Consolidation loans may seem the easiest way to deal with multiple debts but beware of the potential snags.
We've all probably seen the plethora of adverts on the telly this month. "In debt? Why not switch all your debts into one easy, lower monthly payment?" Etc...
Consolidation loans aren't necessarily a bad idea. When you've got multiple claims on your cash for various credit cards and loans -- especially if you're in arrears -- the simplicity of rolling all your debts into one monthly payment seems the ideal choice.
After all, your creditors get paid off and stop pestering you, and you can just settle down to making sure that your one simple monthly debt commitment is met for the term of the consolidation loan.
My beef is not with consolidation loans per se -- it's with the people who don't use them properly because they haven't read the small print thoroughly or because they haven't taken on board the wider picture.
Here come two important facts:
Firstly, seven out of ten people pay off their loans early, yet repaying early entails penalties.
Secondly, and this is more important, it is very common indeed for people taking out a consolidation loan to give in to the temptation to run up further debts.
All those newly paid-off credit cards will subsequently have sizeable spending limits available and it's hard to resist using them -- especially when you've been steadily and dutifully paying off your consolidation loan for six months or more. At that stage you may feel entitled to 'reward' yourself with a new telly/laptop/holiday. The result is invariably more debt.
The Motley Fool has said on many occasions that the things to look out for when taking out any type of personal loan are that it should be:
- flexible (in case you can pay it off early or can afford to overpay);
- unsecured (so you don't immediately put your home at risk);
- at a fixed interest rate (so you don't get surprised with a sudden interest rate rise);
- uninsured - ie: avoid payment protection insurance unless you're absolutely sure you need it. Not only could it increase the cost of your loan by as much as a third but most people never claim on it.
It's also very important to shop around and to compare Annual Percentage Rates (APRs) and the Total Amount Repayable (TAR). Lenders calculate interest rates in different ways so it's important to check how much a loan will actually cost you in terms of real money.
The fact is consolidation loans can be a very good answer to multiple debt problems if handled sensibly. But there are serious pitfalls if they're not!
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