Consolidating your credit card debt can help simplify your monthly payments. Unfortunately, there are a few things that can derail your progress. If you are considering debt consolidation for your credit cards, make sure you avoid these mistakes.
1. Not Changing Your Financial Habits
You should avoid taking on new debt and focus instead on paying down your consolidated debt. This probably means reevaluating your budget and spending habits to support that goal.
You’ll need to ensure that you can cover all of your household expenses and bills using income rather than credit. When you consolidate your debt, it usually involves zeroing out the balances on existing accounts. You may decide to close those accounts, but if you don’t you should avoid spending on them until the consolidation loan is repaid.
You can make a household budget using a spreadsheet.
2. Converting Unsecured Debts to Secured Debts
It is not a good idea to turn unsecured debt into secured debt. A secured loan is a type of debt is attached to a piece of property like a home or car. While credit cards are unsecured debt, secured debt consolidation loans require you to use your property as collateral on the loan. Secured loans are less risky for the bank because they can seize the property if you default on the loan. For that reason, secured consolidation loans typically offer a lower interest rate. This may seem particularly appealing to you, but is incredibly risky so we advise against it.
Secured debts make you vulnerable in the worst case scenario. If something happened to you and you were unable to pay your consolidation loan, you could lose your home in a financial emergency.
3. Minimum Payments That are Too High
You should look for a repayment term that has a minimum monthly payment that you can easily afford. This will usually be less than what you were paying before. Beware of offers that are too good to be true. For example, a loan with an interest rate that has a short repayment period, may look good on paper, but if the minimum payment is too expensive for you you’ll end up struggling to pay it.
4. Loan Terms That Won’t Save You Money
In addition to combining your debt and simplifying your payment schedule, a debt consolidation loan should have repayment terms and an interest rate that is better than what you were paying before. If your debt consolidation loan has a high minimum payment, an interest rate as much or greater than what you were paying before, or a repayment term that is either too short (high minimums payment) or too long (excessive interest paid long term) you could end up paying much more than you would have paid on the original debt.
As a rule of thumb your debt consolidation loan should:
- Have a lower interest rate than the average interest rate of your combined debt
- Have a minimum payment that is lower than or equal to the average minimum payment on your combined debts.
In order for a debt consolidation loan to be worth it, it needs to save you money and improve your financial circumstances. By far the best way for a consolidation loan to do this is through a lower interest rate. If you are paying less in interest then more of your money is going toward the principal balance, shortening the life of the loan.
Beware of a loan with an interest rate that is the same as what you were paying before but has a repayment plan that is very long. This may lower your monthly payment and meet an immediate financial need, but in the long run, you could pay thousands of dollars more in interest.
5. Not Looking at All Your Options
Before making the decision to consolidate your credit card debt, it is important to review and understand all of your options. Alternatives to consolidation loans include balance transfers and debt consolidation. Exploring your options is especially important if you are behind on your debt, have income insecurity, have a low credit score, or simply want to pay down your debt faster and for less than you owe.
If your credit score is subprime, you may not be eligible for a credit card debt consolidation loan with a favorable interest rate. Or perhaps the minimum payment on a consolidation loan would be more than you can afford. Whatever your circumstances it’s best to weigh the pros and cons of all your options so that you don’t end up with a debt consolidation loan that is a bad fit for you and your finances.