5 Costly Debt Consolidation Mistakes – and How to Avoid Them

Debt consolidation can help you save money on interest and get out of debt faster, but it doesn’t always work as planned. In a recent U.S. News survey of consumers who have borrowed a debt consolidation loan, more than a third regret doing so. Nearly as many say their finances haven’t improved since they consolidated their debt.

Here are some of the most common mistakes borrowers make when consolidating debt and how to avoid them:

  • Locking in the first interest rate you’re offered.
  • Choosing the lowest monthly payment.
  • Borrowing more money than you need.
  • Only considering a personal loan.
  • Getting caught in a cycle of debt.

Locking In the First Interest Rate You’re Offered

If you’re applying for a debt consolidation loan, it may be tempting to lock in an offer just because the lender offers a lower interest rate than what you’re currently paying on your credit card balances. But the first offer you receive may not be the lowest one.

Among survey respondents who regret consolidating their debt, 38% said their interest rate is higher than expected. Interest rates and eligibility criteria vary widely between lenders, so one lender might be able to offer more competitive terms than another.

→ Do This Instead: Shop Around With Multiple Lenders

Most personal loan lenders let you get prequalified to check your estimated rate with a soft credit inquiry, which allows you to compare offers across multiple lenders before formally applying for the loan.

You should also shop with several types of financial institutions. For example, online lenders typically have lower overhead costs than brick-and-mortar banks, which can translate to lower interest rates. On the other hand, you may get a better offer through a bank you already use if they offer a relationship discount. But don’t forget your local credit union – because credit unions are nonprofit and member-owned, they often boast some of the most competitive interest rates and fees on the market.

A fifth of borrowers we surveyed took out a debt consolidation loan to lower their monthly payments, but one of the most common regrets among borrowers is that it’s taking them longer to repay their debt. Often, choosing the lowest monthly payment means opting for a longer loan term, which can keep you in debt longer and cost you more money in interest over time.

→ Do This Instead: Calculate Your Total Loan Costs

Use a loan calculator to determine the total interest cost of consolidating your debt. If you can afford a slightly higher monthly payment, you could save thousands of dollars in the long term by choosing a shorter repayment period. That’s because you’d be making fewer interest payments over time – and shorter-term loans typically come with lower interest rates, too.

Take this example: Let’s say you have $10,000 worth of credit card debt at a 22.99% rate. Taking out a five-year debt consolidation loan with a lower 20.49% interest rate could grant you a fixed monthly payment of $268, but you’d pay more than $6,000 toward interest over the life of the loan. On the other hand, taking out a three-year loan with a 17.49% interest rate would increase your monthly payments by less than $100 to $359, while cutting your total interest costs in half, to $2,923.

One of the first steps in debt consolidation is to determine how much debt you want to consolidate, so you can shop for the correct loan amount. If you only want to consolidate $3,000 worth of credit card debt, but the lender has a minimum loan amount of $5,000, you could end up with more debt than when you started. It’s a simple mistake, but overborrowing means you’ll pay interest on debt you didn’t need to take on.

→ Do This Instead: Find the Right Lender for Your Unique Needs

For personal loans, each lender has its own set minimum borrowing amount. Borrowers who only need to consolidate a few thousand dollars of debt should search for lenders that offer small personal loans – there are plenty that offer loans starting at $1,000. If you’re planning to borrow even less than that, check with your local credit union to see if it can lend you the exact amount you need.

Personal loans can be used to consolidate virtually any type of debt at a fixed interest rate and monthly payment, but they aren’t your only option for debt consolidation. Because personal loans are typically unsecured, they usually come with higher interest rates than secured loans, especially if you have fair or bad credit. For some borrowers, a personal loan may not be the best option if your goal is to save money on interest.

A consumer with poor credit and high amounts of debt might be wise to meet with a credit counselor to enroll in a debt management plan. On the other hand, someone with excellent credit and a low amount of revolving credit card debt could potentially use a balance transfer credit card with a 0% annual percentage rate promotion.

