What Are the Risks That Involved With Debt Consolidation?

Can you imagine being able to clear out all your high-interest loans and only having one payment to make from here on?

It would be like a dream come true, right? And not just for you, because many Americans have multiple personal loans mixed up with other types of debts like credit card loans, title loans, and payday loans.

The debt consolidation concept is quite simple because you get a new loan and use the money to pay off other loans. The best part is that you get a loan with favorable terms and possible low interests while you get to pay off several high-interest loans. You get a single monthly payment and a chance to pay off the debt sooner and hopefully save money.

That said, debt consolidation has its fair share of risks and won’t work for everyone. Before you consider it as an option, it’s imperative that you understand all the hidden traps you could fall into.

Read on to find out some of the risks associated with debt consolidation so you can ultimately make informed decisions.

It’s Possible You Won’t Qualify

Even though you may want to get a debt consolidation loan, there’s a high possibility that you may not qualify.

Your current creditworthiness is an important factor that will determine whether you qualify, the interest rate you qualify for, and the total cost of the loan. You see, to qualify for a low-interest rate loan, you need a stable income, a good credit score, and overall good financial health.

If you have a high debt to income ratio and a bad credit score, there’s a very high possibility that any lender will ask for an additional guarantee. The lender will ask for one of two types of security to lower the risk.

The first thing they’ll ask for is an asset to act as security, which will pay for the loan in the event that you’re unable to.

The second thing is a cosigner or a guarantor for the loan. If you have an asset that you can pledge, such as a car or home equity, it will improve your chances of qualifying for a debt consolidation loan. However, you have to understand that you stand to lose your home or your car if you default on loan payments.

The lender is likely to ask for a cosigner if you have a low income to qualify for the amount of money you need. When someone cosigns a consolidation loan, they take over the payments if you’re unable to pay.

It’s imperative for you to think about this decision because you may burden your friend or family member if you lose your job or encounter financial hurdles.

You May Remain in Debt for a Longer Period

To reduce your monthly repayment, you can either extend the repayment period or get low interest rates. If you currently have multiple high-interest debts, then extending the repayment period may be your only option in order to make the debt consolidation loan more affordable.

There may be advantages to making smaller payments for a prolonged period. For instance, you’ll be able to afford them and fit them into your budget, improve your credit card score, and you’ll be unlikely to miss payments. However, the problem with a longer repayment period is that it can hurt you financially because you will end up paying a higher interest rate overall.

It’s Possible You Won’t Save Money

In the best-case scenario, you’re supposed to consolidate to a lower rate loan. This is one of the main reasons why you should get a debt consolidation loan so that you can ultimately save the money you would have paid in interest for your high-interest loans. However, you won’t necessarily save money just because you get a debt consolidation loan.

One of the most significant risks of getting a debt consolidation loan is that there’s a possibility you won’t save any money at all.

It’s vital for you to understand the interest rates before you agree on the loan. Besides, if you’re late on the payments, you may face penalty rates that could raise the overall amount of the loan, and the teaser rates could disappear.

There’s also a very huge risk that comes with getting a high-interest bad credit consolidation loan. This kind of loan will set you back as much as 46% in interest rates. It may also come with a high origination fee, higher insurance premiums, and high penalties for missed or late payments.

It’s of utmost importance that you read the fine print of your contract. You see, there may be a clause that increases interest rates under various circumstances, such as missed payments.

Most Debt Consolidation Loans Shuffle Money Around

The one thing you should understand about debt consolidation loans is that they don’t reduce your debt. It’s important to consider if you have too much debt to actually consolidate and for a debt consolidation loan to be effective. The biggest reason to take a debt consolidation loan is to pay off your debts and get favorable rates.

It’s unfortunate, but a high-interest consolidation loan may not come with this benefit. If your debt to income ratio falls over 40%, then there may be no point for you to consolidate. It may also not be a good idea if you’re barely keeping up with your current monthly payments.

You May Build Up Balances

One of the most common mistakes people make when taking out debt consolidation loans is building up new balances.

For instance, if you’re consolidating credit card debt, you may accumulate a new balance on your old credit cards. It’s important for you to consider your reasons for getting into so much debt in the first place.

If you don’t change your habits and put your personal finances in order, then consolidating your debts may be pointless to a point.

If overspending is a reason for getting into that, consider creating a budget that will help you stop the habit. You can also stop using old credit cards or get rid of them to avoid accumulating more balances.

It May Be Damaging To Your Credit Score

Under the right circumstances, a debt consolidation loan will improve your credit score by getting you into an installment loan instead of revolving credit

However, if you currently have bad credit and have loans from financing companies or payday lenders, you’re credit score could take a turn for the worse. Besides, if you’re late on payments, it will also be reported to credit bureaus and will hurt your credit score.

Reasons To Avoid Debt Consolidation

Debt consolidation is not akin to debt elimination or debt relief. It’s imperative for you to weigh all your options and consider all factors before you go for it. If you realize that you stand to fall into any of these risks, then taking out a debt consolidation loan may not be worth it.

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