When you are considering consolidating your multiple debts, one of the first options that come to mind is to use a loan. Although debt consolidation could also mean debt management or balance transfer, it is defined by Investopedia.com as “the act of combining several loans or liabilities into one loan.” That refers mainly to debt consolidation loans.
That simply means you, as the debtor, will take out a master loan that is enough to cover your multiple credit obligations. The goal is one of two things: a simple payment plan or a lower monthly contribution cause by either a lower interest rate or a longer payment period.
In most cases, people who have no idea what debt relief is all about immediately consider this process as a viable solution. It seems like the logical way to put some order into a seemingly difficult debt situation.
4 risks of using a loan to consolidate debt
But while debt consolidation is a great option to get out of debt but there are a couple of pitfalls that you need to think about. It is proven that debt consolidation loans can fix your multiple problems with debt but you have to take note of these 4 risks.
False sense that you have solved the credit situation. When you get your loan, your next task is to pay for your multiple debt obligations. After all, that is how you consolidate your debt. However, some people get the false sense that they already paid off their debts. When you think about it, you only shifted your debts around. The money that you used to pay for the multiple credit account is still debt. You have to pay that back. Unless you have to paid for the debt, you should not feel that you have already solved your credit problem.
Opting for a high interest rate loan. When you use debt consolidation loans, you have to target a low interest rate. If you cannot do this, you will end up paying more in the long run – as compared to getting a lower rate. It defeats the purpose of using this type of debt solution as it will not make your situation better. It could simplify your debt payment but it will not really save you any money.
Endangering your personal assets. For people who do not have a good credit score to qualify for a low interest rate, they opt to put their personal assets on the line to get a secured loan. While this will guarantee the low rate, it will endanger their homes, cars or other valuable assets. If they cannot pay off the loan, the lender could get these collateral as alternative payments.
Temptation to get more credit. Most of the time, the multiple accounts that you are paying off immediately are credit card accounts. Once you have paid this off with the loan, the temptation to use them again will be very high. You should not give in to this urge because you still owe the same amount of debt. It is just consolidated under one lender.
If you really want to use debt consolidation loans as your means to get out of debt, you have to be very careful of these pitfalls. When you know the risks, you can plan your debt solution to try to avoid them.
How to avoid the pitfalls of credit consolidation loans
Now that you know what you should avoid, you can construct your plans so that you can make this debt solution effective. Here are three things that you can do to guarantee success.
Create a debt payment plan. The pitfall that this will address is the first and the last. You want to make sure that you have a plan for the payment of the master loan. This plan will keep you from forgetting that your debt is still technically, not paid. This plan can also help you gain direction on your quest for debt freedom.
Check your loan options. It is very important to choose the type of loan that you will get. For instance, you have unsecured or secured loans. You also have peer to peer lending or family loans as your option. These all have their pros and cons and you can make a smart choice about your debt solution if you know your options.
Know if you qualify. If you do not have a good credit score or a collateral to make your loan interest rate low, you need to reconsider if this is the right debt solution for you. There are other options like debt management that will not require you to have a good credit score or a collateral. But you can still benefit from the single payment scheme and lower monthly contribution of debt consolidation.
Like all debt solutions, debt consolidation loans can only be effective if you know how to treat it properly. You want to make sure that you understand the processes and rules so you can maximize the benefits that will help you gain faster debt freedom. Not only that, you want to be able to know the tools that will make the journey bearable. Go on a road to self education. You need to start learning how to manage your money properly. That is how you can really move past your debt crisis.
Diana hates debt just as much as you do. She is a finance writer for National Debt Relief. She aims to provide the best information to win the battle against debt.