Beware of These 3 Common Missteps Before Consolidating Your Debt

Debt consolidation can be a helpful way to get out of debt—as long as you don't dig yourself a deeper hole.

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Photo: Olivia Barr

If you're searching for a way to streamline your debt obligations, debt consolidation is a pretty desirable option. "Debt consolidation is a technique used to combine multiple existing debts into one singular loan, ideally with a lower interest rate," says Grant Sabatier, author of Financial Freedom: A Proven Path to All the Money You Will Ever Need. When you do this, you are taking a lump sum of money from a new source to pay off your old debts, he says. This source could be a balance transfer credit card, a personal loan, or refinancing your home mortgage.

Although making one consolidated payment may be easier, more convenient, and may offer a lower interest rate, financial experts will warn to proceed with caution. Missteps along the way could impact your credit rating or put you at unexpected financial risk.

Here are three debt consolidation mistakes to be on the lookout for when researching debt consolidation options.

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Not understanding the terms of a balance transfer offer

Although consolidating your balances is a helpful exercise, as you'll have fewer debts, balances, and interest rates to keep track of (because you're combining multiple payments into one monthly payment), be mindful of the fine print of your debt consolidation path. "There are pitfalls to this approach and you'll want to be careful if consolidating accounts through credit card balance transfers is your preferred approach," says Lauren Anastasio, certified financial planner, and director of financial advice at Stash, an online investing platform.

A caveat is that interest rates increase after an introductory period, so make sure to read the terms and conditions of the balance transfer agreement carefully and thoroughly. "It may sound like a great deal if a card is offering you 0 percent for 12 to 18 months on a balance transferred from another card, but chances are you're receiving that promo rate after paying 3-5 percent up front to do the transfer," she explains.

According to Anastasio, this will add to your total debt and make your minimum monthly payment even higher. "Those promo rates also expire, so try to go into the process with the intention of paying the balance off in-full before the promotional period is up," she says.

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Ignoring the credit score rating implications

Opening a new credit card for the purposes of transferring a balance can hurt your credit, says Anastasio. "A new credit inquiry and account while you're already carrying balances can be a red flag to card issuers and other lenders that you're not able to manage your debt," she says. "You may find you're not able to qualify for other offers or receive higher interest rates moving forward when your credit score is lagging."

There could be even deeper credit implications if you transfer balances from one card to another and then another each time the promotional period expires. "Beware of the vicious cycle of paying only the minimum. Just because you're not being charged a high-interest rate during the promotional period does not mean you're getting rid of your debt," says Anastasio.

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Not recognizing the risks of rolling debt into your mortgage

Using your home equity to consolidate debt can be beneficial from a cash-flow perspective. "Not only are you amortizing your payments over 30 years, you're likely also locking it in at a very low interest rate," says Anastasio. This can drastically reduce your monthly obligations and improve your cash flow over time, she points out. But, she warns there are risks to using your home as your "get out of debt" tool.

Sara Rathner, credit card expert at NerdWallet, outlines issues you need to be aware of during the debt consolidation process: It's time-consuming, there could be thousands of dollars in closing costs, and you may need to purchase private mortgage insurance if you don't have enough equity in your home. But, putting your home on the line is even more serious, so be sure you are in a position to pay your mortgage on time and in full. "If you can't afford your mortgage payments going forward, you risk losing your home," Rathner warns.

The Bottom Line:

As you're considering your debt consolidation options, it's important to understand how you got to this point. Do you have spending triggers? Do you open new lines of credit because of overspending? Getting to the root of the issues of what got you into debt in the first place is certainly a step in the right direction. "If your spending habits are not responsible, then consolidating your debt and paying off your balances will only then free up credit for you to overspend with once again," says Michael Cummins, director of finance at Insurance Geek. "You'll find yourself in a vicious cycle of going into and out of debt." Instead of continuing that cycle, Cummins says to address your spending habits and learn how to be more responsible with money before consolidating your debt and paying it off.

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