5 Serious Downsides of Debt Consolidation
Written by
Joel Lim
Edited by
Ashleigh Ray
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Debt consolidation is often viewed as a lifeline for the millions of Americans drowning in debt. It merges various debts into one loan with a single payment, which makes your debt easier to manage and lowers interest rates.
However, with debt consolidation comes serious risks. Here’s a breakdown of the five major downsides that can turn this your debt consolidation solution into a new set of problems.
It Doesn’t Solve Financial Habits
Debt consolidation itself is a band-aid over the underlying cause of overspending. If you got into debt because of overspending or poor budgeting, consolidating won’t solve your problems. After all is said and done, you could be right back where you started, or worse.
In fact, a Federal Reserve System study found that 60% of those who consolidated debt had about the same or more total debt two years later. This fact highlights just how dangerous it can be to depend on consolidation without actually altering the way in which you approach your finances.
In addition, many people feel relief after consolidating debts, but that sense of security can be deceptive. Consolidating can free up your credit cards, making it tempting to start spending again. Without addressing the behaviors that led to debt in the first place, you risk racking up new debt while still paying off the old one.
The Risk of Higher Costs
Debt consolidation can reduce your monthly payments, but usually for a longer duration, so you will end up paying for longer periods. This could cause you to pay more in total interest over time.
For example, while the monthly payment will be lower if you refinance a 5-year 10% interest loan for $10,000 with a 10-year 7% interest rate, you will end up paying more interest over the time of the loan.
If you do the math, here’s how much interest you’ll end up paying for both of these loans:
- Under the 5-year at 10% loan, you’ll pay exactly $2,748.23 in interest.
- Under the 10-year at 7% loan, you’ll pay exactly $3,933.02 in interest.
That is nearly a $1,200 difference in interest over just $10,000 worth of debt.
Too many of us get caught in the extended debt repayment trap, thinking lower payments amount to savings. In the long run, you could end up paying more than you ever planned to
Collateral at Risk
Some debt consolidation loans, also called secured loans, require collateral, meaning an asset such as your home or a car. That asset will be at risk if you don’t pay back those loans.
Using a secured loan to consolidate unsecured debts like credit cards is especially risky. Missing a credit card payment won’t make you lose your home, but failing to pay back a home equity loan would.
Most people believe they are getting a vastly improved interest rate, but few understand the consequences of using their homes as security. Most Americans who file for debt consolidation through home equity loans risk losing their homes to foreclosure if they cannot pay them back.
Fees and Hidden Costs
Consider the fees associated with debt consolidation services, especially when doing third-party company consolidations for credit card or medical debt. For instance, you could have balance transfer fees, loan origination fees or face penalties for early repayment.
Interest and fees accumulate over time, though these details may not be visible when you first glance through your bank statement.
For instance, various outlets report that balance transfer fees with credit cards are typically between 3% and 5% of the amount transferred (meaning transferring $10,000 in credit card debt could cost you $300 to $500 upfront).
Potential Impact on Credit Score
Consolidation of debt can be good or bad for your credit score. It could increase your score by reducing your credit utilization ratio, but it could also decrease it, especially if you close paid-off accounts and open new lines of credit. Closing accounts diminishes your amount of available credit, which can be bad for your credit utilization ratio.
Even applying for consolidation loans and racking up a few hard inquiries into your credit report can temporarily nudge your score down. The benefits may outweigh the cost in the long run, but if you need to make other big financial moves that depend on your current credit score — like buying a house, for instance — a temporary hit to your credit could be problematic.
Debt Consolidation: Is It a Solution or a Financial Risk?
While debt consolidation can temporarily relieve some problems, it is a complex solution that involves a few significant risks. If you’re thinking about utilizing debt consolidation, consider whether ridding yourself of multiple debts is worth dealing with these potential downsides. Afterward, you could find your decision that much easier to make.
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