When an unexpected event, such as a temporary drop in family income or an unexpected medical emergency leaves a family with a pile of high interest short-term debt, a debt consolidation loan can be a real advantage. A low interest consolidation loan can improve the family’s monthly cash flow position, and can actually help protect the family’s credit score by heading off the potential accumulation “negative events” on the family’s credit report. Debt consolidation loans can often be paid off ahead of schedule when the emergency that made the loan necessary has receded into the past and financial stability has been reestablished.
That’s the bright side of the debt consolidation story. Unfortunately, statistics indicate that debt consolidation loans seldom work out that well.
Debt Consolidation Loans Are Profitable and Easy To Sell
An underlying cause of most of the debt consolidation traps that cause the majority of debt consolidation loans to do more harm than good is that the people who really need a debt consolidation loan usually have already damaged your credit scores. As a consequence, they can’t get debt consolidation loans from low-cost lender such as banks. A large and highly profitable industry has grown up around making loans to borrowers that must have a loan right now without regard to the interest rate or terms. Specialized debt consolidation lenders know that a portion of the loans they make will be end in default. To ensure their own profitability, they spread the cost of those defaults across all the clients who use their services.
Debt Consolidation Loans Usually Increase the Borrower’s Total Debt Obligation
The higher interest rates and extended loan terms that are parts of most debt consolidation loans made by specialized debt consolidation lenders, may help solve the borrower’s immediate financial crisis, but they are the direct cause of one of the most serious of the debt consolidation traps. Debt consolidation loans almost always end up producing a significant increase in the borrower’s debt repayment cost. If the borrower’s income does not increase fast enough to absorb those costs, they will inevitably end up further in debt.
If The Problem Is Lack of Financial Discipline, a Debt Consolidation Loan Won’t Help
While short-term emergencies often play a role in creating the need for debt consolidation loans, the underlying reason loan is needed is often lack of discipline in making financial decisions. This lack of discipline shows itself in the form of bad spending decisions and the failure to allocate enough (or any) money to savings. The debt consolidation loan may resolve the short-term emergency, but it usually has no effect whatsoever on the borrower’s financial discipline, leading to another of the debt consolidation traps to avoid. The same pattern of bad spending decisions and failure to save will sooner or later result in the borrower once again maxing out available credit and having to take on additional debt.
Using the Family Home to Secure a Debt Consolidation Loan
Of all the debt consolidation traps to avoid, using the family home to secure a debt consolidation loan may be the most dangerous. While securing a debt consolidation loan with the family home may provide the borrower with a better interest rate on the loan needed to manage the current financial crisis, the threat of losing family’s principal financial and psychological asset, will make the borrower all the more vulnerable to predatory lenders when the next financial crisis arrives.
Avoiding Debt Consolidation Traps
When used correctly, debt consolidation loans can be very useful in managing the family’s finances. As discussed above however there are many debt consolidation traps that can make a family’s financial situation worse than it was before they consolidated debts. Here are some guidelines for avoiding those traps:
- If you find yourself caught in an upward spiral of debt, find a reputable nonprofit debt counseling service in your community and take full advantage of their services.
- Take advantage of the experience of a qualified debt counselor to help you bring the realities of your family’s financial situation into focus.
- Make sure you understand the relationship between your family’s regular living expenses and total income. This understanding forms the basis for developing a livable family budget, and determining how much money is available for debt service and debt reduction.
- Take advantage of a debt counselor to examine all possible debt management approaches.
- Get a copy of your current credit report, and review it to make sure there are no errors. If there are errors, all credit rating agencies have procedures for disputing in resolving them.
- Make sure you understand the factors that damage the credit score, and the long-term steps your family can take to improve its credit score.
- Before signing any contract for loan consolidation services, make sure the service provider is fully accredited, and check with the local Better Business Bureau to determine how the service provider compares to others in the community.