Debt consolidation can sound like a great solution if you feel as if you’re drowning in debt. Your loans, credit cards and others unsecured debts are consolidated into a single sum that you can pay off – probably with a better interest rate – and with lower monthly payments that should be easier for you to manage.
According to a survey done by Gallup in 2014 we Americans have an average of 3.7 credit cards and carry an average of $5142 just in credit card debts. If you have this many or more cards plus an auto loan, a line of credit and maybe some student debt it becomes clear why debt consolidation might look like a great solution.
However, it’s important to understand above all that debt consolidation is only a tool because it will do nothing to change the amount of money you owe. In fact, in fact debt consolidation alone won’t really solve your problem.
If you’re considering debt consolidation you need to be aware of these six common mistakes that people often make and what you could do to avoid them.
You fail to understand the root of the problem
A trap many people fall into is that they use debt consolidation as a sort of lifesaver because they’ve gotten over their heads and maxed out their credit cards. It becomes a kind of reflex reaction that doesn’t address the biggest problem, which is how their life style got them into so much debt.
The fact is that if you don’t get a good grasp on what you did the got you into so much debt, it could just happen again. What most experts say is if you don’t change the habits that got you into so much debt it’s almost guaranteed you’ll get right back into debt – and maybe in just a few months.
The solution to this is pretty simple.
You may need to get a money coach, a financial advisor or credit counselor who will review your spending and help you identify those areas where you’ve been spending too much. As an example of this you might have been spending too much on expenses like your car payments, housing and other living expenses. If this is the case, the solution could be as easy as tracking your spending and then finding ways where you could cut back. Plus, you will need to develop new habits to replace your old ones.
You don’t investigate other options
There are a number of options for consolidating debts. You could get an unsecured loan, a secured loan or transfer your credit card debts to a 0% balance transfer card.
Other options include debt settlement or a debt management plan. Debt settlement has become increasingly popular because it consists of paying a lump sum to settle a debt for less than its balance.
If you’re not familiar with debt management plans this is where you go to a consumer credit counseling agency, which develops a plan with your creditors so that your debts get consolidated and at a lower interest rate.
To avoid this trap, you need to be proactive and look for the best consolidation plan. Make a list of all of your debts, then shop for the best interest rates. You might even contact your creditors and try to negotiate lower interest rates. Once you crunch the numbers you might actually find alternatives that would be better than debt consolidation.
You consolidate the wrong debts
A mistake some consumers make is consolidating all of their debts – even those that have low interest rates such as their federal student loans. Or worse yet, they roll in credit cards with low interest rates so they end up paying higher interest just to have a single, consolidated payment.
To avoid this trap make sure you’re consolidating only those of your debts that have high interest rates. Then pay off separately those that have low interest rates and low balances.
When you get your debts consolidated you could feel an incredible sense of relief. Just think. No more from calls from angry lenders and no more stress trying to juggle a bunch of different credit card bills with different minimum payments and different due dates.
But there’s a danger here if you start feeling invincible. It’s a trap to think that everything’s okay and you can start using your credit cards again because they now have zero balances. But then, before you know it, you’re in the same position as you were before.
The way to avoid this trap is to keep reminding yourself that you really aren’t out of debt – that you still have a lot of debt outstanding. You might close some of those credit cards, cut them up or put them in a block of ice. Hang on to a couple of them that have low credit limits and use them only in the case of an emergency.
You fail to develop an action plan
Even if you’ve done a really good job of choosing the best possible debt consolidation plan, you’re still not off the hook.
You need to make a plan for paying off the debt that you consolidated. This is so that if life throws you a curve – like your car dies or you need to make an unexpected trip to the hospital – you won’t turn back to using plastic. Or, worse yet, “frugal fatigue” could set in and you could end up going on a shopping spree to relieve it.
The way to avoid this trap is to meet with your family and maybe a credit counselor or financial planner and make a budget will balance you spending your income and savings goals.
The financial counselor Kathryn Bossler notes that “A budget is such a simple, basic concept, but it’s so powerful. It’s the way you learn to live within your means.”
One good way to budget is called the envelopes method. It’s where you put a predetermined amount of cash into envelopes labeled groceries, transportation, entertainment, clothing and so on. You should also have an envelope labeled emergency fund so you’re putting money away to cover an automobile repair, a medical bill, a leaky roof and other unexpected costs.
Then when one of these envelopes is empty, that’s it. You can’t spend any more money in that category.
You can also do this on your smart phone using the free app Mvelopes.
If you’re not familiar with this “tough love” form of budgeting, here’s an entertaining video that explains it in detail.
But whichever envelope method you choose the important thing is that you’ll be putting money aside so that in the future you won’t be forced to create more debt.
Frequently Asked Questions about debt consolidation
Q. What does debt consolidation do to your credit?
A. This will depend on the option you choose. However, whenever you apply for new credit it will ding your credit score by a few points. If you’ve maxed out your credit cards and move those debts into a debt consolidation loan this would increase the amount of credit you have available. Your credit utilization ratio should go down, which would cause your credit score to go up.
Q. How do debt consolidation loans work?
A. You take out a sizable loan and use the money to pay off all your creditors. You then make monthly payments on the loan, which should have a lower interest rate than the average of the interest rates you’re currently paying and a lower monthly payment. You may be able to get that loan through a debt relief company, as a personal loan from your bank or as a home equity loan.
Q. Are debt consolidation loans easy to get?
A. This will depend almost entirely on your credit score. If you have excellent credit (a credit score of 781 or above) it will be easy to get a debt consolidation loan. If your credit score is 661 to 780 it should be fairly easy for you to get one. However, if your credit score is below 601 you may find it difficult.
Q. What debts can be rolled into a debt consolidation loan?
A. In theory almost any debt can be rolled into a debt consolidation loan. However, as you have read in this article the best debts to consolidate are those that have high interest rates. These are generally credit card debts, personal loans, personal lines of credit, payday loans – and other such unsecured loans.
Q. When is debt consolidation a good idea?
A. It can be a good idea if you have multiple, high interest debts. It’s become popular because it offers some important benefits. For one thing, it’s just a lot easier to make one payment a month that a lot of different payments with different due dates. But more importantly, the debt consolidation loan should have a much lower monthly payment than the total of the payments you’re currently making.