The concept behind a debt consolidation loan is simple: you get a new personal loan with more favourable terms and use the money to pay off multiple high interest rate debts, like credit card debts. You benefit from a single monthly payment and, hopefully, get a lower interest rate so that you can save money and pay off debt sooner.
However, if you have a lot of debt, perhaps carrying a combination of student loans, credit cards, and maybe even a payday loan, getting a debt consolidation loan can be as risky as the debt you are already carrying, if not more.
While a debt consolidation loan sounds like an easy way of paying off debt, there are a lot of hidden traps. What is good for the lender is not necessarily good for you financially.
Here are several things you should consider before pursuing a debt consolidation loan when you are looking for ways to reduce your debt.
You may not qualify on your own
Your creditworthiness will affect both your ability to qualify for a loan and the interest rate or cost of your loan. Creditworthiness is a measure of how much risk there is that you will default on your loan payments.
Consider the risk if you are asked for additional security.
To qualify for a low-rate unsecured consolidation loan, you will need both a good credit score and a stable income. If, however, you have bad credit or a high debt-to-income ratio, your lender will want extra guarantees that you will be able to make your payments.
To lower their lending risk, a lender might ask for two common forms of security: assets you can put up as collateral or a cosigner.
If you have assets you can pledge as collateral, like home equity, that may improve your chances of refinancing with a debt consolidation loan, but you risk losing your home if you default on your loan payments. This is especially true if you are taking out a high-risk, high-ratio second mortgage to consolidate debts.
A cosigner is a personal guarantor of your loan and is common when you don’t have enough income to support the size of the loan you are requesting. Asking someone to cosign a consolidation loan means they will be liable for repayment if you don’t pay. If you lose your job or hit any financial hiccup, you may not be able to keep up with your consolidation loan payments, so it’s very risky asking a family member or friend to co-sign on your behalf.
You may not save money
The best debt consolidation loan results in a lower interest rate than what you are paying now, so you save money because you pay less in interest. Unfortunately, this is not always the case. There can be negative financial consequences depending on the type of consolidation loan you use.
Understand the interest rate you are paying.
You may try a balance transfer to a low-interest credit card, for example. There is a risk, however, that the introductory rate may expire before you pay off your credit card balances. Also, if you are late on a payment, teaser rates often disappear, and penalty rates can be much higher than on your original credit card.
Another common risky consolidation strategy is high-interest bad credit consolidation loans. The problem with these types of consolidation loans is that the interest rate is often 35.99% and as high as 45.99%. Before you sign any contract, read the fine print. Many consolidation loans have hefty origination fees, insurance premiums and penalty fees for late or missed payments. There may even be a clause that substantially increases the interest rate charged on your loan in certain circumstances.
Also, be aware that if you consolidate through a variable rate loan like a line of credit, your interest rate can change at any time. While installment loans have a fixed interest rate and fixed monthly payment, if you have a variable rate loan and interest rates rise, your monthly payment will increase as well.
Debt consolidation only shuffles money around
There is an even bigger problem with debt consolidation loans: A debt consolidation loan does not reduce your total debt.
Do you have too much debt for consolidation?
With a debt consolidation loan, a lender advances you new money that you use to pay off debts you owe to other creditors.
If you owe $50,000 on five credit cards, it’s great to replace those five monthly payments with only one payment on a single consolidated loan, but you still owe $50,000. Your total debt level remains unchanged. You may simply be trading one debt for another.
There is a point where you must ask yourself how much debt is too much for debt consolidation to be effective.
The reason to consolidate is so you can pay off your debt. If you can lower your interest rate and keep your monthly payment where it was, you will pay off the principal balance owing much faster. Unfortunately, high-interest consolidation loans rarely provide this benefit.
You may also have too much debt to consolidate if your debt-to-income ratio is above 40%, or you are barely keeping up with the minimum monthly payments. If this is the case, you will need a debt consolidation offer at a much lower interest rate than you are paying today to pay off your debts successfully.
It may also not make sense to move all your debt. There are many reasons why you would not want to consolidate student loans that are government-guaranteed.
Debt consolidation can mean you will be in debt longer
There are two ways to reduce your monthly payment through a debt consolidation loan: get a lower interest rate or extend the repayment period. The second is a common option used by those with high debts to make their debt consolidation loan affordable.
A longer amortization and really low payments can hurt you financially.
For example, let’s say you consolidate $35,000 in credit card and other debts into a new loan at 8%. If you opt for a three-year payment period, your monthly payment will be $1,096 a month. If you extend this to five years, your monthly payment will be $710. That sounds good, but you are in debt for two extra years, and you will pay more in interest over those five years.
There are advantages of making smaller monthly payments for a longer period. Smaller payments are better for your budget and can help improve your credit score as you are less likely to be late or miss payments.
However, longer term loans and smaller payments mean you will be in debt for a longer period. Long term loans mean you pay more in interest over the life of the loan. Long term loans are more common in mortgages and car loans, however, even extending these too long can mean you are jeopardizing your future financial security.
You risk building up your balances again
A common mistake people make when consolidating multiple credit card debts through a new debt consolidation loan is to build up new balances on their old credit cards.
Understand what caused your debt problems in the first place.
If overspending is what caused your debt problems in the first place, make sure you change your spending habits after you get a consolidation loan.
- Create a budget that includes your debt payments and a healthy amount for savings.
- Cut up or stop using your old credit cards once you transfer those balances to another loan.
- Keep one credit card only for paying bills.
- Pay off any new credit card charges in full every month.
- Learn your spending triggers and avoid habits that got you into debt.
If you don’t make healthy financial changes, you could end up with more debt even after getting a debt consolidation loan.
You could damage your credit score
Debt consolidation can improve your credit score by converting revolving credit, like credit card debt, into a term or installment loan.
All consolidation options will affect your credit.
This does not always happen, though. If you have bad credit and borrow from a subprime lender like a financing company or payday lender, this may make your credit report look worse for a short period.
If you don’t cancel old credit cards, the higher credit limits on your report could also harm your credit score. This is a balancing act. Too much debt lowers your score, but a low utilization rate improves your credit score. If you have a lot of available credit, it may make sense to close an old credit card account once your balances start to fall.
And of course, if you are 30 days (or more) late on a payment, this will be reported to the credit bureaus. Any late payment history will hurt your credit score.
Debt consolidation isn’t the same as debt relief
Mostly, debt consolidation is not the same as debt elimination. You have to pay back all your debts, plus interest. That’s fine if you can afford to, but of no help, if you cannot.
If you have a lot of debt, a debt consolidation loan doesn’t provide you with the lowest possible monthly payment and doesn’t provide debt relief.
What should you do? Compare other debt consolidation solutions like a consumer proposal or a debt management plan.
For many people, a consumer proposal is a perfect alternative to a debt consolidation loan. Like a loan, you make one monthly payment, but unlike a loan, there is no interest, and it is often possible to negotiate a settlement with your creditors where you pay less than the full amount owing. Paying $1,000 per month on a debt consolidation loan may not be affordable, but paying $500 per month may be possible in a consumer proposal.
Of course, that’s just an example; the actual amount the creditors would accept may be higher or lower in your case.
Try our debt options calculator to see what your payments might be.
A consumer proposal is not right for everyone, but to find out if it’s a better consolidation approach for you contact us today for a free consultation.