When is debt consolidation not a good idea?

You’ve got the big credit card due on the 7th, the little credit card on the 15th, and the emergency card that you use for more than emergencies because you get double points on groceries and everybody needs groceries on the 18th. Then there’s that special medical credit card they made you open when your cat needed dental surgery, your Target card, your gas card and the card you opened to get 15% off jeans at that place in the mall that you’re not allowed to go back to because you bought too many jeans that one time.

And all of that’s not including your mortgage, your car payment, your student loan payment, your electric bill, your gas bill, your internet, cable, phone, Netflix and on and on…

It’s easy to see why debt consolidation is so appealing. If nothing else, the ability to simplify your finances and reduce the number of payments you make each month means less work and fewer opportunities to accidentally forget one of your bills. However, it's important to understand why debt consolidation may not be a good idea.

The Truth About Debt Consolidation

Debt consolidation exists because it’s beneficial to lenders. Debt consolidation is popular because it’s often beneficial to consumers. When debt consolidation loans, balance transfers, debt management programs and mortgage refinances are mutually beneficial, they’re a great way to put your financial house back in order.

But when are they not in your best interests? There are a few circumstances where consolidating your bills can cause more harm than good, so see if you fall into any of these categories and weigh the pros and cons before signing off on that consolidation.

You don’t plan on changing your habits

One of the primary benefits of debt consolidation should be breathing room. By combining a number of small, variable payments into one (usually) fixed payment, you should find some space opening up in your budget.

What you do with that space determines whether or not the consolidation is going to work.

If you view that breathing room as an opportunity to continue stretching yourself financially – to pay for wants instead of needs – you’ll very quickly find that breathing room disappearing and your ability to manage your new budget extremely taxed.

Do not approach debt consolidation as a one-stop fix for all of your financial worries. If you have bad money habits that you’re not addressing or issues maintaining a healthy budget, debt consolidation will only delay your financial problems. Instead, focus on the issues that lead you to consider a consolidation first – once you’ve addressed those, then consolidation might be the right tool for you.

You’re putting your house in danger

One of the more popular forms of consolidation is refinancing your home or taking out a home equity loan. This usually makes sense financially, because those loan rates are almost always going to be significantly lower than credit card rates.

The trouble here is that you’re converting unsecured debt into secured debt and putting your house at risk in the process.

If you’re living on the financial edge, with out-of-control credit card bills, it may be appealing to roll those debts into your mortgage and deal with that new fixed payment every month. Just remember – if you fail to pay your credit cards they’ll go into default, they might go to collections and you could even be sued for them, BUT your house would be unaffected. Once you’ve rolled your credit card debt into your mortgage it can’t be separated again, and if you default on the new combined mortgage payment then you can lose your house.

The key is to look long and hard at your finances before including your unsecured debt in a refinance or home equity loan and make sure you’re prepared for a worst case scenario. Dealing with debt collectors isn’t any fun. Filing for bankruptcy is even less fun. But losing your home is the worst. So be careful.

You’re concerned about the impact on your credit score

Debt consolidation – in whatever form – will almost always have an impact on your credit score, and it’s usually a negative impact.

Most major credit scoring systems use the age of your accounts as part of how your score is calculated. Older accounts have a more positive impact on credit scores because they reflect a proven track record of creditworthiness. When you consolidate your debts, the old accounts are closed and replaced by one new account.

So simply keep that in mind before proceeding with a consolidation. If you’ve got a good score and can manage your individual accounts well enough at the moment, consolidation might not be in your best interests.

You have to pay it all off in a hurry in order to save any money

Before agreeing to any kind of debt consolidation make sure you fully understand the terms. Some things to ask yourself include:

  • Is there an introductory rate? And if so, when does it expire and what does it become?
  • How many years will it take to pay everything off and how much will you have paid in interest by that point?
  • Are there penalties for paying off early? What are the penalties for late or missed payments?

Take the time to do the math where necessary. Something that seems to be good for you today might not be so great in a year.

Weigh the risks of debt consolidation vs. debt settlement

One form of debt consolidation that stands separate from the rest is debt settlement. It’s incredibly important to know what you’re getting yourself into with any consolidation, but debt settlement can be especially damaging.

As refresher, here’s how most debt settlement companies work:

  • The debt settlement company reviews your unsecured accounts and creates a monthly “consolidated” payment.
  • You pay the debt settlement company this amount every month.
  • The debt settlement company holds the money and does not make payment to your creditors.
  • Your accounts become delinquent.
  • Your credit score is negatively impacted.
  • Eventually, your accounts are charged off – meaning they are moved to the lender’s collections department.
  • The debt settlement company negotiates with the collections department and “pays off” the debt for a portion of what’s owed.
  • The accounts are listed as “settled” on your credit report and continue to have a negative impact for up to seven years.

This kind of consolidation is costly (the debt settlement company’s fee will usually be substantial) and will make it extremely difficult for you to obtain credit again in the immediate future. If you’re hoping to use a consolidation to get your finances back in order you might want to pass on debt settlement.

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

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