When you’re drowning in due dates, debt consolidation can sound like a godsend. Your credit cards, line of credit and other loans get consolidated into a lump sum you can tackle at a lower interest rate and with a minimum payment that’s manageable. But if you aren’t savvy when combining your debts, you could be worse off.
According to a 2014 Gallup survey, the average American credit card holder has 3.7 credit cards; TransUnion 2015 research found the average borrower carries $5,142 of credit card debt. Tack a line of credit, car loan or student debt onto your string of credit card bills, and you can see why debt consolidation looks like a viable resolution.
“Somebody who considers [consolidation] is in over their head, reaching their limits on their credit cards and they’re experiencing financial hardship,” Kathryn Bossler, a financial counselor at Green Path Debt Solutions, says. “But consolidation is just a temporary bandage for a bigger problem.”
“It’s a tool and it’s not step one because nothing has changed,” agrees Carol Lewis, a certified financial planner who specializes in helping consumers get out of debt. “By itself, debt consolidation won’t do anything for you.”
Tread carefully, the experts say, or you could end up in more financial trouble. Here are six common debt consolidation mistakes consumers make and how to steer clear of them.
Trap 1: You don’t acknowledge the root of the problem
People often turn to debt consolidation because their spending gets out of hand and they can’t manage the repercussions, Bossler says. It’s typically a knee-jerk reaction as the debtor grasps at straws, but it doesn’t address how their lifestyle sunk them into debt.
“When I counsel someone, I encourage them to really understand the root issue of what got them there in the first place,” Bossler says.
Consolidation occurs with debts that are greater than $10,000, Bossler estimates. Those debts didn’t happen overnight, and a resolution shouldn’t either. If you don’t come to terms with what got you into debt, it could happen again.
Both Bossler and Lewis have seen it firsthand: Clients promise they won’t rack up insurmountable debt again, but within a few years they’ve returned to their old ways. “If you haven’t changed any habits, you can guarantee you’ll be right back in debt in a matter of months,” Lewis says. “This is about changing behavior and making sacrifices.”
Solution: Don’t gloss over your previous actions. Face them head on and get professional help in retracing your steps.
A credit counselor, money coach or financial adviser can comb over your spending and help you identify trends. Perhaps you were pouring too much of your income into basic expenses such as housing, car payments and living costs, and you need to evaluate ways to downgrade. In other cases, the problem could be as simple as reducing overspending on entertainment.
Replace your old habits with new ones. Track your spending on a regular basis and evaluate the differences between your needs and wants.
Lewis doesn’t advise consolidation often. She says she prefers to work with clients for months to gauge how serious they are about repaying their debt. If they show that they won’t go back to spending, they’re a better candidate for debt consolidation.
Trap 2: You don’t research your options before consolidating
There are multiple ways to consolidate your debt. You may commit to a secured or unsecured loan, transfer outstanding debt onto a new or existing line of credit, or pool your debt on a balance transfer credit card.
Debt settlement and debt management plans are other options. Debt settlement is the practice of paying a lump sum to settle a debt for less than what you owe. For-profit debt settlement companies negotiate with creditors on your behalf and charge you a fee, often a percentage of the amount of debt that is forgiven.
A debt management plan is an agreement between you, your creditors and a nonprofit credit counseling organization. Your credit counselor works with creditors to consolidate the full amount of your loans at a lower interest rate or for a longer repayment period (three to five years usually). You make your payments to the agency and usually pay a small fee (max $50 a month).
Thomas Nitzsche, a financial educator at the nonprofit counseling agency Clearpoint Credit Counseling Solutions, estimates that the average credit counseling client cuts their interest rates in half and reduces their total monthly payment amount by 20 percent.
Each option comes with its own benefits and drawbacks, and they will differ depending on your circumstances. You can run into trouble if you don’t understand the terms of a deal before agreeing to it.
Some consolidation plans come with hefty upfront costs from origination fees or transfer fees. A credit card balance transfer, for example, will likely cost 3-5 percent of the amount of money transferred onto the new card. It may also offer a low interest rate for a promotional period but then the rate spikes. Forgetting that deadline could cost you dearly.
“A lot of people treat the minimum payment as an installment payment,” warns Nitsche. But “it won’t get you out of debt, especially if you keep using the line of credit or credit card.”
Solution: Be proactive in your search for the best consolidation plan. Lay out all of your outstanding debts, shop around for interest rates and even pick up the phone and call your creditors to see if you can negotiate a lower rate. You may find options that are better than consolidation after crunching some numbers.
Creditors may be especially willing to work with you if your debt is due to a job loss, health emergency or other extenuating circumstances. “Consumers hold more power than they realize,” Lewis says.
