Debt Consolidation: Is It Worth The Risk?

Sunday, Jun 15, 2008

The promise of debt consolidation is compelling-but don't get lulled into ignoring the risks.

A seasoned blackjack player will tell you to never split a pair of 10s. Doing so puts you at risk of trading in your winning hand for two losing hands. Some would argue that a similar dynamic exists for debt consolidation. Trading in one set of debts for another could be an overly risky move with relatively little financial reward.

Debt consolidation is often pitched as the credit cure-all: it lowers your payment burden, knocks down your interest rate, and gets you moving towards a debt-free future. But for a sizeable number of people, debt consolidation runs a small risk of backfiring, leaving them holding more debt than they had before. A look at the risks of debt consolidation reveals how things can go wrong so easily.

Fixing the symptoms

Many borrowers get into debt trouble because they spend more than they make. If this practice isn't resolved, debt consolidation will undoubtedly lead to bigger problems. The borrower will inevitably start charging on the newly paid off credit accounts, and the debt level will skyrocket. From there, the borrower has only a few options left, and none of them are good ones: another consolidation, bankruptcy, or even foreclosure.

Putting home at risk

Home equity loans are the least expensive means of consolidating debt. When funds generated by home equity debt are used to pay off credit cards, the borrower is trading in unsecured debt for secured debt. This is risky business, because now the borrower's home is on the line. If the payments can't be made, foreclosure looms as a possible outcome.

Someone else takes the wheel

The debt consolidation agency industry is overrun with scammers and predatory lenders who charge high fees and offer little value in return. Borrowers are likely to be deliberately or accidentally misled about the terms of the deal they've arranged. Some consolidators might roll fees into the monthly debt payments, so that borrowers don't even know what they're being charged. Others might collect money from borrowers and then fail to apply those payments to the debt.

Two steps back, only one forward

Debt consolidation loans can cause serious damage to the borrower's credit score. This may be worth it, if the terms of the loan are sufficiently better than the terms of the debt being consolidated. The trouble is that some consolidation loans only extend the pay-off period, without reducing the interest rate. In other cases, the improved terms may not be any better than what a borrower could have negotiated with her own credit card companies.

Mishandling a debt consolidation loan can be the kiss of death to your already shaky financial profile-an outcome far more severe than losing a hand of 21 because you split your 10s. Always remember the risks of debt consolidation, and make your decisions accordingly.

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