Debt consolidation can simplify multiple bills into a single monthly payment, but it’s important to remember that easier doesn’t always mean less expensive.
Whether it’s through a consolidation loan, a balance transfer credit card, or a home equity loan, you’re essentially replacing existing debts with a new one. It’s crucial to think about factors like the interest rate, fees, repayment timeline, and even your own spending habits before making that decision.
The 8 mistakes to avoid when consolidating debt
1. Consolidating without addressing the root cause of the debt
If you consistently spend more than you earn, moving your balances to a new account won’t fix the budget problem at hand. A consolidation loan isn’t going to be effective for someone who keeps overspending unless they also manage to curb their spending or find ways to increase their income.
2. Focusing solely on the monthly payment for a consolidation loan
A lower monthly payment might just mean that the lender has extended the repayment period, which can lead to paying more in interest and fees over time. The CFPB points out that longer terms may result in overall higher costs, despite a lower required monthly payment.
Additionally, fees can add to that cost. Personal loans might have various added costs like origination fees and late fees, so it’s wise to focus on the annual percentage rate (APR) and total repayment amount, rather than just the advertised interest rate.
3. Misunderstanding promotional balance transfer rates
Although many credit cards offer a 0% or low introductory rate, it’s typically only for a set time, and there can be a transfer fee involved. New purchases on the card may also come with different interest rates.
Before transferring a balance, it’s essential to calculate how much needs to be paid each month to clear the debt during the promotional term, factoring in the transfer fee. If that amount is too high for your budget, you may find yourself at the end of the promotion with lingering debt that now has a standard interest rate.
4. Converting unsecured credit card debt into home equity debt
Think carefully about turning unsecured credit card debt into a loan that’s secured by your home. A home equity loan may offer a lower rate, but you’re putting your house on the line. It’s a misconception to think that creditors can’t force the sale of your home. Plus, borrowing against your home often involves upfront costs that could negate any interest savings from paying off credit card debt.
Additionally, using home equity for consolidation reduces your available equity for emergencies. This is risky since credit cards aren’t backed by your home, while failing to repay a home equity loan could result in losing your property.
5. Not comparing options to find the best rates
Interest rates and terms can vary significantly between lenders. It’s vital to review the details and compare offers before committing. The key comparison shouldn’t just be about which lender offers the lowest monthly payment, but rather which alternative offers the most affordable overall cost while remaining manageable.
6. Accumulating more credit card debt
Consolidating doesn’t eliminate the original debt; it just moves it to a different account. If you continue to use a credit card after paying it off, you risk having both the consolidation loan and new credit card balances. Increasing your debt to manage your existing obligations could just delay the issue if you don’t keep your spending under control.
7. Assuming that paid-off credit cards should be closed immediately
While you might think destroying your credit cards is a smart move, closing a card can negatively impact your credit score. It could raise your credit utilization ratio, which is not ideal. If an open account comes with a hefty annual fee, then it might make sense to close it, but having some open, unused credit can actually benefit your credit profile.
8. Confusing debt consolidation with debt settlement
A consolidation loan generally consolidates multiple debts into one, while debt settlement usually involves negotiating reduced balances with creditors. Many who are in debt have turned to both methods; surveys indicate that about 30% of heavily indebted individuals have utilized consolidation loans, while around 27% have opted for debt settlement.
Settlement companies may suggest pausing payments while negotiating with creditors. However, this can lead to accumulating more interest and fees, potentially exposing you to collections if negotiations don’t succeed.
Steps to effectively reduce your debt
Before you go ahead with consolidation, take stock of each debt’s balance, interest rate, minimum payments, and payoff dates. Compare those figures against what the new loan would involve regarding its rate, fees, term, and total repayment. It might also be beneficial to reach out to your current creditors, as some may be willing to lower rates, waive fees, or adjust payments.
Ultimately, the actual measure for consolidation should not just be whether you’re dealing with one payment instead of several. Instead, it’s about whether the new arrangement genuinely lowers the repayment costs, fits into your budget, and comes with a strategy to avoid accumulating new debts in the future.
