The Consequences of Debt Consolidation


Consolidating debts is a broad term for making them simpler and less costly to pay off. There are a few ways to go about achieving this — with two of the most popular forms being a personal loan or transferring high-interest debts to a balance transfer credit card.

Some property owners decide to take out a home equity loan to wipe out their high-interest debts. Another way to consolidate is signing up for a debt management plan (DMP) through a credit-counseling agency. This means you’ll make one single monthly payment to the agency and it will handle splitting up your funds.

There are both advantages and disadvantages to consider whichever way a borrower consolidates. Knowing the upsides and downsides before taking action will help you navigate the process more smoothly, hopefully avoiding “potholes” along the way.

Here are some of the consequences of debt consolidation.

Your Credit Score May Dip

One short-term effect of consolidating debt that may surprise borrowers is a temporary dip in credit score. Why does this occur? Because applying for either a loan or a new line of credit triggers a hard inquiry on your credit report. Don’t be alarmed if you see your credit score — which you’ve been working hard to keep as high as possible — drop a couple points in the aftermath.

The good news is that debt consolidation can raise your credit score, provided you make payments on time and avoid racking up new debts. This is mostly because you’ll be using a healthier percentage of your available credit after paying off high credit card balances, and because your timely installments toward your loan will bolster your credit history.

You Put Your Assets at Risk (with a Secured Loan)

There are two main types of loans for debt consolidation: unsecured and secured. The former does not require offering up any assets as collateral, but usually carries higher interest rates as a result. The latter does involve putting up an asset, like a home as collateral — which may lower interest rates and help borrowers with less-than-stellar credit ratings qualify for approval.

While the option of getting a secured loan does open doors for borrowers, it also puts the asset used for collateral at risk. Missing payments on your loan can result in your lender putting a lien on your property. This is especially risky if you’re using your home as collateral.

This potential risk underscores the importance of doing the math before accepting a loan to make sure your budget can support monthly payments for as long as it takes to fulfil the obligation — which can often be years.

You May Be Tempted to Spend

Whether you transfer balances to a new card, use the debt consolidation process, take out a loan, use home equity or enroll in a DMP, wiping out your high-interest unsecured debts can definitely create the illusion you’ve suddenly become “debt free.” Of course, we know this isn’t true because you’re actually taking on new debt to satisfy old debt.

But this illusion can lend a false sense of security, tricking borrowers into thinking it’s fine to start spending on credit again. Avoiding this trap requires avoiding the root behaviors that contribute to the accumulation of debt — and committing to sticking to a healthy budget to avoid backsliding into even more debt.

Debt consolidation, like any strategy, has its share of potential benefits and potential consequences. Knowledge is power when it comes to avoiding these pitfalls to get the most out of the process.