There are at least four ways that a debt consolidation loan can go wrong. Create a plan before borrowing.
If you are juggling multiple high interest debt accounts, consolidation might be a good solution. The right debt consolidation loan could save you a lot of money in interest and simplify your finances with just one fixed monthly payment.
However, there are some important issues you should be aware of before embarking on a new loan. The wrong consolidation loan – or even the right loan taken out for the wrong reasons – could end up costing you as much or more than your original debt.
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What is debt consolidation?
The idea behind debt consolidation is simple: merge multiple loan balances into one new loan. Here are the four most common sources of loan consolidation funds:
Personal loans: A personal loan from a bank or credit union can offer a lower interest rate, allowing customers to pay off high interest balances more quickly.
Balance transfers: Credit cards often offer introductory low interest rates for balances transferred from other credit cards. They charge a fee for the service, but if the transferred balance is refunded during the promotional period, balance transfers can be a money saver.
Home equity loans (or lines of credit): With these loans, homeowners with equity use their property as collateral for a consolidation loan.
Retirement account credits: Some retirement accounts – such as 401 (k) – allow the owner to borrow money from the invested funds as long as the money is paid back according to the rules of the pension plan.
While there is nothing unusual about debt consolidation loans, here are four ways they can evolve:
1. The interest rate can stink
If your credit is strong, it is possible to score a consolidation loan with an interest rate low enough for you to take advantage of it. However, if you have a bad credit score (less than 580), you may be hit with a high interest rate.
One of the online banks that Experian suggests that people with bad credit charge an interest rate of up to 35.95%, with terms of 36 or 48 months. To put these terms in perspective, if you were to consolidate $ 20,000 in debt at 35.95% for three years, your monthly payment would be $ 916. If you opted for a four-year loan instead, those monthly payments would be $ 791.
A consolidation loan only makes sense if the interest rate on the loan is lower than the interest rates on the loans being consolidated. However …
2. Extending your repayment period can get expensive.
If your main reason for taking out a consolidation loan is for a lower monthly payment, it may be tempting to go for the longer repayment period available. The longer the repayment period, the lower the monthly payment. The problem is, the longer the repayment period, the more interest you’ll pay in the end. For example,
- Suppose you have $ 20,000 in debt at 10% interest for four years. Your current monthly payment is $ 507. After four years, you will have paid $ 4,348 in interest.
- You consolidate the loan at an 8% lower interest rate, and because you want a lower payment of $ 312, you take out a seven-year loan. At the end of seven years, you will have paid $ 6,185 in interest, which is $ 1,837 more than the higher interest four-year loan.
Go for the shortest term consolidation loan you can afford to save on interest.
3. Your warranty is at risk
Unless you are absolutely certain that you can make payments on your consolidation loan on time and in full each month, anything you use as collateral is at risk. An unpaid home equity loan can lead to foreclosure, ultimately costing you more than the original debt.
If possible, avoid a loan that requires you to use personal property as collateral.
4. A loan will not solve bad financial behavior
If the cause of your debt was beyond your control (for example, prolonged illness or job loss), it is possible to use a consolidation loan to your advantage. However, if you’ve got into debt because you tend to spend more than what you earn, push your budget to the limit each month, or refuse to budget at all, none of these issues are likely to change. simply because you have consolidated your debt. . You may have a brief honeymoon period in which you feel good about paying off high interest loans and credit cards, but the debt is still there – just in a different form.
Unless your relationship to money changes dramatically (miraculously) when you take out the consolidation loan, you risk jumping from the pan into the fire. Any new debt or mismanagement of your monthly budget will only make your financial situation worse.
A study by The Ascent on the psychological cost of debt found that 74% of people in debt had made only the minimum payment on at least one of those debts in the past month. What this tells us is that many of us live on the edge, just to get by. Unless a consolidation loan addresses the root cause of the debt, the cycle of borrowing longer than you can reasonably afford is likely to continue.
Approach your relationship with money by working with a financial and / or credit advisor.
You can avoid the problems with consolidation loans by being honest with yourself about how you handle money and taking steps to get out of debt – and stay out.