While there’s no easy way to get out of debt, there are strategies you can employ to streamline the process — like consolidation. The general idea here is to turn multiple debts into a single monthly payment, often by taking out another loan. There are a few other ways to consolidate, too, like transferring balances to a new credit card or signing up for a debt management program.
Consolidation, like every other debt elimination strategy, comes with a set of potential rewards and risks. Knowing these potential pitfalls ahead of time can help you anticipate and sidestep them.
So, what are the risks of debt consolidation?
Risk #1: Spending More to Consolidate
The biggest draw of consolidation is its ability to help some borrowers get out of debt for less than it would cost to manually pay it all down. How can debt consolidation loans help? If borrowers secure a lower interest rate on a loan than they’re paying on their credit card accounts, they can wipe out their debts for less. For instance, a borrower might be able to qualify for a consolidation loan with 8 percent APR, then use it to pay off their credit card quiz balances charging 18 percent APR or higher.
But notice we said, “if.” Getting a competitive interest rate depends on factors like credit scores, income, debt levels, and loan terms. It’s also important to factor in fees. Loans may carry up to 8 percent of the amount borrowed.
To avoid inadvertently spending the extra money to consolidate, use a calculator tool to estimate how much you’ll pay all expenses considered.
Risk #2: Experiencing Consequences After Missing Payments
Missing consolidation payments can trigger a variety of negative occurrences, starting with damage to your credit score. As credit scoring models consider payment history the most important factor, falling behind on payments has the potential to seriously sink your rating.
Another potential consequence here is losing any assets you put up as collateral if you pursued a secured loan rather than an unsecured one. While taking on a secured loan can make it easier to get approved and even lower interest rates, the flip side is the lender can seize the assets you offered if you do not hold up your end of the bargain.
Risk #3: Racking Up More Debt
The entire purpose of undertaking debt consolidation is to get out of debt. Paradoxically, this can actually make it even more tempting to accumulate new debt — especially when you see your credit card balances suddenly paid off.
An important component of debt consolidation is addressing both your problem debts and the behaviors contributing to them. The situation you want to avoid is chalking up new debts on your credit cards while simultaneously owing on a consolidation loan. Coming up with a workable budget and a plan to avoid overspending is a must before you consolidate, otherwise, you could find yourself in even deeper debt.
Yes, debt consolidation has some risks. There’s no guarantee it will save you money, so it’s vital to crunch the numbers ahead of time. If you miss payments, you could suffer consequences like damaged credit and repossessed assets on secured loans. And, you may even experience the unfortunate temptation to accrue new debt due to a false sense of security — which is where a spending plan becomes absolutely vital to achieving short- and long-term success. The better you know these risks, the more ready you are to decide if consolidation is the right choice.
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