The Dangers of Borrowing to Get out of Debt
One of the first options that many consumers consider when they decide to get out of overwhelming credit card debt is to look for a debt consolidation loan. Although many confuse a credit card balance transfer with a debt consolidation loan, they are different. A debt consolidation loan might seem like a great solution to fix consumer debt problems, but it presents many financial dangers and barriers.
Is a Debt Consolidation Loan a Good Idea for Paying Off Credit Card Balances?
Consumers who get debt consolidation loans do not pay off their debts. They simply transfer them from credit card accounts to a new lender. Debt consolidation loans can be difficult to qualify for if the consumer has poor credit, and they can end up creating more debt than the consumer started with.
Consumers who take out debt consolidation loans (DCLs) are shuffling their debt balances, not paying them off. Even if they qualify for a DCL, many consumers who have not addressed the original reasons they got into credit card debt will find themselves even worse off than before.
Debt consolidation loans offer a few advantages to consumers, but there can be too many dangers and barriers for them to be good options for most consumers.
A Debt Consolidation Loan Is Not the Same as a Balance Transfer
A debt consolidation loan is an unsecured personal loan provided by a lender for the express purpose of paying off other debts, usually credit cards. Many lenders will offer what they call debt consolidation loans but are really just personal loans (aka signature loans) that the borrower can use to pay off other debts or for any other purpose.
Debt consolidation loans are installment loans and require a set monthly payment until the balance is paid off.
A credit card balance transfer is not a loan but a new credit card account. The new credit card company sends payments to the consumer’s other credit card accounts (or other debts) and adds those amounts to the new account balance. Such transfers typically come with transfer fees, while others come with introductory offers to waive or lower interest rates for a certain number of months.
The consumer who uses a balance transfer option can treat their new balance as any other credit card purchase. They can pay the new balance off in full (if they have the money), make minimum payments each month, or pay some amount in between the two.
The 3 Main Benefits of a Debt Consolidation Loan
Debt consolidation loans have three main benefits when compared to credit card debts. First, most consumers who consider a debt consolidation loan want to simplify their debt repayments with a single monthly payment rather than payments due to multiple credit card companies. For such consumers, a DCL will be an effective option for them.
Another advantage to debt consolidation loans has to do with their structure. Rather than the flexibility of making minimum payments and increasing balances each month like a credit card, DCLs require the borrower to make a set payment each month until the debt is completely repaid. You can’t use a debt consolidation loan to make additional purchases. This essentially forces the consumer onto a debt elimination path rather than giving them the option of continuously going back into debt as credit cards do.
Finally, many borrowers hope to get a lower interest rate on a debt consolidation loan than they have on their current credit card accounts. Even if the consumer has good credit, most credit cards have average interest rates that range between 14% and 18% APRs. For consumers who have missed a payment or two, their account APRs might have defaulted to 29% or higher.
Debt consolidation loans, on the other hand, typically have interest rates in the upper single digits to the mid-teens. However, some lenders will advertise rates as low as 3% or 4% but will offer, after the application process, a loan in the 30% to 40% APR range. Unfortunately for borrowers facing default on their credit cards, they may feel this is their only option, even though it’s a classic bait-and-switch ploy by predatory lenders.
Key Considerations Before Applying for a Debt Consolidation Loan
While the benefits of debt consolidation loans can seem obvious to consumers struggling with credit card debts, there are several drawbacks and even roadblocks along the path to debt freedom through debt consolidation. First of all, to qualify for a debt consolidation loan with a reasonable interest rate, the consumer will need to have a decent credit rating. Additionally, they will have to have sufficient income to cover the monthly payments. Depending on the terms the new lender offers, these requirements might block many borrowers from taking advantage of consolidation’s benefits.
Speaking of terms, it’s important to keep in mind that the consumer is asking the debt consolidation loan lender to take on the cumulative risks from all the debts the new loan will repay. For good reason, the new lender will feel they are taking on greater risks than those individual credit card companies were. And in a world where risk is almost always directly tied to reward, the higher-risk-taking consolidation loan company will require a higher reward in the form of high-interest rates. Consequently, it is unlikely a debt consolidation loan will come with an interest rate considerably lower than the credit card rates or than a credit card balance transfer rate.
Best Tips for Consumers Looking for Debt Consolidation Deals
The most important issue for any consumer considering a debt consolidation debt is to address the cause of the debts they’re wanting to consolidate. If you are paying off medical debts, you might consider waiting until you have emerged from the medical emergency or situation that led to the original debts.
If you want to pay off credit card debts that resulted from overspending or otherwise unmanaged consumer spending, you will want to address your spending issues before you make your debt situation potentially twice as bad as before. Most debt consolidation loan borrowers who pay off credit card debts with a new loan will run the balances on the newly-paid-off credit card accounts back to where they were before the consolidation, leaving them with double the debt!
Debt Consolidation Loans Help Rebuild Your Credit Rating… at Least Temporarily
According to a study of more than 1,500 borrowers by LendingTree released in June 2022, the typical consumer who took out a personal loan appeared to get a 38-point (or 7%) increase in their credit score. Before you run out and shout the findings from the rooftops, keep in mind these major caveats and limitations to the findings.
First, the study focused on personal loans, not on loans used exclusively for debt consolidation. It found that those who used the loans to pay down credit card debt saw greater boosts to their credit score than those who did not pay down other accounts.
Second, the study only looked at the effect of the new loans on credit scores just one month after the loan was approved. The problem with this limitation is that other studies have found that consumers who consolidate their debts will often run their original credit card balances back up in about a year, effectively doubling their debt. It’s to be expected that if they pay off their credit cards with a personal loan, they won’t start using those credit cards again within a month. However, if those credit card accounts are not closed, the temptation to start using them again can be too great for many consumers to resist in the long run.
Obviously, if a consumer takes out a personal loan to pay off their credit card debts but then runs those credit card balances back up, their credit score will suffer. The consumer will likely see their scores drop below the levels they were at when they first took out the consolidation loan.
Alternatives to Debt Consolidation Loans
Before jumping on the personal loan or debt consolidation loan bandwagon, be sure to consider your options.
First, a credit card balance transfer might seem like a good idea because of the advantageous introductory offers commonly included. However, nearly three-quarters of consumers who use one credit card to pay off other credit cards will run the balances on those other credit cards back up to their previous balances within one to two years after the balance transfer. As noted above, address any spending issues before going down the balance transfer route. Additionally, close out any credit cards that are paid off if you feel any possibility that you might continue to use them.
Next, consider using a nonprofit credit counseling agency like Money Fit to get both lower interest rates and to close your old accounts so you don’t run the balances back up. There’s no direct effect on your credit score, and you will be out of debt in five years or less.
Finally, if you have the resources, energy, and availability, you might consider getting a side hustle or part-time job to earn extra cash that you can use to accelerate your debt reduction. Although many side hustles come with extra expenses (e.g. vehicle expenses for ride-sharing or food delivery), many don’t. If you commit to sending everything you earn from side hustling to your current debts, you might be surprised just how quickly you can find yourself completely debt-free.
How long does it take to get a debt consolidation loan?
If you have the account numbers and balances of the debts you want to consolidate, the process of applying and qualifying for debt consolidation can take just 10 to 15 minutes if done online. However, if approved, it can take three to six weeks for the new lender to pay off the old debts. Keep making payments until this happens.
Do debt consolidation loans put money into your bank account?
Depending on the lender, a debt consolidation loan may go directly to the accounts you are paying off (e.g. credit card accounts) or the loan proceeds may end up being deposited directly into your bank account. This latter option is particularly true for personal loans not exclusively used for debt consolidation.