Consolidating Your Debt? Here’s What NOT to Do
Every month, you face a mound of credit card and bank statements (or your inbox fills up with them, and you have to write a separate check (or perform an individual internet transfer) for each of them. All the while, you feel like you’re no closer to zeroing out your balance on any of those debts.
To get out of this frustrating and time-consuming loop, many people opt for consolidation to combine multiple debts into one. You can consolidate all different types of debt – and the result is a simplified repayment process that involves a single payment each month.
It works by getting one new loan and using that to pay off multiple existing creditors. You pay off multiple types of loans and credit card balances with your new consolidation loan, and you’re left with a single monthly payment to the new lender.
Debt consolidation can be a great tool to get out of debt faster – but only when it’s used correctly. It won’t work in every financial situation, and it isn’t right for every consumer. And if it’s used incorrectly, it can make your bad debt situation even worse. Here are four traps to avoid when you’re using consolidation to knock down your debt.
1. Don’t apply for multiple accounts at once.
First, keep in mind that consolidating your debt can cause a temporary dip in your credit score. Every time you apply for credit, your lender performs a hard inquiry on your credit report. Each hard inquiry shaves a few points off your credit score, so don’t apply for multiple accounts in a short period of time (anywhere from 14 to 45 days, depending on the scoring model).
The good news is that this is usually a temporary dip. Remember your goal: You’re getting this new loan as a way to consolidate your debt to make paying it off easier. So if you alter the habits that led to that debt and make your payments on time (every time!), you’ll restore your score – and actually improve it.
2. Don’t close old accounts.
The length of your credit history makes up 15% of your credit score. This means the longer you’ve held an account, and kept it in relatively good standing, the better it reflects on your score. But because a new loan has no history, your newly opened consolidation account will reduce the average age of all your credit accounts.
To keep your average from sinking further, don’t get rid of other long-standing accounts. Even that old credit card you never use is still working for you. Closing that account reduces your pool of available credit, which can negatively affect your credit score. If you don’t trust yourself to refrain from using your card, cut it up or lock it away – but keep the account open.
3. Don’t jeopardize your home.
Remember that there is unsecured debt (like your credit card balances) and secured debt (such as your mortgage and auto loan). The difference is that unsecured debts are not backed by collateral. You might be tempted to use your substantial home equity to consolidate debt. This can work, but only if you can maintain the regular payments. Because your home’s equity is backing the loan, you could face foreclosure if something catastrophic prevents you from affording the payments in the future.
It’s best to use home equity for consolidation as a last resort. Instead, consider a personal loan (that is unsecured and doesn’t require collateral to get approval) to consolidate your debt. Personal loans typically come with repayment terms ranging from one to seven years which will give you ample time to repay.
4. Don’t overpay for convenience.
If you’re consolidating credit card debt, an effective method is to use a balance transfer credit card. Depending on the lender, you may even be able to combine other types of debt. Many balance transfer cards have a promotional period with zero interest, which can range from a few months to a couple of years. If you pay off your balance during the introductory period, you’ll end up saving a ton in interest charges.
But there’s always a catch. Balance transfers typically require good credit for approval. And you’ll often see a transfer fee of 3% to 5% of the total transfer amount. Be sure to shop around – it’s possible to find a lender who won’t assess this convenience fee.
Debt consolidation can simplify your financial situation, save you money on interest, and even improve your credit over time. But it can be a complicated, and sometimes scary, process. If you have questions about whether debt consolidation is the right strategy for you, please reach out to DebtGuru.com. Our team of advisors will assess your situation and work with you to figure out your ideal game plan.