The biggest risks associated with debt consolidation include damage to your credit score, fees, the possibility of not receiving low enough rates, and the possibility of losing any collateral you provide. Another danger of debt consolidation is ending up with more debt than you start, if you are not careful. However, some borrowers apply for home equity loans to pay off existing debt or will borrow at a 401 (k). Doing any of these things can be very risky because if you don't repay your loan, you'll put your house in danger or you'll receive a 10% penalty plus income tax owed on money withdrawn from your retirement account.
While it may seem attractive to pay a very low interest rate with a home equity loan or to pay interest to yourself with a 401 (k) loan, you should think very carefully about converting unsecured credit card debt, which has no collateral attached to it, into one of these high-risk loans. One of the main problems with debt consolidation is that it can free up “space for consumers to accumulate even more debt. Also, if any of your old debts were credit card debts and you keep your cards open, you'll have a better credit utilization rate and a stronger credit history. The amounts owed represent 30 percent of your credit score, while the length of your credit history accounts for 15 percent.
These two categories could lower your score if you close your cards after paying them. Keep them open to improve your credit rating. Consolidation loans are a better option for most, as they require payment of principal in addition to paying interest each month. This provided a fixed term during which the loan will be repaid.
Most will have an interest charge comparable to that of an unsecured line of credit, but cannot be borrowed again. This helps ensure that the debt is repaid. The main drawback comes when you try to adjust the payment to the budget. With a limited time frame and a required interest and principal payment, it can be difficult to find money in the budget to address debt in this way.
When you consolidate your debts, you risk losing certain options and programs. Consolidating federal student loans into private loans could result in the loss of applicable repayment programs. Converting unsecured debt into guaranteed debt could make it difficult to file for bankruptcy, should you attempt to pay off your debts. To ensure that debt consolidation doesn't worsen your situation, it's important to understand the dangers so you can make an informed decision about whether consolidating your outstanding debt makes sense for you.