4 Dangers of Debt Consolidation

Debt consolidation could make your financial problems worse if you don't recognize these risks and take steps to mitigate them.

Debt consolidation can be a great way to lower your monthly payments, reduce your interest cost, and simplify the process of paying back what you owe. But, consolidation isn't always the right choice -- and it isn't necessarily a risk-free process.

To make sure debt consolidation doesn't make your situation worse, it's important to understand the dangers so you can make an informed choice about whether consolidating your outstanding debt makes sense for you.  Here are four major risks associated with the process that you'll want to mitigate if you plan to take this approach.

1. Going deeper into debt

One of the biggest risks of consolidating debt is that you'll apply for new credit without solving spending problems that caused you to get into debt in the first place.

If you take out a personal loan or get a balance transfer card to repay existing debt, you'll now have lots of available credit on the cards you transferred the balances from. If you turn around and start charging on those cards, they could soon have high balances again -- and you'll also owe on your consolidation loan.

To avoid making this mistake, don't consolidate debt until you have a plan to avoid overspending. Make up a budget you'll live on, ideally start saving toward an emergency fund, and vow not to use your newly freed up cards for any purchases.

2. Paying more in interest

One of the biggest benefits of debt consolidation loans is that you can lower your interest rate. A personal loan or a balance transfer credit card offering 0% interest for a limited time period can all carry far lower interest rates than existing credit card debt. But, your interest rate isn't the only factor in how much interest you'll pay.

Your timeline for debt repayment also plays a big role in the total interest cost you'll incur. If you take out a debt consolidation loan and lower your monthly payments by stretching out your repayment period, your interest rate may be lower but your total costs higher since you're paying interest over such a long period of time.  

Say you owed $2,000 on a credit card at 15% interest and $3,000 on a card at 20% interest and were paying $200 a month to each card. Your debt would be paid off in 1.5 years (18 months) and you'd pay a total of $629 in interest. But, if you took a 36-month consolidation loan at 9.24% and took the full time to repay the loan, your monthly payments would drop from the $400 you were paying to $159.56.

Sounds good, but the problem is, even at the lower interest rate, your total interest cost would be much higher. That's because you'd pay interest for the 36 months it took to repay the personal loan, rather than for 1.5 years. You'd pay a total of $744 in interest, which is $115 more.

You could avoid this problem by continuing to make the same monthly payment -- or a higher one -- on the new loan used to consolidate debt. Just make sure you don't have a prepayment penalty on the consolidation loan.

3. Getting caught up in a consolidation scam

Some lenders specifically market debt consolidation loans to consumers who are struggling financially. Unfortunately, many of these loans aren't very consumer friendly. Interest charges may be very high, the loan terms may be very long, or there may be other unfavorable terms such as exorbitant penalties for a single missed payment.

You don't want to get caught up in debt consolidation scams, so research loans and lenders carefully. Compare interest rates, terms, and total loan costs and check for complaints about the lender you're working with. The Consumer Financial Protection Bureau has a helpful database of consumer complaints to use.  

Or, just stay away from these "debt consolidation lenders," and opt for a standard personal loan or balance transfer credit card instead and you won't have to worry about this problem.

4. Putting your home or retirement at risk

There are different ways to consolidate debt, including personal loans and balance transfers -- both of which can be great options to reduce your rates without taking on a lot of additional risk.

But, some borrowers will take home equity loans out to repay existing debt, or will borrow from a 401(k). Doing either of these things can be very risky because if you don't pay your loan, you'll put your home in jeopardy or get hit with a 10% penalty plus owe income tax on money withdrawn from your retirement account.

While it may seem attractive to pay a very low interest rate with a home equity loan or to pay interest to yourself with a 401(k) loan, you should think very carefully about converting unsecured credit card debt -- which doesn't have any collateral attached to it -- to one of these loans that carries such big risk.

Consolidate debt the smart way

You can consolidate debt the smart way using a credit card or personal loan, after creating a budget to avoid overspending in the future. If you take this approach, consolidation can be a great first step towards paying down your debt and improving your overall financial situation.