Debt consolidation is an attractive way for consumers to roll smaller debts into one large debt. This can be achieved in many ways: by taking out a home equity loan to pay off numerous debts, transferring existing credit card debt to one card with a lower interest rate, or obtaining a personal loan to pay off the debts. However, debt consolidation dangers are rife for the consumer who is unaware of the risks.
Risk to Collateral
Homeowners have an advantage when it comes to consolidating debt in that they can get a loan by taking out a second mortgage or using the equity they've accrued in their home as a line of credit. However, if the consumer cannot make the payments or if payments are made late, he risks losing the property, warns the Federal Trade Commission. Credit.com also points out that those who unknowingly extend the term of the loan (and the interest) might end up paying more than if they simply had paid the debts individually.
Bank Loan Dangers
Obtaining a bank loan is another way to consolidate debt. However, as noted by Credit.com, many consumers who have the weight of numerous, unsecured debts are already in arrears, which is reflected in their credit scores. A bank might be unwilling to give a loan to a high-risk customer or might charge a high interest rate. Again, the consumer may end up paying more for debt consolidation than if she had paid the debts off one by one.
Credit Card Debt Transfers
Consumers with pristine credit records might be able to transfer the balance of their credit cards to another credit card with a lower interest rate. But as noted above, those with a checkered credit history probably won't have this option. Also, many credit cards offer a low interest only for a few months, after which the consumer is left holding a high-interest credit card, notes MSN Money's contributing editor, M.P. Dunleavey. Transferring debt from one credit card to another shows up on credit reports and can give future creditors the impression that a consumer is high risk.
Estrangement from Family
For the debtor with nowhere else to turn, getting a personal loan from a family member or friend might be one option, especially if there is very little or no interest on the loan. However, as Credit.com warns, if the money isn't paid back, it could tarnish or destroy an important relationship; the pressure a relative or friend feels when asked for such a loan can also create a rift. Additionally, the Internal Revenue Service might tax the lender for interest the consumer would have normally paid to a conventional lender. And the consumer may end up being taxed for the loan as well, if it is not paid back.
Unscrupulous Credit Consolidators
Debt consolidation is particularly risky if the consumer opts to seek the services of a debt consolidation company. These companies have a built-in fee as part of the monthly payments consumers make to them, generally around 10 percent, or $40 on a $400 monthly payment, notes MSN Money's Dunleavey. Again, consumers could end up paying more for the consolidated debts than if they paid these off individually. Also, Dunleavey warns that some debt consolidators might make late payments to creditors or skip payments, which in turn is reflected in the consumer's credit records.
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