4 Ways Debt Consolidation Loans Can Go Wrong
The idea of a debt consolidation loan is to simplify multiple loans by merging them into a single payment. We’ll give you some tips about the ways that debt consolidation loans may go wrong. Use the information to your advantage to avoid any unpleasant surprises.
Always check the details to make sure that your debt consolidation loan is going to help and not hurt your financial situation. Some of the most common sources of loan consolidation funds are as follows:
Personal loans: Banks or credit unions may offer lower interest rates on personal loans. This can allow customers to pay off high-interest balances more quickly.
Balance transfers: Some credit cards will offer low-interest introductory rates when transferring balances from other cards. There will be service fees involved, but if you pay the balance off before the end of the promotion, then this can save you money.
Home equity loans: With this type of loan, homeowners can use their property as collateral to support the consolidation loan application process and increase the chances of approval.
Retirement account loans: Some retirement accounts will allow the customer to borrow from invested funds. The money then needs to be repaid according to the company’s terms for that particular plan.
Tip 1: Check the Interest Rate First
If you have a good credit score, then there’s a good chance that you would be granted a debt consolidation loan with a low-interest rate. However, if you’re credit score is poor (below 580), then the likelihood is that the loan may not be beneficial to you. A consolidation loan is only practical if the interest rate is lower than that of the loans you already have.
The online bank Experian suggests that a poor credit score can result in an interest rate of up to 35.95% over a term of 36 or 48 months. For $15,000 worth of debt, this would mean a monthly payment of $687 for three years or $593 for four.
At these rates, a debt consolidation loan probably isn’t your best option financially.
Tip 2: Beware of an Extension of the Repayment Period
When your main reason for taking out a consolidation loan is to lower the monthly payment, you may be tempted to choose the most prolonged repayment period. While this may result in a lower amount each month, you will end up paying out a lot more due to the buildup of interest.
- If your current debt is at $15,000 and you’re paying an interest rate of 10% over four years, then your monthly payment would be $380. By the end of the four years, you will have paid $3,261 in interest.
- When consolidating the loan, you are offered an interest rate of 8%, and take it out for seven years to reduce the monthly payment to $234. By the end of the seven years, you’ll have paid $4,639 in interest, $1,378 more than the 4-year loan.
The best thing to do is to select the consolidation loan with the shortest term that’s affordable for you. This will mean that you save on the interest in the long-term.
Tip 3: Taking Out a Loan Won’t Fix Your Financial Decisions
If you got into financial difficulty for reasons that you couldn’t control, then a consolidation loan is a beneficial way for you to get out of your situation. However, if your debt was caused by bad financial decisions, then these issues won’t change by you taking out another loan.
Unless your relationship with money improves after you receive your consolidation loan, then you’ll only end up making your situation worse. Additional debt and failing to stick to your monthly budget will only have a negative impact.
A study by The Ascent looked into the psychological cost of debt. The study found that 74% of people in debt had only made the minimum payment on at least one of the debts for that month. This suggests that the majority of people are in debt to a level they can only just afford. Unless the consolidation loan helps with the cause of debt, then the cycle of borrowing that bit too much will only continue.
You can address your relationship with money by discussing your situation with a professional. Avoid issues with consolidation loans by honestly considering your situation and taking steps to get out - and stay out - of debt.
Tip 4: You Put Your Collateral at Risk
You should always be sure that you can make the full payments for your consolidation loan on time each month. If you fail to make a payment, you put anything you’ve used as collateral at risk. Unpaid home equity loans may lead to foreclosure, which will result in you paying out more than the original loan was worth.
Where possible, it’s best to avoid a loan that uses your personal property as collateral.