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How Debt Consolidation Could Lead to Big Financial Trouble

Christy Bieber, The Motley Fool

 

Consolidating debt can get you out of financial trouble -- but it can also land you in a tough spot.

Stack of past due bills.

Image source: Getty Images.

Consolidating debt is the process of borrowing more money to pay off existing debt. Many people use debt consolidation as a tool to help repay what they owe and to simplify the repayment process.

Debt consolidation can make paying back loans simpler because you can pay off multiple existing creditors with a single new loan -- leaving you with just one monthly payment instead of multiple payments to different lenders. It could also help you reduce the cost of repayment if you can get a better rate on your new loan than you’re currently paying.

While there are clear pros to debt consolidation, it could also lead to very serious financial trouble if you aren’t prepared to be responsible with your spending and to pay off the consolidation loan on time.

Will debt consolidation cause financial trouble for you? Here are some of the different ways consolidating your debt could be very damaging to your financial future.

You could end up really deep in debt

Consolidation can help you pay back your debt, but the consolidation process itself doesn’t bring you any closer to becoming debt free. Instead, you’re just moving your debt to a new creditor -- and, in the process, you’re probably freeing up lines of credit.

If you had a couple maxed out credit cards and you pay off those cards using a debt consolidation loan, you now have the chance to charge up the credit cards again. If you don’t have your spending under control and an emergency fund to cover unexpected expenses that arise, there’s a very good chance this is exactly what will happen.

If you have your new consolidation loan and you run up a balance on any of the credit cards you still have open, you’ll now owe more money than you started with -- sometimes much more. You could end up so far in over your head in debt that paying everything back becomes a virtual impossibility.

The good news is, you can avoid this mistake by making sure you have a very detailed budget, that you’re living within your means, and that you have money set aside for unexpected expenses before you consolidate your debt.

You could increase the cost of debt repayment

The ideal goal of debt consolidation is to reduce the total cost of paying back your debt. By lowering your interest rate, you can make sure more of your payment goes to principal so it takes less total money to pay back what you owe.

Unfortunately, there are times when debt consolidation could end up being more expensive. Obviously, this can happen if you end up consolidating debt at a higher interest rate than you’re currently paying -- so this should definitely be avoided.

You could also end up paying more than you otherwise would have if you stretch out the time it takes to pay off your debt. If you consolidate two loans that you had two years left to pay on into a new loan that has a five-year repayment timeline, you’ll be paying interest for three extra years. Even if you significantly lowered your interest rate and your monthly payment went down a lot, you’d end up paying more money in the long run if you took this approach.

Consolidating debt using a credit card balance transfer also means you run the risk of ending up paying more. Credit card balance transfer offers usually have a 0% promotional rate only for a limited period of time. If you don’t pay off the consolidated debt in full before that 0% rate expires, you could be stuck paying the balance at the card’s standard high interest rate. This could be a higher rate than the debt you consolidated, depending on what each card issuer charges.

To avoid this, you’ll need to focus on the total cost of your consolidation loan, not just the monthly payment. If you take a credit card balance transfer, you’ll want to be 100% sure you can pay it off before the 0% rate expires.

You could put other assets at risk

There are lots of different ways to consolidate debt, including personal loans and balance transfers. But two common approaches involve 401(k) loans and home equity loans. If you consolidate debt with either of these types of loans, you’re taking a really big risk.

Consolidating with a 401(k) loan may seem attractive since you pay interest to yourself and borrow from your own retirement account. But if you lose your job or quit and you don’t pay back the borrowed amount by tax day for the year you took the 401(k) loan, you could end up getting hit with a 10% penalty for early withdrawal if you’re below retirement age. You’d also be taxed on the money as a distribution, which would increase your IRS bill.

A home equity loan may also seem like a good way to consolidate debt because the interest rate on home equity loans is typically well below the interest rate on personal loans or credit cards. Unfortunately, you’re literally putting your home on the line and you’re gambling the house that you’ll be able to pay back the debt. If you don’t repay what you owe, you could be foreclosed on, which would be both financially and personally devastating.

These risks can be avoided by opting for a personal loan to consolidate debt, even if the interest rate is a little higher and you have to pay interest to someone other than yourself.

Don’t let consolidation ruin your financial future

Consolidation can definitely help you get out of debt, so don’t be afraid to use it as a tool. Just make sure you’re ready to pay back what you owe responsibly, that the consolidation loan is actually more affordable than keeping your current debt, and that you can live within your means before you take out a consolidation loan. If you do these things, you should be able to consolidate the right way and can hopefully make debt payoff easier, faster, and cheaper than it otherwise would be.

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