Debt consolidation: the pros and cons

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A loan might improve monthly cash flow but it can also pave the way to more debt

When consumers rack up lots of debt on several different accounts, they often find the various monthly payments take a huge bite out of monthly cash flow.

That's when consumers might consider taking out a debt consolidation loan, using the proceeds to pay off all or most of the existing debts so that there is just a single payment, usually for a lower amount, each month.

It can be a sound strategy, but because there are so many different ways to consolidate debt -- some better than others -- you need to consider all the pros and cons.

Bruce McClary, Vice President, Communications at the National Foundation for Credit Counseling (NFCC), says a consolidation loan can sometimes save money in the long run if it has a lower interest rate and fees. And since most of the debt most consumers have is on credit cards, there is a very simple way to consolidate it.

Balance transfer credit card

"Consolidating unsecured debt can be done by transferring multiple balances to a single credit card," McClary told ConsumerAffairs.

And if you choose the right card -- one that provides a year or more of 0% interest -- you can quickly make progress on paying down the debt while having a lower monthly payment.

One things to consider, however, is most balance transfer cards charge a fee of 3% of the balance you are transferring. The Chase Slate Card, however, does not if you transfer the balance within 60 days of opening the account.

Home equity line

Another way to consolidate high interest debt is with a home equity line of credit (HELOC). The advantages are the interest rate is low and the interest you pay is tax deductible.

But in most cases, you are paying off unsecured debt with secured debt -- debt that is secured by the equity in your home. Attorney Patricia Dzikowski, writing on the legal site Nolo, says there is a huge downside to consolidating unsecured loans into one secured loan.

"When you pledge assets as collateral, you are putting the pledged property at risk," she writes. "If you can’t pay the loan back, you could lose your house, car, life insurance, retirement fund, or whatever else you might have used to secure the loan."

Bank loans

Banks and other financial institutions offer unsecured loans for the specific purpose of consolidating other debt. While these may be an alternative, the interest rate can be fairly high..

Personal finance guru Dave Ramsey is not a fan of debt consolidation. In fact, writing on his website, he calls it "nothing more than a con."

"You think you're starting with a clean slate," he writes. "But the truth is the debt is still there, as are the habits that caused it -- you just moved it!"

But other personal finance advisors say, properly selected and managed, a debt consolidation loan can give your monthly budget a little breathing room, helping you to get back in control of your finances.

John Ganotis, founder of Credit Card Insider, says it's very important not to take on additional debt while you're trying to pay down the consolidated debt.

"Once you commit to a debt consolidation loan, don't fall behind on payments since late or missed payments can damage your credit for many years," Ganotis told ConsumerAffairs.

He also says online lending marketplaces like Prosper and LendingClub can be alternatives to getting loan at a bank. A local credit union could also be a good place to go when you want to consolidate loans.

The Consumer Financial Protection Bureau (CFPB) suggests consulting with a non-profit credit counselor before trying to consolidate your debt.

McClary, whose organization represents non-profit credit counselors, agrees. He also says consumers should check their credit scores before shopping for a loan, since a low score will severely limit choices.

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