4 common debt consolidation mistakes and how to avoid them

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

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

Sounds like a no-brainer, right?

Although financial experts agree that debt consolidation can be a smart decision, 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 ratings tend to qualify for 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 establish credit before consolidating.

When working with clients who want to consolidate, Ho pulls their credit report and identifies what he calls “low hanging fruits” – quick fixes with big payoffs. This could be disputing a mistake or scheduling a few payments on time to reduce credit usage, which is the amount you owe on revolving credit accounts relative to the total available credit in those accounts.

According to Ho, small changes could impact your short-term score by 50 to 100 points. “It’s literally money saved by having a lower interest rate when consolidating, just waiting a few months,” he says.

Avoid it: Before applying for a debt consolidation product, pull out your credit report and find ways to build credit fast. Until April 2022, you can check your credit report each week for free from every major credit bureau using AnnualCreditReport.com.

Mistake 2: Ignoring the Root Cause of Your Debt

Although debt consolidation may feel like a big step in the right direction, it may not be enough to keep you out of financial trouble.

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

“If someone gets into debt consolidation and they don’t fundamentally address the budgeting habits that might have gotten them there in the first place, they’re just going to fall back into that trap,” he says.

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

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Avoid it: Build a monthly budget that balances your income and expenses and leaves room for an emergency fund. As you work to pay off debt, avoid financing non-essential purchases.

Mistake 3: Choosing the wrong debt consolidation loan

Personal loans for debt consolidation are available to borrowers from all credit backgrounds, including those with bad credit (629 FICO or less).

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

A smart debt consolidation loan is a loan whose annual interest rate is lower than the average interest rate on your current debts. You will also want to pay close attention to the repayment term. A longer term will mean lower monthly payments, but it will also extend the debt. Determine if you can stay motivated to make payments over a three- or four-year period and what other financial goals can 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 will want your new APR to be lower. Also look for the shortest repayment term with monthly payments you can still afford.

Mistake 4: Not Considering Other Debt Repayment Options

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

Klipa says credit counseling can provide benefits that a simple debt consolidation product cannot, as clients receive personalized advice on their finances, in addition to a restructuring and repayment plan. debt. This is especially useful for clients who need budget advice.

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 urges caution. If you fail to repay the loan, you could lose the asset or face a hefty 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’s rarely a magic pill that makes debt go away,” Ho says. “We live in a society that values ​​instant gratification, but with debt, it’s a slow, methodical process.”

Avoid it: Do your research on the different ways to repay the debt, especially if you have bad credit. Consider working with a nonprofit credit counseling agency or licensed fee-only financial planner for advice on your specific financial situation.

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

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