If you do decide to consolidate debts into a new loan, make sure you understand its implications. Check to see if there are fees, rates that may creep up or if you’re leveraging assets you aren’t comfortable putting on the line to secure a lower interest rate.
“You need to be strategic because you might be doing more damage than good and experience financial loss,” Nitzsche says.
Trap 3: You consolidate the wrong debts
In some cases, consumers consolidate all of their debts, even the ones that have low interest rates, such as student loans (for federal student loans you can only do this if you’re already in default; private lenders’ policies vary). If you aren’t careful, you might even roll in low interest credit cards so you’re paying higher interest in the end for the convenience of a single, consolidated payment.
It’s not worth it, the experts say. “There is a psychological effect of combining all the debt because it seems more manageable, but if you don’t pay attention to interest rates, it might not make sense,” Nitzsche says.
Solution: You’re better off consolidating high interest debts and leaving out the low interest, low balance debts to pay off separately.
A 4 percent interest rate on a student loan transferred onto credit card with a temporary 0-percent rate may sound reasonable, but you need to factor in the balance transfer fee, then remind yourself of the double-digit interest rate to follow if you don’t pay off the debt within the promotional period.
Trap 4: You choose the wrong professional
The debt settlement industry is notorious for aggressive tactics and shady practices. Firms will often withhold payments from creditors for months to force a deal. This is sometimes effective, but does serious damage to your credit score.
Until a few years ago, another common practice among debt settlement firms was to charge clients fees before obtaining results. The Federal Trade Commission barred such fees for any firms that contact you by phone but fees can still be hefty.
Even among nonprofit credit counseling agencies, some are a better fit than others. Not all agencies work with all creditors, for instance. Some have dismal success rates with their debt management plans or counselors with whom you just won’t click.
Solution: Check with the Better Business Bureau about any organization you’re considering, look at the company’s website and read through reviews. If the organization is bombarding you with junk mail or aggressive sales tactics, avoid it.
Be especially wary of debt settlement firms. “I’ve never known [these companies] to be a good proposition for anyone,” Lewis says, suggesting that high fees and empty promises may be on the other end of a too-good-to-be-true deal.
Nonprofit credit counseling agencies are usually a better bet. Look for one that belongs to either the National Foundation for Credit Counseling or the Financial Counseling Association of America (formerly the Association of Independent Consumer Credit Counseling Agencies). Agencies accredited by these organizations must maintain standards and their counselors have to complete a certification program.
Then ask questions of the credit counselor about fees and success rates, and get a feel for the counselor you would be working with. If it doesn’t feel right, find someone else.
Trap 5: You use your cards too soon
Consolidation can feel like an incredible relief from angry collections calls and the task of juggling a dozen credit card bills with mounting interest. But there’s a danger of feeling invincible.
“The mistake is to say everything’s OK again and all of my credit cards have zero balances now,” Bossler says.
A common error is using the newly freed up credit on your once maxed-out credit cards to spend again. Many people promise they’ll only charge the card once, but before they know it, they’re back in the same spot they were in before.
Solution: Remind yourself that you don’t have a clean slate — you still have a considerable amount of outstanding debt.
Close most of your credit cards or, at the very least, cut them up, put them in a vault or freeze them in a block of ice. Hang on to one or two credit cards with low credit limits — they should only be used for emergencies.
“You need to cut them up because if you don’t, the temptation will be there to use them again,” Bossler warns.
Leaving many cards open also leaves you vulnerable to identity theft.
Trap 6: You don’t have a plan moving forward
You’ve sought the help of a professional, picked the best consolidation plan for your needs and bid good riddance to your credit cards. But you aren’t off the hook yet.
You need a solid plan for paying off your consolidated debt. That way, if life throws you off course, you won’t turn back to plastic.
“When you need new tires of your washing machine goes, your instinct will be to charge these expenses. That’s a sign you could get yourself in trouble again,” Bossler says.
Without an action plan, you’re blindly paying off your consolidated debt. Frugal fatigue could set in and you might turn to shopping sprees to relieve it if you don’t have effective coping strategies in place.
Solution: Sit down with your family, and with the help of a credit counselor or financial planner, create a budget that balances your income with your spending and savings goals.
“A budget is such a simple, basic concept, but it’s so powerful. It’s the way you learn to live within your means,” Bossler says.
Lewis teaches her clients to live off predetermined amounts of cash set aside in envelopes — a separate stash for groceries, entertainment and transportation, for example.
Your budget should also include putting money into an emergency fund for job losses, a leaky roof and other unexpected costs. You’ll ideally save for seasonal expenses such as Christmas presents, weddings and holidays, too.
“You’re putting that money aside so it eliminates the need for credit moving forward,” Lewis says.
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