If you’re dealing with a high level of debt, you may be delving into the potential benefits of debt consolidation. Your eye is likely on the prize of getting to a more affordable monthly payment, which can help you eliminate your debt and lower the level of money stress you’re experiencing.
While that’s understandable (and sensible), it’s also important to be aware of the hidden costs of debt consolidation. There are fees that tend to get glossed over by lenders when loan applicants are trying to get approved. This is a common sales technique known as “focus on the positive.”
This article will help you understand the fine print of debt consolidation loans. You’ll learn about the potential fees and how much they can cost. Once you have those details, you can then proceed to make the best possible decision about managing your debt.
1. Origination Fees May Be Hidden in the Loan Agreement
The Truth in Lending Act (TILA) of 1968 prohibits lenders from concealing the fees and costs associated with personal loans. Unfortunately, that law does not specify where in the loan contract those disclosures need to be published. It also doesn’t mention anything about the size of the type that they’re printed in. Some lenders take advantage of that, and the details about these fees could be difficult to find and in a tiny type size.
One of the most important fees to know about is an origination fee, which is taken off the top when your loan is first approved. Lenders usually describe it as an administrative or processing cost, and it can be considerable. This fee can range from 1% of the total loan amount to as high as 10%, depending on the lender and your financial profile. Lenders can use this charge as a way to mitigate risk for lenders servicing subprime borrowers. Translation:: If your credit score is low, you can expect a high origination fee from anyone willing to issue you a debt consolidation loan.
An origination fee is one of the most common hidden costs of debt consolidation, so if you don’t get information about whether it will be charged or how much it will be, ask. You might also search for loans that don’t charge origination fees. They’re out there; just make sure there isn’t some kind of trade-off involved that doesn’t suit you.
2. The Interest Rate vs Annual Percentage Rate (APR) Can Matter
Consumers often wonder why the annual percentage rate (APR) is so much higher than the interest rate advertised for a loan or credit card. The answer to that quandary is that APR and interest rate are different.
- The interest rate is simply the percentage charged for the privilege of borrowing funds.
- The APR also includes fees. This figure can give you a more accurate representation of how much you will truly pay.
Many consumers use the terms “APR” and “interest rate” interchangeably, but you want to focus on comparing APRs. Since lenders can bundle additional charges into their APR and credit card companies may include monthly and annual fees, that percentage vs. interest rate is the one that counts.
A little more detail about lending disclosures: One of the components of TILA that references APRs is Regulation Z. It was added to the legislation as part of the “Competitive Equality Banking Act of 1987” and deals mainly with disclosures when advertising APRs. Unfortunately, Regulation Z doesn’t mandate a fee and interest breakdown of the APR. Only the actual number needs to be disclosed.
3. Your Credit Score Can Decrease
This is one of the hidden costs of debt consolidation that’s sometimes overlooked because it doesn’t come with a monetary price tag. Accepting a debt consolidation loan or opening a balance transfer credit card account creates “new credit,” which is a factor in determining your credit score. When you access new credit, it can often cause your credit score to temporarily go down. That, in turn, could be problematic if you’re applying for another loan (say, a mortgage) and don’t have as high a credit score as you’d hoped for.
Another consideration when taking out a debt consolidation loan is to make sure you can really and truly afford the new payment. As with most other payments, your history with the lender will be reported to the three major credit reporting bureaus and will impact your credit score.
Paying your loan late or skipping a payment will probably ding your credit score and remain on your the record for up to seven years. If you are feeling unsure of your ability to make the payments, consider other options, from bringing in more income via a side hustle to meeting with a credit counselor for advice.
4. You May Pay More Over the Life of Your Loan
It’s important to understand that when you take out a debt consolidation loan, that a lower monthly payment isn’t a get-out-of-jail-free card. In fact, the math often works this way: The lower the monthly payment you are offered, the longer the repayment term may well be. A lower monthly nut can of course be hugely helpful and provide a way to get your head above water, financially speaking.
But do not overlook the fact that you will probably pay more in interest over the life of a loan with an extended term. That could have an ongoing impact on your finances and your ability to reach other goals that are important to you. Take a look at how different offers shape up, both in terms of the monthly payment and the total amount you will need to spend to pay off the debt consolidation loan. You can use an online calculator to get these numbers together quickly.
5. You Could Get Caught in the Consolidation “Debt Trap”
One of the most insidious hidden costs of debt consolidation is the “debt trap.” What’s that, you ask? It’s when you use your debt consolidation loan to pay off what you owe. Then, a feeling of relief and freedom can settle in, and you can start spending again and accumulate more debt with your available credit.
We call this a “debt trap” because there’s nothing other than good sense stopping you from using your credit cards. (Yes, you may be able to keep existing credit cards open in this situation or open new ones, depending on your circumstances.) Most Americans live in an economy built on credit, with the average person carrying $7,951 in credit card debt. It’s far too easy to go shopping and wind up with both credit card debt and your debt consolidation loan to pay off.
Avoiding the Hidden Costs of Debt Consolidation
The best way to avoid hidden costs of debt consolidation is two-fold. In terms of the actual dollars and cents risk, protect yourself by reading the loan agreement carefully. The Truth in Lending Act requires that lenders disclose fees, so make sure you know what you’re getting into. There’s nothing worse than being blindsided because you didn’t read the fine print.
As for the emotionally-driven risks, be focused and strict with yourself. Commit to not using your credit cards again until the debt consolidation loan is paid off. Use your debit card instead or pay with cash. This may be difficult initially, but it becomes easier with time. It honors the commitment you’ve made to debt consolidation, and watching your financial standing improve can be a major pat on the back.