Rule 39: Debt Consolidation Isn’t Always Good

Obviously the best advice is don’t get into personal debt in the first place. If it’s a bit late for that nugget of wisdom, then you need to pay as little interest as you can while you are paying off your debts (which clearly you will be doing as quickly as possible). Consolidating debts is one way of doing this that might be right for you, but often times it can make things worse. You’re solving your debt problem with debt. You’re just moving from one plantation to the other.

A word of warning: if you consolidate your debts, make sure you aren’t turning short-term debts into long-term debts. That would be stupid. The idea is strictly to pay off debt quickly.

Here are some issues I have with debt consolidation loans.

It won’t solve financial problems on its own. Consolidation may help you pay debt off, but it will not eliminate the financial habits that got you into trouble in the first place, such as overspending or failing to set aside money for emergencies. You can prevent more debt from accumulating by laying the groundwork for better financial behavior.

There may be up-front costs. Some debt consolidation loans come with fees. These may include:

• Loan origination fees.
• Balance transfer fees.
• Closing costs.
• Annual fees.

Before taking out a debt consolidation loan, ask about any and all fees, including those for making late payments or paying your loan off early. Depending on the lender that you choose, these fees could be thousands of dollars.

You may pay a higher rate. You may pay more in interest, even if the rate is lower. Consolidation does not always end up reducing the interest rate on your debt, particularly if your credit score is less than ideal. Your debt consolidation loan could come at a higher rate than what you currently pay on your debts. This could happen for a variety of reasons, including your current credit score. Consumers consolidating debt get an interest rate based on their credit rating. The more challenged the consumer, the higher the cost of credit.

Additional reasons you might pay more in interest include the loan amount and the loan term. Extending your loan term could get you a lower monthly payment, but you may end up paying more in interest in the long run.

As you consider debt consolidation, weigh your immediate needs with your long-term goals to find the best solution.

Missing payments will set you back even further. If you miss one of your monthly loan payments, you’ll likely have to pay a late payment fee. In addition, if a payment is returned due to insufficient funds, some lenders will charge you a returned payment fee. These fees can greatly increase your borrowing costs. Before you take out a debt consolidation loan, make sure you can afford the monthly payments. Missing a payment can lead to late fees and a lower credit score. This is a great way to screw yourself.

Also, since lenders typically report a late payment to the credit bureaus after it becomes 30 days past due, your credit score can suffer serious damage. This can make it harder for you to qualify for future loans and get the best interest rate.

The may encourage increased spending. Paying off credit cards and other lines of credit with a debt consolidation loan may create the illusion of having more money than you actually have. It’s easy for borrowers to fall into the trap of paying off debts, only to find their balances have climbed once again.

If you do decide to consolidate your debts, here are some useful tips:

• Never ever respond to any ads from companies offering to consolidate your debts for you. Those companies are for people with more money than brains.
• Shop around for any loans that you will use to consolidate debt—don’t accept your bank’s just because it is your bank; they may not be the cheapest.
• Don’t secure anything against your home, ever, under any circumstances. If you do, you could lose your home if you don’t keep up repayments. Is anything worth this risk? I don’t think so.
• Check the small print regarding paying off your loans early and make sure you aren’t going to be penalized if you do.
• Only ever take out one loan to consolidate and only do this once. Learn your lesson and move on.
• Pay off as quickly as you can afford. The longer the term, the more you’ll have to pay in interest.