There are at least four ways a debt consolidation loan can go wrong. Create a plan before borrowing.
If you’re juggling multiple accounts of high-interest debt, 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 one fixed monthly payment.
However, before embarking on a new loan, you should be aware of some important issues. 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.
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 may offer a lower interest rate, allowing customers to pay off high-interest balances more quickly.
Balance transfers: Credit cards often offer low interest introductory rates for balances transferred from other credit cards. They charge a fee for the service, but if the transferred balance is paid off within 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 Loans: Some retirement accounts — such as 401(k)s — allow the owner to borrow money against invested funds as long as the money is repaid according to the rules of the retirement plan.
While there’s nothing uncommon about debt consolidation loans, here are four ways they can go sideways:
1. The interest rate can stink
If your credit is strong, it is possible to take out a consolidation loan with an interest rate low enough to benefit you. However, if you have a bad credit score (below 580), you may be hit with a high interest rate.
One of the online banks Experian suggests people with bad credit to charge an interest rate of up to 35.95%, with terms of 36 or 48 months. To put these terms into perspective, if you were to consolidate $20,000 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 consolidated loans. Nevertheless …
2. Extending your repayment period can be expensive
If your main reason for taking out a consolidation loan is to get a lower monthly payment, it may be tempting to opt for the longer repayment term offered. The longer the repayment period, the lower the monthly payment. The problem is that the longer the repayment period, the more interest you will ultimately pay. For example,
- Let’s say you owe $20,000 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 a lower interest rate of 8%, and since you want a lower payment of $312, you take out a seven-year loan. After 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 your consolidation loan payments on time and in full each month, anything you use as collateral is at risk. An unpaid home equity loan can lead to foreclosure, which will ultimately cost you more than the original debts.
If possible, avoid a loan that requires you to use personal property as collateral.
4. A Loan Won’t Fix 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 accumulated debt because you tend to spend more than you earn, push your budget to the limit every month, or refuse to budget at all, none of these issues will likely change just because you have consolidated your debt. . You may have a brief honeymoon period where you feel good about paying off high interest loans and credit cards, but the debt is still there, but in a different form. .
Unless your relationship with money changes profoundly (miraculously) upon receiving the consolidation loan, you risk jumping from the frying 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 only made 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 more than you can reasonably afford is likely to continue.
Address your relationship with money by working with a financial and/or credit counselor.
You can avoid problems with consolidation loans by being honest with yourself about how you handle money and taking steps to get yourself out of debt.
The Ascent’s Best Personal Loans for 2022
The Ascent team has scoured the market to bring you a shortlist of the best personal loan providers. Whether you’re looking to pay off debt faster by lowering your interest rate or need extra money to make a big purchase, these top picks can help you reach your financial goals. Click here for the full rundown of The Ascent’s top picks.