4 Common Debt Consolidation Mistakes And How To Avoid Them

If you have accumulated multiple forms of debt, such as credit cards, medical bills, or personal loans, you may be considering consolidation.

Debt consolidation involves consolidating your debts into one payment, usually with a consolidation loan. Not only does this simplify your debt, but if you qualify for a rate low enough, you can pay less interest and even get out of debt faster.

Sounds like a no-brainer, right?

While financial experts agree that debt consolidation can be a smart move, it is not without risk. Avoid these four common mistakes when consolidating.

Mistake 1: rushing into debt consolidation

Being in debt is stressful, and it makes sense to want to get out of it as quickly as possible. But rushing into consolidation can cost you money.

Borrowers with higher credit scores tend to benefit from lower interest rates, including when refinancing. That’s why Charles Ho, a California-based certified financial planner and founder of Legacy Builders Financial, says borrowers should look for ways to build credit before consolidating.

When working with clients who want to consolidate, Ho pulls their credit report and identifies what he calls “fruits at hand”: quick fixes with big payoffs. This could be disputing an error or scheduling a few payments on time to reduce credit usage i.e. the amount you owe on revolving credit accounts versus the total credit available from those. accounts.

According to Ho, small changes could impact your score in the short term, 50 to 100 points. “It’s literally dollars saved by having a lower interest rate on consolidation, just by waiting a few months,” he says.

Avoid it: Before applying for a debt consolidation product, take a look at your credit history and look for ways to build credit fast. Until April 2022, you can check your credit report with every major credit bureau for free every week using AnnualCreditReport.com.

Mistake 2: ignoring the root cause of your debt

While debt consolidation can seem like a big step in the right direction, it may not be enough to save you financial hardship.

It’s common for people to find themselves trapped in recurring debt if they haven’t tackled the source, says Pete Klipa, senior vice president of creditor relations at the National Foundation for Credit Counseling.

“If someone goes into debt consolidation and they don’t fundamentally tackle the budget habits that maybe got them there in the first place, then they’re just going to fall back into this trap,” says -he.

Consolidation can even exacerbate a common root cause of debt: overcharging credit cards. Removing your current debt from these cards through consolidation frees them up again. If you can’t resist using them, you’ll have more problems than if you hadn’t consolidated in the first place.

Avoid it: Set up a monthly budget that balances your income and expenses and leaves room for an emergency fund. As you strive to repay debt, avoid financing non-essential purchases.

Mistake 3: Choosing the Wrong Debt Consolidation Loan

Personal loans for debt consolidation are available for borrowers across the credit spectrum, including those with bad credit (629 FICO or less).

But just because a lender will give you a debt consolidation loan doesn’t mean you should take it.

A smart debt consolidation loan is a loan that has an annual percentage rate that is lower than the average interest rate of your current debts. You will also need to pay special attention to the repayment term. A longer term will result in lower monthly payments, but it will also extend the debt. Find out if you can stay motivated to make payments over a three- or four-year period and what other financial goals may be delayed until your loan is paid off.

Avoid it: If you are considering a debt consolidation loan, first plug your debts into a debt consolidation calculator to see your average APR. You’ll want your new APR to be lower. Also, look for the shortest repayment term with monthly payments that you can still afford.

Mistake 4: Not Considering Other Debt Repayment Options

Debt consolidation isn’t the only option available, and depending on factors such as your financial situation and credit rating, you might be better off choosing another strategy.

Klipa says credit counseling can offer benefits that a simple debt consolidation product cannot, as clients receive individualized advice on their finances, in addition to a plan to restructure and pay off their debt. . This is especially useful for clients who need advice on budgeting.

Another option may be to borrow against an asset, such as a home equity loan or 401 (k) loan, Ho says. These loans often have lower APRs than an unsecured consolidation loan, especially for borrowers with bad credit.

However, Ho calls for caution. If you don’t repay the loan, you could lose the asset or face a large tax bill, in addition to the impact on your credit score.

Whichever option you choose, the key is to make a plan and commit to it by staying on track with your payments.

“There is rarely a magic pill that makes debt go away,” Ho says. “We live in a society that promotes instant gratification, but with debt it’s a slow and orderly process.”

Avoid it: Research the different ways to pay off your debt, especially if you have bad credit. Consider working with a nonprofit credit counseling agency or certified paid-only financial planner for advice on your specific financial situation.

About the Author: Jackie Veling covers personal loans for NerdWallet. Read more