4 Debt Consolidation Traps to Avoid
Debt consolidation loans are like a politician during an election year--they make a lot of promises, but don't always deliver. They promise lower monthly payments, lower interest rates and the convenience of a single payment. For many, however, the reality is high fees, greater debt and potentially more interest payments.
If you're drowning in a world of high-interest credit card debt, a debt consolidation loan could help you reduce your monthly payments and pay down debt more quickly. But when debt consolidation becomes something that masks the underlying issue instead of fixing it, you could make things worse.
Here are four signs that a debt consolidation loan may drown your finances:
If you use debt consolidation as a cure-all. If the ultimate goal is to climb out of debt, consolidation loans don't have a good track record. Estimates suggest that at least 70 percent of those who consolidate their debt end up with as much or more debt a few years later. For example, one might consolidate credit card debt into a single loan, only to max out the credit cards with the newly found available credit. Think of it as yo-yo dieting, only with debt.
Why does this happen? Because getting a debt consolidation loan to make your payments more manageable doesn't require you to change your behavior. It's similar to losing weight with a dieting pill; if you don't also adjust your eating habits, you'll probably pack the pounds back on once you quit using the pill.
This isn't to say consolidation loans are bad. They can be useful tools for managing and paying off. However, they'll only work over the long term if you can be financially disciplined enough to change your lifestyle so that you don't go into debt again.
If you rely on an expensive consolidation service. Consolidation loan services, in truth, don't do much that you can't do yourself. And they'll often require hefty fees for their services: either in interest, in up-front fees or in monthly fees when you run your payments through them. Sometimes, such services are a good idea, but not if they're going to cost you more money in the long run.
You're probably better off looking into debt consolidation options on your own. You could move your high-interest credit card debts to a no- or low-interest option, take out a home equity loan or possibly get an unsecured line of credit.
As with most things in life, when you take out the middleman, the costs go down. If you are considering using a debt consolidation company, try to work out your debt problem in other ways before opting for a potentially expensive loan.
If you wind up paying more interest over time. This is one hidden problem with debt consolidation loans. While you may lower your monthly payments, those payments often come at a cost--more interest payments. The lower monthly payment may be the result of extending your payments out over more years; it's like getting a 7-year car loan rather than a 3-year loan. You'll pay less each month, but your total interest payments will be a lot higher. That's true even if your consolidation loan lowers your interest rate.
If you have high credit card or other debt payments, you may be more motivated to pay them down one by one--a plan that will leave you with huge interest savings over time. If, on the other hand, you consolidate your loans so that your monthly payment is less worrisome, you may just make minimum payments. Again, this leaves you paying a great deal of more interest over the life of the loan.
You can use an online calculator to determine how much loan consolidation will cost or save you in interest and decide whether this is the right debt payoff strategy for you.
If you put your house on the line. Here's where debt consolidation can cause serious problems. Consolidating your debt onto a home equity loan or line of credit--while a reasonable approach in some cases--puts your home at risk.
If you use a home equity loan, line of credit or cash-out refinance to consolidate your debts, recognize you are guaranteeing the loan with the pink slip to your home. It may seem like a good idea--especially with today's incredibly low interest rates, but you're going from unsecured debt to debt that's secured by your most important asset: your home.
If you're considering leveraging your home's equity to consolidate credit card debt at a lower interest rate, make sure you can make this extra payment. Also, make sure you still have at least 20 percent equity in your home by the time you take out your line of credit or second mortgage. If you default on the loan, you're at risk of foreclosure--just like if you defaulted on your original mortgage.
Take these factors into consideration before deciding whether one of these debt consolidation loans is right for you.
Rob Berger is a trial attorney and the founder of the popular personal finance blog, the Dough Roller, where he covers topics ranging from investing to zero percent interest credit cards.
