Ideally, debt consolidation improves a person's financial situation by combining multiple debts into one loan with a reduced interest rate, thereby lowering monthly payments. However, debt consolidation does have its pitfalls, including taking on more debt, consolidation scams, lower credit ratings and even loss of property. There are no guarantees with debt consolidation, and individuals should investigate a company with the Better Business Bureau prior to taking out a consolidation loan or agreeing to a debt management plan.
Cost
Debt consolidation companies and banks charge interest on a loan just like any other lender. Ideally, the interest rate is lower than your current rates. However, debt consolidation companies also charge fees for their services. Individuals looking to consolidate debt through a third party need to make sure that they are not taking on more debt when consolidating.
Credit Score
Debt consolidators may negotiate with creditors in an attempt to reduce the debt and lower interest rates. They often do this by stopping all payments to the lender for months, then offering a reduced lump sum payment. This tactic does work sometimes. However, stopping payments to creditors will hurt your credit score if you were current with payments prior to consolidation. Additionally, your credit report will show that you're working with a third party on a debt repayment plan, which may hinder future credit offers.
Additional Debt
If debt consolidation involves a negotiation and a repayment plan, lenders will usually close or freeze the account as part of the agreement. However, if an unrestricted consolidation loan is used to pay off debts, it frees up open lines of credit. Individuals may fall into the cycle of running up accounts or credit cards, leaving them in a worse financial situation than they started with.
Secured Consolidation Loans
Consolidation loans requiring collateral put homes, vehicles and other property at risk if payments become delinquent. Banks, credit unions or consolidation companies will put a lien on properties to ensure payment.
Disreputable Companies
Unfortunately, there are companies that prey on individuals with financial problems. Some are unreliable companies that disappear with your money, while others lock you in to less than favorable contract terms. Individuals who feel they have been victims of unfair business practices should file a complaint with the Federal Trade Commission on their website or by calling their toll-free hotline at 877-382-4357.
No Guarantee
Guarantees that seem to good to be true, such as promises to eliminate debt, usually are. There is never a guarantee that creditors will accept lower payments, reduce interest rates or otherwise work with a consolidation company. This still leaves the consumer responsible for the debt, and creditors may take legal action to get paid.
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