Published in: Personal Loans | Dec. 16, 2019
4 Ways Debt Consolidation Loans Can Go Wrong
By: Dana George
There are at least four ways a debt consolidation loan can go wrong. Create a plan before you borrow.
If you’re 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, as well as simplify your finances with one fixed monthly payment.
However, before you dive into a new loan, there are some important issues you should be aware of. The wrong consolidation loan -- or even the right loan taken out for the wrong reasons -- could end up costing you just as much as 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. These are the four most common sources of loan consolidation funds:
Personal loans: A personal loan through a bank or credit union may offer a lower interest rate, allowing customers to possibly pay off high-interest balances faster.
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 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 loans: Some retirement accounts -- such as 401(k)s -- allow the owner to borrow money from invested funds as long as the money is repaid according to the rules of the retirement plan.
Although there is nothing rare about debt consolidation loans, here are four ways they can go sideways:
1. The interest rate may stink
If your credit is strong, it is possible to score a consolidation loan with an interest rate low enough to benefit you. However, if you have a poor credit score (below 580), you're likely to be hit with a high interest rate.
One of the online banks Experian suggests for those with poor credit scores charges an interest rate of up to 35.95%, with terms of either 36 or 48 months. To put those terms into perspective, if you were to consolidate $20,000 worth of 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 makes sense only 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 be expensive
If your primary reason for taking out a consolidation loan is to achieve a lower monthly payment, it might be tempting to opt for the longest repayment period 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,
- Say you have $20,000 in debt at an interest rate of 10% for four years. Your current monthly payment is $507. At the end of 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. At the end of seven years you will have paid $6,185 in interest, or $1,837 more than the higher-interest four-year loan.
Opt for the shortest-term consolidation loan that you can afford in order to save on interest.
3. Your collateral is at risk
Unless you are absolutely positive 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 initial debts would have.
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, a prolonged illness or job loss), it's possible to use a consolidation loan to your benefit. However, if you racked up the debt because you tend to spend more than you earn, push your budget to the limit each month, or refuse to develop a budget at all, none of those issues is likely to change simply because you consolidated your debt. You may experience a brief honeymoon period during 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 with money profoundly (miraculously) changes upon receipt of the consolidation loan, you are likely to jump from the frying pan into the fire. Any new debt or mishandling of your monthly budget will only make your financial situation worse.
A study by The Ascent into the psychological cost of debt found that 74% of people with debt made only the minimum payment on at least one of those debts in the last month. What that tells us is that many of us are living on the edge, just getting by. Unless a consolidation loan addresses the root cause of 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 head off issues related to consolidation loans by being honest with yourself about how you deal with money and by taking steps to get out -- and stay out -- of debt.
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