can be found traveling with his wife or spending time with their eight wonderful grandchildren and two cats.
At a Glance
Lenders don’t often tell borrowers about the dangers of
debt consolidation. If you fit their qualification criteria, you’re getting the loan you apply for. The terms and conditions show the interest rate, terms of repayment, and any fees you might need to pay. Some of that is in the fine print, so borrowers can easily miss it. That’s just one of several risks of debt consolidation to be aware of.
Is debt consolidation a bad idea? It can be. Like anything else in the financial world, there are pros and cons to it. The main pro is that you can pay off high-interest credit card debt. Unfortunately, though, you might end up paying more out of pocket to do that. We’ll review some of the risks of debt consolidation and how you can avoid them.
In this article, you’ll find:
Lower Interest Rates Don’t Always Equal Savings
Trading high interest rates on credit cards for a lower interest debt consolidation loan seems like a good idea but beware of oversimplification. Interest is charged on outstanding balances throughout the life of the loan or credit card. Paying a high-interest card off in two years may cost you less than stretching that balance to five years with a lower-interest loan.
Of course, your monthly payments will be lower. That’s what is usually highlighted at the top of the list when lenders discuss debt consolidation advantages and disadvantages. They don’t want you to look at consolidation risk. Ask what the total payout will be for the life of the loan. Then compare it to a similar payoff program with your credit card company.
Other variables to consider here are the loan origination fees and annual fees. These should be added to the total debt payoff number. The sum of those plus the interest plus the principal amount borrowed may change your mind about going this route. Debt consolidation is not a good option if you’re not going to save any money by doing it.
Debt Consolidation Doesn’t Always Solve Your Problem
The problem isn’t that you need money to pay off debt, it’s how you got into debt in the first place. One of the requirements for debt consolidation should be a change in spending behaviors or a course in personal finance. If you borrow money to pay off credit cards and don’t stop using your credit cards, you’re going to double your debt, not eliminate it.
A failure to recognize this leaves the borrower vulnerable to any number of loan payoff scams that can be found online. Some of them promote themselves as debt consolidation “services.” Those are more likely to be debt settlement agencies. A settlement agency will have you make monthly payments to them, but they won’t pay your cards off. Their job is to settle for less than what’s owed.
Some lenders are also not legitimate. Make sure that whoever you get your debt consolidation loan from is FDIC insured with a good track record. Check the interest rate for conformity to industry and banking standards. Most importantly, read the terms and conditions thoroughly before signing anything. That’s how to avoid getting burnt.
Debt Consolidation Doesn’t Always Help Your Credit
Think of debt consolidation as using a can of fix-a-flat on a damaged tire. Eventually, you’ll need to replace the tire. Debt consolidation is only a temporary solution if you don’t correct the behaviors that got you into debt in the first place.
Debt consolidation can ruin your credit if you don’t change your spending habits. Taking on a loan increases your credit utilization. Failing to pay off your credit cards or paying them and then using them again will keep that utilization rate high. A high utilization rate will lower your credit score.
Your primary objective should be to lower the amount of money you owe in debt, eventually eliminating it completely. If you borrow to pay off existing debt, then run up new debt while paying off the loan, that does not achieve your objective.
Are the Risks of Debt Consolidation Worth It?
Debt consolidation can help you become debt free and improve your credit, but only if you make a commitment to stop accumulating new debt. Understand that if you don’t do this, you could hurt your credit score. These are the risks involved with debt consolidation.