First and foremost, realize that debt consolidation lenders are in the business of selling money. So are credit card companies, for that matter. When it comes to interest payments, every lender wants a piece of your household budget. It’s up to you to protect yourself by knowing (and avoiding) some of the enticing gimmicks and predatory tricks lenders use in the process.
Debt consolidation is the process of collectively moving multiple consumer debts into one loan or credit account. Seemingly, putting all your higher interest rate debts under the roof of one lower interest rate debt should save you money. And it may. But it depends on a few factors.
Debt Consolidation Considerations:
1. Balance Transfers:
Often, credit card companies offer tempting balance transfer promotions at (or near) 0% interest. If you can pay the balance transfer amount down to zero before the promotion period expires, this may be a great option. However, if you’re even one day late in exceeding the promotional period, your transferred balance may be subject to deferred interest. Deferred interest is interest that is applied to your transferred balance, retroactively to the beginning of the promotion period. And the deferred interest rate may be higher than what you had been paying on your other debts. So, you could end up paying more with a balance transfer promotion than you would have otherwise paid.
Also keep in mind that most balance transfer promotions are charged a 3% to 5% fee on whatever amount you consolidate. In other words, the lender is guaranteeing themself a 3% to 5% profit on your money. But if you let the promotion period lapse before your entire balance is paid to zero, you might end up paying them up to 29% APR interest (or more) on borrowed money that you already paid off.
2. Debt Consolidation Loans:
Debt consolidation loans are a financial product offered by many lenders. They are typically amortized loans that wrap your higher-interest debt balances under one roof at a lower APR rate. Though it may sound good, do some math before you jump into this kind of arrangement.
First, amortized loans are front-loaded interest loans. Your payments start out as mostly-interest. In other words, the lender pays themself first, up front. Consolidation loans often advertise lower rates, using the subtle disclaimer “rates as low as…”. The wording “as low as” indicates the low end of the spectrum, but in the fine print you will find that it’s possible (likely) that you may pay a substantially higher rate. You may not be offered a specific rate until the lender performs a hard inquiry on your credit score. Hard inquiries lower your score, so beware. Likewise, many lenders charge an “origination fee” to take out a consolidation loan. So, already, you’re borrowing more money than you owe to pay back the lender.
The lure for consolidation loans is a potentially lower monthly payment. Though it may be true that you have a lower payment each month, your total payments might well exceed the balances you would have paid otherwise. In other words, lenders use “improved cash flow” as the temptation to guarantee themselves higher profits in the long term.
3. Home Refinancing/Borrowing Equity:
To consolidate or pay off debts, many people turn to their mortgage lender. Sometimes they refinance their primary mortgage and roll their consumer debt into the new mortgage balance. Other times they may apply for a second mortgage to serve as a consolidation loan. Or perhaps they open a Home Equity Line of Credit (HELOC) to use their home’s value as a credit account to pay off other debts. In any case, each of these situations can incur substantial fees and risks.
In the case of a first or second mortgage, there are typically origination fees and points to pay. Though the expenses are often rolled into the balance of the new loan, the result is a higher debt balance with more interest paid to the bank over the life of the amortized loan. Also, know about any pre-payment penalties that might affect the payoff. And, if the interest rate is adjustable/variable, there can be some ugly surprises with balloon payments or increasing monthly payments.
Again, do the math to determine what the total cost of the debt will be to pay it off. Your lender would prefer that you just look at the lower monthly payment, rather than how much money you end up putting in their pockets.
4. Continuing Bad Habits:
Consolidating debt treats the symptoms of poor financial habits but is not a cure. Though some lenders may require you to cancel the credit accounts you consolidate, not all of them do.
Canceling credit accounts can have a significant negative impact on your credit score, since a large portion of your score is based on the ratio of debt balances to overall available credit. If your score drops significantly, your other lenders may increase your APR interest rates and/or lower your credit limits– thereby further dropping your score in a downward spiral. It can be very hard to get ahead, financially, if you end up paying higher payments each month, cause-and-effect.
If you habitually use your credit resources after wrapping their balance into a consolidation loan, you will find yourself in a worse predicament. Before long, you could be buried in debt with all your resources maxed out again.
Get in Control of Your Finances
If what you’re doing isn’t working to improve your financial situation, the obvious answer is: you must change something you’re doing. One of the best ways to do so is to find a qualified, Certified PSG Debt & Wealth Coach to help you develop better habits and learn more about money.
The good news is you can likely adjust what you’re doing without suffering a negative change to your lifestyle. Improving your financial literacy helps you make better financial choices and minimize the money you give away to your lenders. Rather than resorting to conventional ways of debt payoff which cost you more money, consider using the strategic ways explained in The Financial Acumen Course® for better results. The money you save can help make positive changes to your lifestyle and your debt-free future!