Chloe Meltzer | October 19, 2022
Summary: Debt consolidation might feel like the only way out, but is it all it's cracked up to be? Consolidating your debt might lead to paying off more in the long run, a damaged credit score, and more.
Debt consolidation carries certain risks that financial advisors and lenders often fail to disclose to borrowers. The terms and conditions you receive are usually in the fine print, and a borrower may miss crucial aspects such as additional fees and unfavorable payment terms. Most borrowers are only keen to receive a lower interest rate than their original debt.
The Fair Trade Commission requires debt consolidation companies to reveal all the information before agreeing. This includes informing borrowers of:
You have probably heard of debt consolidation if you are going into foreclosure on your home, considering bankruptcy, or have significant debt. Additionally, you may consider debt consolidation if you are struggling to pay off multiple debts. Before consolidating your debt, you must understand the risks that come with it.
In this article, we will discuss the advantages and disadvantages involved in debt consolidation. But first, let's explore how debt consolidation works.
When you consolidate your debt, it turns multiple loans into one single loan. This strategy enables you to pay off all of your debt in one large monthly payment, rather than juggling several debts.
The purpose of debt consolidation is to make your debt management easier. If you have one payment, it will be easier to focus on and pay off that debt. Typically debt consolidation allows you to lower the interest rate, reduce your monthly payment, and ultimately pay off your debt quickly.
It is important to note that a debt settlement is not the same as debt consolidation. Debt consolidation has fewer risks than a settlement. It allows you to pay your debt entirely without negative consequences to your credit report—if you have not defaulted.
Debt consolidation is different depending on whether you have a secured or an unsecured loan.
Let's take a look at an example.
Example: Stacy has a credit card debt of $900, a store card debt of $480, and a utility debt of $520. She finds it a challenge to pay each debt separately and decides to consolidate it with a new loan of $1900. Once the loan is approved, she will pay off the three debts simultaneously with just one loan to pay off.
To understand debt consolidation options, you must understand the difference between a secured and unsecured loan.
Mortgages and car loans are considered secure loans. When you take out a secured loan, you pledge your property. In other words, when you fail to make payments on a secured loan, you risk losing the property that the loan helped you acquire. For example, with a mortgage, you are offering your house in exchange for the debt if you do not pay it. When you obtain a mortgage loan, your house is offered as security to the loan officer. If you fall behind, a foreclosure will occur to repay the loan officer. The same applies to a car loan.
Unsecured loans are based on your promise to repay them. Although any property does not secure them, they are offered based on your credit history. An example of an unsecured loan is a credit card. A credit card carries a higher interest rate because more risk is involved for the lender if you do not pay it back.
When looking to consolidate your debt, there are many options available through secured loans. Some of these options include refinancing your house, taking out a second mortgage, or obtaining a home equity line of credit. In addition, you can also take out a car loan or use your car as collateral. If you have a life insurance policy, you might obtain a loan against it.
Putting up your house or car to pay off your loan is a risk. Consider the fact that you may not be able to pay off your debt consolidation loan and then you lose your home in the process. Although you can also use a 401K as collateral, you risk your future retirement.
Positive aspects of consolidating with a secured loan include getting lower interest rates, reduced overall monthly payments, and saving money in the long run. Interest rates can also be tax-deductible, meaning any interest paid on a real estate loan will be considered a tax deduction.
You will eventually save money if you have one monthly payment with a lower interest rate, rather than multiple with different rates. Even with the attractive benefits, there are many debt consolidation risks under a secured loan.
One of the most significant debt consolidation risks associated with combining unsecured loans into one secured loan is putting your property at risk. Whether it is your home, car, or 401K,, you risk losing these assets.
Will you manage to pay your debt diligently to avoid risking your investments? Certain assets, such as life insurance or retirement funds, may not be available to you if you do not pay the loan back. Losing your assets puts you and your family at risk.
Consolidated loan debts take longer to pay off than the original debts. Although you may have already paid off the original debt amount, you will continue paying the loan, plus interest. Even though your monthly payment may be lower, you will probably pay more in the long run.
Unsecured personal debt consolidation loans are less common than they used to be. You must have an excellent credit profile if you want to consolidate your debt with an unsecured loan. Most borrowers who want to consolidate their debt probably do not qualify for such loans. This about it: people with good credit probably aren't considering debt consolidation, and people who are considering debt consolidation probably have damaged credit due to missed payments.
That being said, finding a no-interest or low-interest rate on a credit card is the best way to obtain an unsecured personal loan to consolidate debt.
Let's consider an example.
Example: Bob has a fuel credit card debt of $560 with a 9% interest rate, a student loan balance of $940 with an 11% interest rate, and a store card debt with a 13% interest rate. He gets a new credit card to pay off the $1500 debt with a 0% Annual Percentage Rate (APR) for the first 18 months. If he succeeds in clearing the debt, he will have paid his original debts at no interest rate.
Consider consolidating your debt with an unsecured loan (or a credit card) if you have multiple credit card debts. This move is your best chance of combining them into one bill and having the opportunity to pay them off with little to no interest.
One of the debt consolidation risks that comes with using an unsecured loan is that getting a new line of credit may be impossible without a good credit score.
While debt consolidation is a helpful way to manage your debt, it doesn't come without risks. Here are some aspects of debt consolidation that you should consider before moving forward with it:
These are some of the major risks you take when consolidating your debt. Now, let's break each of these risks down in detail.
Debt consolidation can help you get out of debt by paying less if you secure a lower interest rate on a loan or credit card offer. But, getting a reasonable interest rate depends on factors such as:
If the debts you want to cover with debt consolidation have adversely affected your credit score, or your debt to income ratio is below 36%, you risk getting a loan with a higher interest rate. Conversely, if you get one with lower interest than the multiple debts, you risk getting repayment plans or loan terms that may eventually cause you to pay more.
If you already have a history of missing payments, you may still encounter the same challenge with your consolidated loan unless you are committed to staying up to date. Also, an unexpected life emergency may occur, which can drain your finances. Missing payments on another loan will cause your credit score to plummet further. You also risk losing your assets if you have taken a secured loan.
Debt consolidation helps you get out of multiple debts at once. You may be tempted to acquire a new credit card once you see all your other credit card balances combined or paid off. The primary reason for debt consolidation is to get you out of debt and help you manage your spending habits. Devising a budget and a spending plan may help you avoid this debt consolidation risk.
Despite debt consolidation having risks, it is a debt management option that can help you recover from bad debt when you commit to it. Debt consolidation risks are avoidable if you do your research well before taking a loan, acquire good spending habits, and stick to the monthly payments.
As you continue planning to manage your debt, a creditor may already have contacted you or sued you for failing to honor your monthly payments. SoloSuit can help. Use our Answer form to respond to a debt lawsuit before your state's deadline to respond has passed. You have up to 35 days to answer, depending on where you live.
Responding as soon as possible will help you avoid losing by default. To learn more about how to respond to a debt collection lawsuit, check out this video:
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