What You Need to Know About Debt Consolidation

If you are experiencing financial difficulties or struggling with debt, you may have already looked into debt consolidation. Many companies that specialize in debt consolidation tend to highlight the benefits of their programs through various advertisements, but rarely discuss the potential risks. Before making important financial decisions, you should always be completely informed on the product or service.

What is Debt Consolidation?
When you elect to consolidate your debt, you take out a single loan which is used to payout all your existing debt (generally unsecure debt). The attraction to debt consolidation is that it can be a better way to manage debt. It allows for one manageable monthly repayment versus multiple. In addition, the new repayment amount is typically lower because the length of the loan is extended and it may have a lower interest rate. You can also save thousands in interest repayments and shorten the repayment period if you pay more than the minimum by reallocated a portion of the savings back into the new loan.

Your personal financial situation will determine what types of consolidation loan you may qualify for. Loan options are strongly impacted by your credit history.

  • Unsecure loans are a good option if you can get an interest rate that is lower than the rates attached to your debts. Be sure to review all fees and charges that may be associated with the loan.
  • With a secure loans, lenders require some form of collateral such as your home, automobile, 401K or insurance policy. These types of loans can have a lower interest rates since collateral is attached to it, but that also leaves you in a precarious situation if you are unable to repay the loan.

What are the Drawbacks?
There are a few drawbacks to debt consolidation loans which can include; an increase in total debt, the possible loss of assets if you are unable to repay a secure loan, and the overall amount of interest being paid. Below is a closer look at these drawbacks.

  • A major drawback to a debt consolidation loan is that it could cost you more money over the life of the loan if you only make the minimum repayment. Even if you receive a lower interest rate, the loan is extended for a longer period meaning that you could actually pay more in interest fees. Some companies also charge prepayment penalties if you attempt to pay off the loan ahead of your payment schedule.
  • Secondly, if your consolidation loan is secured, you are essentially putting assets at risk. If you are unable to repay the loan, the lender has the right to repossess the assets or foreclose on your home if used as collateral. If you secure the loan with your retirement fund or insurance policy, those assets will not be available to you until the loan is repaid.
  • Lastly, if you pay off outstanding debts with the new consolidation loan but don’t close off those accounts. You could end up using that money again which would put you in even deeper debt.

The Bottom Line
While many risks are associated with debt consolidation programs; the greatest potential risk comes from your own spending habits. Debt consolidation can help you address the symptoms of poor financial management, but it does not address the issue that created the debt. If you do not have enough self-control when it comes to your spending habits, you may be tempted to accrue more debt if more credit is made available to you. It is important for you to identify and change poor financial behaviors.

Debt consolidation is not the best solution for every situation, so contact a financial counselor or specialist to discuss your options. Having a clear understanding of all options available for your specific situation is crucial in breaking the cycle of debt.