Risks Of Debt Consolidation Loans - The Hidden Traps
What are the Risks Of Debt Consolidation Loans?
The idea of a debt consolidation loan is fairly straightforward.
You receive a new personal loan with more favourable terms and use the money to pay off multiple high-interest rate debts, such as credit card debts.
You’ll have a single monthly payment, which will benefit you and ideally a lower interest rate.
It’s a scenario that will hopefully set you up for success so you can save money and pay off debt quicker.
However, be cautious if you have several debts you’re paying off like credit cards, payday loans, and student loans.
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In this case, a debt consolidation loan may be a risky option.
You need to protect yourself and do what’s best for you and not just what’s best for the lender.
When looking for ways to reduce your debt, there are several factors to consider before you move forward and choose a debt consolidation loan.
You May Not Quality on Your Own
One of the risks of debt consolidation loans is that you may not qualify for it on your own.
It’s important to note that your creditworthiness will impact your ability to qualify for the loan and the interest rate you receive.
The lender is looking to weigh how much risk there is involved such as if you’re likely to default on your loan payments.
Therefore, consider the risk if you are asked for additional security.
Two of the most common ways a lender can lower their risk is to request assets you can put up as collateral (i.e. home equity) or a cosigner.
Ideally, you’ll have a stable income and a good credit score to show for.
However, if you have a high debt-to-income ratio or bad credit, your lender will be searching for extra confirmations that you’ll be able to keep up with your payments.
While home equity may be an asset you can pledge as collateral, you risk losing your home should you default on your payments.
It’s especially true if you are taking out a high-risk, high-ratio second mortgage to consolidate debts.
As for a cosigner, they’ll be responsible for payments if you can’t make them.
You’d want to have a personal guarantor of your loan if you don’t have enough income to support the loan size you are requesting.
It’s risky to ask a friend or family member to consign because they may be responsible for covering the costs if you have a financial hiccup or lose your job.
You May Not Save Money
Your goal is to get a debt consolidation loan that offers a lower interest rate than what you’re currently paying.
In this case, you will save money and be in a better financial position.
However, this isn’t always what plays out.
Therefore, you need to be aware of the financial consequences and hidden traps that may come with the type of consolidation loan you use.
You must understand the interest rate you’re paying.
An introductory rate may expire before you have the debt paid off, or you may incur penalty rates if you’re late on a payment.
These are a few hidden costs and risks that you need to have on your radar.
Another common risky consolidation strategy is high-interest bad credit consolidation loans.
The issue with these types of consolidation loans is that the interest rate is often 35.99% and as high as 45.99%.
It’s in your best interest to take the time to read the fine print before you sign any contracts.
There may be instances where you find these loans have hefty origination fees, insurance premiums, and penalty fees for late or missed payments tied to them.
There are even instances where your interest rate may increase substantially over time on your loan.
For example, your interest rate can change at any time if you choose to consolidate using a variable rate loan like a line of credit.
Not only will your interest rate increase, but your monthly payments will go up as well.
Debt Consolidation Only Shuffles Money Around
Another risk and hidden trap with debt consolidation loans are that they shuffle your money around.
A debt consolidation loan does not reduce your total debt, so you must ask yourself if you have too much debt for consolidation.
What happens with a debt consolidation loan is that a lender advances you new money that you use to pay off debts you owe to other creditors.
Although you may now only have one payment, you still have the same amount of debt to pay off.
You can think of it as trading one debt for another.
If your debt is significant, then a debt consolidation loan may not be effective.
The point of consolidating is so you can pay off your debt and in a reasonable timeframe.
It all depends on if you can get a lower interest rate and keep your monthly payment as it was.
The reality is that high-interest consolidation loans hardly ever provide this benefit.
If your debt-to-income ratio is above 40 percent or you’re having trouble making monthly payments, you may find you have too much debt to consolidate.
You will need a debt consolidation loan with a much lower interest rate if you’re going to be able to pay off your debts successfully.
Also, consider which debts you want to move.
For example, you may not want to consolidate student loans that are government-guaranteed.
Debt Consolidation Can Mean You’ll be in Debt Longer
Your debt consolidation loan will only be affordable if you can reduce your monthly payment with a lower interest rate or by extending the repayment period.
Be aware that a longer amortization and really low payments can hurt you financially.
By extending your payment period, you’ll be in debt for a longer period and will pay more in interest over those five years.
It may sound appealing initially to make smaller monthly payments for a longer period, but you’re going to be in debt longer too.
While it’s good for your budget and credit score, long term loans mean you pay more in interest over the life of the loan.
Extending out your debts may mean you’re jeopardizing your future financial security.
You Risk Building up Your Balances Again
You risk building up new balances on your old credit cards when you consolidate multiple credit card debts through a new debt consolidation loan.
While it’s a common mistake, you need to understand what caused your debt problems in the first place to get ahead.
You must change your spending habits after receiving a consolidation loan if this is what got you into debt in the first place.
A few healthy financial modifications to consider are to:
- Create a budget that includes your debt payments and a healthy amount for savings;
- Cut up or stop using your old credit cards once you transfer those balances to another loan;
- Keep one credit card for paying bills only;
- Pay off any new credit card charges in full each month;
- Learn your spending triggers and avoid habits that got you into debt.
You Could Damage Your Credit Score
It’s important to note that all consolidation options will impact your credit.
While debt consolidation can improve your credit score by converting revolving credit, like credit card debt, into a term or installment loan, it doesn’t always happen.
Your credit report may look worse initially if you have bad credit and borrow from a payday lender, for example.
Opting not to cancel old credit cards may harm your credit score because of the higher credit limits on your report.
Too much debt lowers your score, but a low utilization rate improves your credit score, so it’s a balancing act.
Of course, late payments will be reported to credit bureaus and will hurt your credit score.
Debt Consolidation Isn’t the Same as Debt Relief
It’s good to remember that because you consolidate your debt doesn’t mean you’re eliminating it.
You still have to pay off your debt, plus pay interest on it.
It’s only beneficial for you if you can afford this type of solution.
If you’re dealing with a lot of debt, then a debt consolidation loan isn’t going to provide debt relief or provide you with the lowest possible monthly payment.
A consumer proposal may be an excellent alternative instead of using a debt consolidation loan.
You make one monthly payment, but unlike a loan, there is no interest, and it is often possible to negotiate a settlement with your creditors where you pay less than the full amount owing.
We encourage you to contact the experts at Bankruptcy Canada for further consultation and financial advice.
We are proud to have helped Canadians from every walk of life get a fresh financial start.