4 Common Debt Consolidation Mistakes & How to Avoid Them
After months of stress from a growing pile of credit card statements and a continuous stream of aggressive collections calls, you decide that consolidating your debts is your best option for turning over a new leaf.
Debt consolidation may feel like a big relief: with a single lump sum debt to owe, you’re no longer trying to stay on top of multiple creditors, you aren’t missing deadlines and there isn’t the fear of steep interest rates compounding.
But you aren’t in the clear yet — debt consolidation loans are only the first step in the process of getting your personal finances under control and getting you out of debt.
You still have major strides to make in your journey to become debt-free. While it’s tempting to relax once you’ve taken the steps to consolidate your debts, if you aren’t careful you could end up worse off.
Here are four common debt consolidation mistakes you need to be wary of.
Mistake 1: Not fully understanding how you got there in the first place
Debt consolidation can be a Band-Aid solution. Once you get your debt consolidation loan, you can simply deal with the one monthly payment and keep trucking on with your spending. If you don’t carefully consider how you ended up with a mountain of debt that you couldn’t manage, you may not be changing your habits that got you into this situation.
In the majority of cases, people who consolidate their debt are consolidating at least $10,000 to $15,000 of debt. It took them time to accumulate enough debt to realize that they were struggling to pay it back. This brings us to a good learning point: when you consolidate debt, you need to acknowledge the severity of the situation, and take a closer look at how you got there.
Debt consolidation is a good time to clean up your finances and reflect. Acknowledge how you got into this position, what it’ll take to get you out of it, and how to ensure it won’t happen again.
Be cognizant of your vulnerabilities and triggers — do you turn to impulse buying with online shopping too much or tap away on your credit card for lunch and snacks during your workday?
You’ll have to comb through credit card statements, bills, receipts and other expenses to create a detailed breakdown of your spending to better understand what the culprits might have been, or for the next few weeks, you can track your spending and see where your money is going. Most people who honestly track their spending are surprised!
Once you’ve noticed the negative patterns, carve out a plan or budget and stay disciplined to avoid the spending pitfalls that got you into bad financial shape.
Mistake 2: Not looking into all your options
There is no single, one-size-fits-all way to consolidate your debts. There are plenty of options for you to choose from. Options can range from moving all of your credit card debts onto a single card in a balance transfer, opening a line of credit to house all of the debt you’ve incurred, or even signing up for a secured or unsecured loan with the bank.
With so many people struggling with debt, other options have also opened up that can function as a form of debt consolidation too. These options can include a Debt Management Program, a debt relief option which consolidates all your unsecured debt into on affordable monthly payment, or a Consumer Proposal which consolidates and reduces your debt. While a Debt Management Program is completely private and confidential option for people who are struggling with their debt, a Consumer Proposal is a legal process and form of insolvency that should only be considered as a last resort.
When someone is looking for a debt consolidation loan, we often find it's very helpful for them to first meet with a non-profit credit counsellor to ensure they figure out why their debt balances have grown. A credit counsellor will also help them put together a realistic budget to make sure their spending stays within their income, help them explore all their options to get out of debt, and provide them with a plan to get out of debt within a reasonable time frame. Unfortunately, with consolidation loans, many times people don't get out of debt quickly. It's pretty normal for people to continue to spend more than they earn and re-accumulate debt at the same time they are trying to pay down their consolidation loan. Working out a realistic budget and putting in place a plan to get out of debt with a credit counsellor helps people to avo id this common problem.
When consolidating debts, some people are too eager to set the wheels in motion with the first option that appeals to them, but it’s worth looking at all of the routes you can take and weighing their benefits and drawbacks.
Balance transfers, for example, could come with incredibly low interest rates at the start, which may be enticing. The fine print could reveal that upfront fees are pricy and the interest rate may be promotional for the first six months only. Credit card companies offer these low introductory rates because most people end up paying a lot more in the long run.
It's important to do your homework and crunch all of the numbers before settling on the best choice for you and your finances. Carefully consider the effects of your decision as well, since some options can leave you with bad credit for many years after you’ve paid back your debts. This is another reason why it can be a good idea to ask a professional credit counsellor about the benefits and drawbacks of the options you are considering.
As part of doing your homework, you can start by listing all of your outstanding debts and their interest rates. A student loan, with a fixed interest rate that’s significantly lower than your credit cards’, doesn’t need to be rolled into your consolidation, for example. Other cards may have small limits and can be easily paid off instead of being lumped into the consolidation, too.
If you feel intimidated with the process, that’s okay. A credit counsellor can advise you through the process.
Mistake 3: Not limiting your use of credit
If debt consolidation isn’t done right, it can be a major gamble. When you move all of the debts from your credit cards and pile them onto a single card or another loan, you effectively free up thousands of dollars in your wallet.
If you’re a spender, there’s a chance you could turn to your cards again.
However, if you're choosing to approach debt consolidation with a brave face and the intention of turning over a new leaf, it would be wise to limit your access to credit and limit your temptation to spend. You can close and cut up any credit cards you don't need if you think that's the discipline you need, or you can put your credit cards on ice - literally freeze them in a big block of ice in your freezer. Then when you get the urge to use them, you'll have time to think twice about your decision while the ice thaws.
If you chose to close credit accounts, that will lower your credit score (because part of your score is based on how much credit is available to your versus how much of that credit you are using). However, sometimes a little bit of short-term pain is worth the long-term gain. If you choose to close your credit cards, your best bet is to keep a single card open — typically, the one with the best and longest credit history. Hang onto this card for emergency and safety measures. Lower the limit on the card if you’re concerned you’ll start swiping again.
While it's true that closing all of your cards at once may take a toll on your credit score, for many people this is better than keeping the door open to excessive spending. Your credit will naturally improve as you pay down your debt, and you can always re-open another card in the future once you have things in hand.
Mistake 4: Not having a plan to pay off the debt consolidation plus other debt within a specific period of time
A consolidated loan could take years to pay off, especially if you’re making minimum payments every month. It can be an arduous journey to being debt-free, and if you’re adding on more debts, this will only exacerbate the process.
In some cases, there are defined deadlines. When debt repayment plans are carved out by credit counsellors, for example, the consumer and the creditors agree that the debt is repaid within three to five years.
But balance transfers or lines of credit are managed on your own. You need to thoughtfully make contributions and whittle down your debt in a manageable way that fits into your budget.
You need to determine how much you can realistically allocate to debt repayment. Create a budget that includes a dedicated amount to debt repayment and automate that expense. Set a deadline based on your monthly debt repayments, so you’ll know when you’ll be debt-free.
You can also commit to throwing extra bonuses, tax refunds, or any cash gifts that come your way to your debt, too (for more ideas on where to find money to pay down your debt more quickly, have a look here).
Stay accountable throughout the process and set checkpoints so you can revisit how you’re faring. You might even learn you’re ahead of schedule or you want to prioritize paying off your debt consolidation by making accelerated payments.