4 major risks of debt consolidation and how to avoid them
December 05, 2016
Debt consolidation is often associated with people who have gotten into financial trouble and need help finding a way out. However, debt consolidation can be a valuable process even for people whose finances have not gotten out of control. It is just a question of knowing what debt consolidation goals you want to accomplish, and what tools to use to reach those goals.
Why consider debt consolidation
In its simplest form, debt consolidation involves borrowing from one source to pay off debts from multiple other sources, but while you are changing creditors, it is also possible to change the nature of the debt so as to change interest rate terms and/or restructure the repayment schedule. This makes it possible to accomplish additional goals:
1. Organize bill paying
If you have been having trouble keeping track of your bills, using one source of credit to pay off the others can narrow down your monthly bill-paying burden, and also simplify your communications.
2. Reduce monthly payment
If your monthly debt obligations have reached the point where you are in danger of not making your payments, debt consolidation and restructuring could help lower your monthly payments and buy your budget more breathing room.
3. Lower interest rates
If interest rates have come down, or much of your debt is from high-interest credit sources, you may have an opportunity to shift that debt to a lower-interest rate source.
4. Reduce long-term interest expense
Either by reducing interest rates and/or accelerating your repayments, debt consolidation can help you reduce long-term interest expense.
You usually cannot accomplish all these goals at once through debt consolidation, but it may be possible to accomplish more than one of them. In any case, it is important to know exactly what your debt consolidation priorities are. Those priorities determine which debt consolidation tools you use, and how you apply them.
How to achieve debt consolidation
Here are four tools that can help you achieve the above goals:
1. Low-interest rate credit cards
Credit card rates vary greatly, so shop for lower-rate cards and shift debt from higher-interest cards to them. This can both simplify bill-paying and lower your interest expense.
2. Zero-interest balance credit card transfer offers
These can also be a tool for reducing credit card interest expense. However, watch out for transfer fees, and enter into these deals with a goal of paying off your balance by the time the zero-interest period wears off.
3. Personal loan
This is likely to carry a lower interest rate than credit card debt - though if you have run up too much debt, you may have trouble qualifying for a personal loan.
4. Home equity loan/cash out refinancing
Borrowing against equity in your home can often be a lower-interest source of credit. But don't put your property at risk unless you are absolutely sure you can meet the payments.
Risks of debt consolidation
Along with the possible benefits of debt consolidation come with potential traps. Here are four things to watch out for:
1. Heightened interest expense
People under financial pressure are tempted to reduce their monthly payments by spreading the debt out over a longer time. However, this is likely to result in you paying more interest in the long run. Monthly payments need to be manageable, but understand that every reduction in those payments is likely to cost you more by the time you pay off your debt.
2. Variable payment traps
People who need immediate financial relief often sign on for debt restructuring that makes immediate payments easier to meet at the expense of making future payments more onerous, wither through variable interest rates, balloon payments or both. Think through both the long and short-term consequences of any change to your debt program. Don't sign up for any restructuring unless you have a realistic plan for how to make all the payments.
3. Credit rating damage
Some actions people take to manage debt problems, from opening new credit accounts to trying to renegotiate debt terms, can have negative effects on their credit ratings and thus make debt more expensive in the future.
4. Consolidation 'help' rip-offs
Desperate for help, people in debt trouble often turn for help to predatory debt "counselors" who do more harm than good. There are legitimate, not-for-profit organizations that can provide good advice. But if someone wants to charge a fee for help with debt consolidation, advises you to stop paying certain bills or wants you to funnel all payments through them, you should steer clear of their services.
Debt consolidation should not be considered an act of desperation. In fact, the more calmly you can enter into it, the greater your chance of success.
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