Consolidating loans can be a smart way of preventing excess interest payments. Consolidating debt means taking out a single, larger credit facility to pay off other existing debts, giving you a single figure for interest repayments instead of multiple different ones. Of course, you need to have the capacity to borrow a sufficient amount, but in many cases, paying off the single loan interest is much cheaper than dealing with multiple separate debts.
When you consolidate a loan, you need to plan rationally how it will work. Consolidated borrowers sometimes fall into traps, which can be avoided quite simply with a little forward planning. Some of the most common mistakes borrowers fall into when consolidating loans are laid out below:
Not understanding terms and conditions
One of the most significant mistakes is not taking the time to thoroughly review and understand the terms and conditions of the new consolidated loan. This includes carefully examining interest rates, repayment terms, fees, and any potential penalties for early repayment. It's crucial to be fully aware of what you're committing to, especially since this has a direct cash impact on your financial freedom. Hopefully few borrowers would not read them at all, but even a skim reading can miss vital information. Think carefully about the features you need and whether they are all present.
Ignoring the total cost of the new loan
It's important to consider the overall cost of the new consolidated loan. While the prospect of lower monthly payments can be enticing, extending the loan term can lead to paying more interest over time. Make sure you calculate the total amount you'll repay, not just the monthly instalment, and ensure that the consolidation loan makes financial sense for you in your situation.
Underlying causes of financial distress
Consolidating loans can provide temporary relief, but it doesn't address the root causes of financial difficulties. If the consolidated loan merely serves as a band-aid solution and doesn't address overspending or financial mismanagement, the borrower may find themselves in a similar situation down the road. This is especially true where habitual overspending or a loss of income have led to the debt situation becoming unmanageable to begin with.
Lack of research about debt management options
Loan consolidation is just one option for managing debt. Before proceeding, it's advisable to explore alternative solutions like negotiating with creditors, debt counselling, or creating a comprehensive debt repayment plan. Consider what other strategies might be more suitable for your specific financial situation before taking out a consolidating loan.
New debt after borrowing
After consolidating loans, some individuals make the mistake of accumulating new debt. It's essential to avoid this by creating a budget, managing spending, and refraining from taking on new loans or credit card debt while repaying the consolidated loan. The purpose of a consolidation loan is to reduce your debt obligations, not to allow more of them.
Wrong type of consolidation loan
There are various methods of consolidating loans, including balance transfer credit cards, personal loans, and home equity loans. Choosing the wrong type of consolidation for your specific needs and financial situation can lead to unintended consequences. Ensure you select the method that aligns with your objectives and capabilities; do not take out a mortgage on your house if you fear you will be unable to repay.
Making a decision without guidance
Consolidating loans can be complex, and the best approach may vary from one individual to another. Failing to seek advice from a financial advisor or credit counsellor can result in choosing the wrong strategy. Professional guidance can help you make informed decisions based on your unique financial circumstances, and such services are often available free of charge under government schemes. Make sure your plan for debt reduction makes sense.
Impacts on credit
Debt consolidation can affect your credit score, primarily in the short term. Failing to consider the potential impact on your credit and not taking steps to mitigate this effect can be a mistake. Develop a plan to rebuild your credit after consolidation; the impact of debt consolidation is often mixed as it involves going further into debt while also paying off many previous debts, some of which may have been in default. In the long run, a successful debt consolidation should improve your credit score, but be aware it can cause short term dips in some cases.
Missing repayment instalments
An obvious one, but this is still an important point to remember. Once loans are consolidated, it's vital to adhere to the new repayment plan diligently. Missing payments or failing to meet the terms of the consolidation can lead to financial setbacks and potential damage to your credit; though you now have only one creditor instead of several, they are likely to take a dim view on any non-repayment considering the nature of the loan.
Impatience
Debt consolidation is a process that takes time and discipline. Rushing the process or expecting immediate results can lead to impulsive decisions and dissatisfaction with the outcome. It's essential to be patient and stay committed to your debt consolidation plan. Impatience is often the root cause of missed repayments and unnecessary additional debt following the loan, so it is vital to control this tendency.
Final words
In sum, debt consolidation is an attractive prospect for people with multiple sources of debt who want to simplify, and perhaps reduce the cost, of their obligations. Negotiating with a single creditor is always simpler than with dozens, so debt consolidation into a single credit facility is often a smart move. However, as always with debt, there are many traps borrowers can fall into. The most important is not to repeat the situation that brought about debt problems in the first place – though old habits may die hard, it is vital to avoid excessive borrowing after the loan or missing repayments. If you can steer clear of these common mistakes, you are much more likely to see success in your debt consolidation plans.