→ Do This Instead: Weigh Alternative Debt Consolidation Strategies

Balance transfer credit cardsSome credit card issuers offer 0% APR periods, usually up to 18 months after opening a new account, which can help you pay down your debt much faster at zero interest. You’ll need very good or excellent credit to qualify – typically a FICO score of 740 or higher. Plus, you might have to pay an annual fee and a balance transfer fee equivalent to 3% to 5% of the amount being transferred, and there may be a limit to how much you can transfer.

Home equity loansA loan that’s secured by your home’s equity will typically have a lower interest rate than an unsecured debt, such as a personal loan or credit card. The trade-off of paying a lower rate is that you may have to pay closing costs, including origination fees, appraisal fees and title fees. The biggest risk of using a secured loan to consolidate debt is that you risk losing the asset you used as collateral – in this case, the roof over your head.

401(k) loans. Some (but not all) retirement plans let you borrow money from your own account, which means you can get a low interest rate that you’re essentially paying back to yourself. Still, tapping your retirement account to pay off debt comes with a fair amount of risk. If you don’t repay the balance, you could end up paying steep fees or even being taxed on the amount you withdrew. And if you leave your job while repaying a 401(k) loan, the balance may become immediately due.

Debt management plansA certified nonprofit credit counselor can enroll you in a debt management plan to repay your creditors without needing to take out a new loan or line of credit. As an added bonus, credit counselors might be able to negotiate with your creditors to lower your interest rate and waive fees. Debt management plans may come with a fee, which can be waived if you fall under a certain income threshold.

Getting Caught in a Cycle of Debt

Too often, borrowers will consolidate their credit card debt into a personal loan only to rack up a balance on their newly free credit line, stuck with an additional loan payment on top of their credit card bills. Consolidating debt can take some pressure off your budget in the short-term, but unless you address the root cause of your financial trouble, you could end up right where you started (or even worse off).

→ Do This Instead: Commit to Long-Term Financial Wellness

Debt consolidation is only the first step in getting your finances in order. It takes dedication and follow-through to build healthy spending habits that last. Here are a few tips to ensure lasting financial wellness after consolidating your debt:

  • Review your credit report. You can get a free copy of your credit report from all three credit bureaus (Equifax, Experian and TransUnion) on AnnualCreditReport.com. This will give you an in-depth look into your finances, including how much you owe and your on-time payment history. You might even find long-forgotten credit accounts or, worse yet, fraud. If you find any errors on your credit report, file a dispute through the bureau directly.
  • Keep tabs on your credit score. You can usually view your FICO credit score through your bank’s mobile app, but there are third-party apps that let you check your credit for free, too. Determine which factors are impacting your credit and work on improving them. For example, if you have a poor on-time payment history, you might want to enroll in automatic payments. Sometimes, enrolling in autopay can earn you an interest rate discount.
  • Dive deep into your budget. Analyze your bank statements every month to keep tabs on where your income is spent. For some households, the ease of online shopping might be a financial burden; for others, it could be too many monthly subscriptions set on autopilot. Free budgeting apps like Mint can help you track your progress and identify areas in which you may be overspending.
  • Review your nondiscretionary bills, too. You might be able to save money on mandatory expenses, like shopping around for a cheaper auto insurance policy or cellphone plan. Replacing old windows or outdated HVAC equipment to cut down on your utility bills can be expensive upfront, but homeowners can claim tax credits for eligible energy-efficient home improvements. Even something as simple as switching from paper towels to rags or ditching single-use plastic water bottles can save you money on grocery runs.
  • Hit the pause button on impulse purchases. When you add a new item to your online shopping cart, don’t check out immediately. Click “save for later” and come back to the item in 24 hours – not only does this give you time to determine if you really need something, but it also allows you time to comparison shop and search for coupons. If the temptation is still too powerful, consider deleting online shopping apps from your phone or closing your accounts altogether.

As the name implies, personal finance is highly personal. What works best for one person may not be worthwhile for you, so it’s important to find a strategy that works with your lifestyle.

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