Dangers of debt consolidation

Debt consolidation does have a few pitfalls that may not be quite so obvious when faced with daunting debt. Even so, being aware of the dangers of debt consolidation before obtaining a consolidation loan can help reduce and avoid additional financial complications later on. Some of the dangers of debt consolidation are described below.

• Costly variable interest

If a consolidation loan offers a low introductory interest rate that is variable, the rate could go up at any time after the initial interest rate offer expires. This may save money in the short-term, but if the variable rate rises to a weighted average interest rate higher than the loans that were consolidated, it's no longer cost effective. After this point the consolidated debt becomes financially ineffective and possibly dangerous depending on how high the interest rate goes.

• Lower debt to credit ratio

Another potentially negative consequence of consolidating debt is it can affect credit score in the wrong way. One way this can happen is if previous loans, credit cards or lines of credit become closed accounts. This is because credit score is partially based on how well you manage different types of credit. If the amount of debt paid off with regular payments is less than a proportional amount of prior debt payment, a negative affect on credit score may also occur due to the slower rate of payment despite a lower cost of debt.

• Extra consolidation fees

Depending on the type of consolidation loan, consolidation fees may present an additional danger of debt consolidation. For example, if you obtain a consolidated refinancing of your mortgage other loans may be incorporated into the refinanced loan. Several things can happen here including consolidation fees associated with the mortgage refinance. Moreover, these costs potentially add up to thousands of dollars.

• Poor terms of agreement

Consolidation loans like other loans have terms of agreement. These terms of agreement can be a danger of debt consolidation if they are misunderstood or involve a caveat or policy that can be financially harmful to you at a later point in time. For example, can the lender increase interest rate if any payments are late? or are there ongoing loan management fees that you didn't read about? Several financial penalties or fees may be associated with a consolidation loan and may be detailed in the loan's terms of agreement.

• Type of consolidation

The type of debt consolidation can also be a danger. This is because consolidated debt can be rolled into several types of loan products which differ in cost considerably. Some different types of debt consolidation include mortgage debt consolidation, credit card consolidation, and refinancing of multiple auto loans under one new consolidated loan agreement. If the potential problems of debt consolidation described above occur together, the affects multiply for a more negative and compounded financial consequence.

Businesses such as banks use risk management to avoid becoming victim of bad debt consolidations. Individuals can also use a risk management when assessing debt consolidation loans. For example, to avoid bad interest rates build credit first and review the consolidation loan terms. If there are excessive front end fees and the re-scheduling of a mortgage amortization does not make the consolidation worthwhile, consider alternative options such as snowballing debt payments.