4 Common Debt Consolidation Mistakes and How to Avoid Them

NerdWallet
Borrowers with higher credit scores tend to qualify for lower interest rates, including when refinancing debt.

Borrowers with higher credit scores tend to qualify for lower interest rates, including when refinancing debt. Getty Images

If you’ve amassed multiple forms of debt, like credit cards, medical bills or personal loans, you might be considering consolidating.

Debt consolidation is when you combine your debts into one payment, usually with a consolidation loan. Not only does this simplify your debt, but if you qualify for a low enough rate, you can pay less in interest and even get out of debt faster.

Sounds like a no-brainer, right?

Though financial experts agree debt consolidation can be a smart move, it’s not without risk. Avoid these four common mistakes when consolidating.

Mistake 1: Rushing into debt consolidation

Being in debt is stressful, and it makes sense to want to get out as quickly as possible. But rushing into consolidation can cost you money.

Borrowers with higher credit scores tend to qualify for lower interest rates, including when refinancing. That’s why Charles Ho, a California-based certified financial planner and founder of Legacy Builders Financial, says borrowers should look for ways to build their credit before consolidating.

When working with clients who want to consolidate, Ho pulls their credit report and identifies what he calls “low-hanging fruit” — quick fixes with big payoff. This could be disputing an error or scheduling a few on-time payments to lower credit utilization, which is the amount you owe on revolving credit accounts compared with the total available credit of those accounts.

According to Ho, small changes could impact your score in the short term, 50 to 100 points. “It’s literally dollars saved by having a lower interest rate when you consolidate, just by waiting a couple months,” he says.

Avoid it: Before applying for a debt consolidation product, pull your credit report and look for ways to quickly build credit. Through April 2022, you can check your credit report with each major credit bureau for free every week using AnnualCreditReport.com.

Mistake 2: Ignoring the root cause of your debt

Though debt consolidation can feel like taking a big step in the right direction, it may not be enough to keep you out of financial hardship.

It’s common for people to get trapped in recurring debt if they haven’t tackled the source, says Pete Klipa, senior vice president of creditor relations at the National Foundation for Credit Counseling.

“If someone comes into debt consolidation, and they don’t fundamentally address the budget habits that might have gotten them there in the first place, then they’re just going to fall right back into that trap,” he says.

Consolidating can even exacerbate a common root cause of debt: overcharging credit cards. Moving your current debt off those cards through consolidation frees them up again. If you can’t resist using them, you’ll be in worse trouble than if you hadn’t consolidated in the first place.

Avoid it: Build a monthly budget that balances your income and expenses, and leaves room for an emergency fund. As you work toward paying off debt, avoid financing any nonessential purchases.

Mistake 3: Choosing the wrong debt consolidation loan

Personal loans for debt consolidation are available to borrowers across the credit spectrum, including those with bad credit (629 FICO or lower).

But just because a lender will give you a debt consolidation loan doesn’t mean you should take it.

A smart debt consolidation loan is one with a lower annual percentage rate than the average interest rate of your current debts. You’ll also want to pay close attention to the repayment term. A longer term will mean lower monthly payments, but it also prolongs debt. Consider whether you can stay motivated to make payments over a three- or four-year term and what other financial goals may be delayed until your loan is paid off.

Avoid it: If you’re considering a debt consolidation loan, first plug your debts into a debt consolidation calculator to see your average APR. You’ll want your new APR to be lower. Also look for the shortest repayment term with monthly payments you can still afford.

Mistake 4: Not considering other debt payoff options

Debt consolidation isn’t the only option available, and depending on factors like your financial situation and credit score, you may be better off choosing another strategy.

Klipa says credit counseling can offer benefits a simple debt consolidation product cannot, since clients receive individualized counseling about their finances, in addition to a plan to restructure and pay off their debt. This is especially valuable for clients who need budgeting advice.

Another option may be to borrow against an asset, like a home equity loan or a 401(k) loan, Ho says. These loans often have lower APRs compared to an unsecured consolidation loan, especially for borrowers with bad credit.

However, Ho urges caution. If you default on the loan, you could lose the asset or face a large tax bill, on top of the hit to your credit score.

Regardless of the option you choose, the key is to make a plan and commit to it by staying on track with your payments.

“There’s rarely a magic pill that makes debt go away,” Ho says. “We live in a society that favors instant gratification, but with debt, it’s a slow, methodical process.”

Avoid it: Do your research on different ways to pay off debt, particularly if you have bad credit. Consider working with a nonprofit credit counseling agency or a fee-only certified financial planner for advice on your specific financial situation.

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