The Disadvantages of Debt Consolidation

Debt consolidation may make sense in some cases, but it is not a magic solution to your debt problems, financial adviser Liz Pulliam Weston at MSN Money notes. Your current arrangement may work just as well as debt consolidation. Debt consolidation may not save you any money or reduce your monthly payments. If your monthly payments are smaller under debt consolidation, that’s because you might have extended the term of the loan, meaning it’s going to take you longer to pay it off, possibly costing you more in interest charges over the long term.

Transferring your credit card debt from credit cards with a high interest rate to one card with a low introductory rate could work, but this approach has some pitfalls. After the low introductory rate ends, the rates could rise to be more than you were paying on your original cards. If you use this new card for new purchases, the new purchases could accrue interest at a higher rate. If you only pay the minimum on your credit card, you could be in debt for years or even decades, according to MSN Money. Finally, by consolidating your debt into one credit card, you can damage your credit score. Available credit counts for 30 percent of your credit score. Being maxed out, or close to it, on a card lowers your score. Small balances on multiple cards are better for your FICO score than a large balance on one card.

Taking out a home equity loan or a home equity line of credit can get you a lower interest rate than what you currently pay on your debts. But this approach is risky, says Weston. Your home is on the line and if you miss your payments, you could lose your home. If you are teetering on the verge of bankruptcy, your credit card debt can be erased if you file, but home equity loans can’t. In a down housing market, draining your equity by taking out a home equity loan puts you in a bad spot if you have to sell your home. You may not net enough to pay off your mortgage. And, credit counselor Chris Viale told Bankrate.com, you are likely to wind up with the same or higher debt load once you get the home equity line. That happens to 70 percent of Americans, says Viale. The key is to fix the problems that got you into debt.

Borrowing from your 401k is an option, but not a good one. Even though you’re borrowing your own money, you have to pay it back within five years. Otherwise, the Internal Revenue Service will tax you and charge you penalties. Also, if you lose or change jobs, you have to pay the loan back in full. Finally, the point of your 401k is to save money for your retirement. If you borrow from it, you could be losing money that could have accumulated in your fund.