Christy Bieber* says debt consolidation can be a helpful tool, but it can also go very wrong, so there are a few key mistakes we can’t afford to make.
Photo: Steve Buissinne
Consolidating debt can make it much easier to manage the process of repaying the money you owe.
When you consolidate, you use one new loan to pay back multiple existing loans — which could include credit cards or other loan types.
Debt consolidation can often save you money on repayment, in addition to simplifying the repayment process.
But, unfortunately, it can also cause your financial situation to get worse if you make mistakes.
To help make sure this doesn’t happen, here are some common errors you’ll definitely want to avoid.
- Taking out a new loan at a higher rate
The goal of debt consolidation isn’t just to simplify repayment by combining multiple debts into one.
It’s also to lower the cost of paying back what you owe.
But you can only do this by consolidating into a loan that offers you a lower interest rate than you’re paying now.
If you have a bunch of maxed-out credit cards, or have been late on payments, you unfortunately may not be able to qualify for a loan that charges you less interest.
If that’s the case, you’re better off working on paying down your current debt and improving your credit.
Once you’ve made some progress, you can try again to see if you can qualify for a consolidation loan at a better rate.
- Stretching out the repayment process
If your goal is to reduce your monthly payments, it may be tempting to opt for a debt consolidation loan that offers you a long repayment timeline.
After all, the longer you have to pay back your loan, the lower your monthly payment will be.
Unfortunately, there’s a big downside to this.
A longer loan repayment term means you pay more interest over time.
If you consolidate the debt you were on track to pay off in two years, and you take five years to repay the new loan, you could end up paying more in total interest costs — even if your new loan offers a lower rate.
To avoid this problem and maximise your interest savings when consolidating, try to pick the loan with the shortest possible repayment timeline.
And, when comparing loan repayment terms, be sure not to focus on monthly payment alone.
Always look at the big picture, including total interest expenses, so you’ll know exactly how much your loan will cost you by the time the repayment process is complete.
- Not paying off your transferred debt on time
One common way to consolidate debt is to use a balance transfer credit card.
These cards give you a 0 per cent promotional annual percentage rate (APR) for a limited period, such as 12 or 15 months.
If you go this route for your debt consolidation, it’s imperative to pay off the full transferred balance before the promotional rate expires.
If you don’t do this, you’ll owe interest at the credit card’s standard APR, which is usually pretty high.
When you’re transferring your balance, figure out how much you have to pay per month to get the debt paid off before this happens.
Then, make those payments on schedule.
If you take out a personal loan to consolidate debt, your monthly payments will be set to ensure you pay off the loan balance in full on a predetermined schedule.
Just make sure you don’t miss a payment so that you can pay off the loan as planned and not hurt your credit.
- Getting deeper into debt
If you’ve consolidated credit card debt, you free up available credit on your existing credit cards.
The worst thing you can do is to start charging up those cards again.
If you do this, you could end up owing money to the consolidation loan and having a high balance on your cards.
You’ll owe significantly more money, which could make it impossible for you to climb out of debt.
To avoid this, create a detailed budget you’re able to live on before you consolidate your debt.
And if you can’t trust yourself not to charge up your credit cards again, cut them up so you don’t use them and get yourself into serious financial trouble.
These debt consolidation mistakes aren’t difficult to avoid, as long as you’re responsible with your spending.
You just need to make sure you pay your consolidation loan on time and shop around for a consolidation loan with a reasonable interest rate and appropriate repayment timeline.
If you do this, consolidation should be a faster, easier way to pay off what you owe.
* Christy Bieber is a personal finance and legal writer.
This article first appeared at www.fool.com.
