A debt consolidation loan is a large loan used to pay off smaller debts. It can be an excellent tool to lower overall interest on outstanding loans and credit card debt, and provide a means to enjoy the ease of a single monthly payment. However, it can become a serious pitfall for those who can’t resist the lure of a zero balance credit card or big sales at their favorite stores.
In order to properly use a debt consolidation loan, it is imperative to understand what your spending habits are and how you got into debt in the first place, as well as what the loans truly offer.
Assess your spending habits honestly
How did you get into debt? Was it by making conscious, thoughtful decisions about necessary or otherwise important purchases, or through picking up items here and there without much thought? If your style is less of the first and more of the latter, a debt consolidation loan might be a direct ticket into a heavier debt load.
If the consolidation includes paying off credit cards, one option to avoid spending and racking up more debt is to destroy the cards and close the accounts. However, if you plan on purchasing a home, vehicle, or other large credit-based purchase, a lack of revolving credit can have a negative impact on your credit report.
If you already have a high credit score, lack of revolving credit on your recent credit history may not pose a problem, especially if you stay on time with all payments to the debt consolidation loan. However, if your credit is only fair and you want to continue to build your credit score, it may be wise to use a card regularly while making payments and keeping only a small outstanding balance.
A card with limited use such as a gas or store-issued card can be a middle solution, but it can also be important to have a credit card available for a financial emergency, and a credit card company may close an account with no activity. Keeping a card in use after a debt consolidation loan eliminates the benefit of only having one monthly payment, but the trade off may be worth the hassle. A compromise solution may be to consolidate, but close all credit accounts with the exception of one card with the lowest credit limit.
The next factor to consider is whether or not you can truly trust yourself to use the card only for purchases you would have made with cash or in an emergency situation. Do you regularly succumb to impulse buys? How often have you gone out or shopped online without the intention of spending much money, and found yourself making multiple unplanned purchases for items you don’t need? Have you acquired a number of items you never or rarely use? If you answer strongly in the affirmative to any of these questions, then you may want to work on your spending habits and attitudes before jumping into a debt consolidation loan.
Assess the terms of the loan
Once you’ve been truly honest with yourself about your spending habits and what factors have put you into debt, the next step is to understand if the terms of a debt consolidation loan will truly be beneficial.
A low interest rate and/or smaller monthly payments are usually the factors which draw people to debt consolidation loans. However, how much you pay over the long term should be considered. Some banks offering debt consolidation may sound enticing if their ads offer to cut payments in half, but if the loan stretches over a long period, the amount paid over that time could be enormous, even with a low interest rate.
Ask for a breakdown of the total you will be paying over the period of the loan, and to have the payments calculated over shorter lengths of time. You may find a sweet spot in the numbers — perhaps by paying off the debt in three years instead of five, or five years instead of 10.