Financial Litearcy - Smart borrowing
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Consolidation loans versus credit cards

Consumers get into trouble with credit card debt and often turn to consolidation loans to bail them out. The rationale: If you have multiple credit cards with high interest rates, they can be neatly packaged into one fixed-rate loan with a predictable monthly payment.

However, debt substitution can be dangerous for the fiscally undisciplined, says Paula de Vos, a Certified Financial Planner and president of Synergist Wealth Advisors in Carmel, Calif.

"The danger that people run into is taking out a loan and running up their credit cards again," she says.

But for disciplined consumers looking to turn a new leaf on their borrowing habits, the plan can be a viable alternative to making minimum credit card payments. Before taking out a consolidation loan, consumers should first assess their overall debt picture, says de Vos.

"It's hard to look at debt and debt products in isolation," she says. "One should also be considering taxes and ramifications to your other assets and looking at it in a more holistic fashion."

Consolidation loan vs. credit cards
Consolidation loanCredit card
Pros
  • One predictable monthly loan payment versus several with different due dates.
  • Deal with one creditor versus many.
  • Interest may be tax-deductible if you use home equity to consolidate your debt (see separate section on home equity).
  • May come with lower interest rates and lower monthly payments than credit cards.
  • Paying off multiple credit cards in a disciplined way can be satisfying.
  • Full credit limits prevent more borrowing.
Cons
  • Once credit card balances are cleared, it's easy to fall into debt again.
  • Often comes with high fees and rates.
  • If you default on a consolidation loan, you could lose any collateral to which the loan is tied.
  • Can cost more if you stretch out the payments over a long term.
  • Paying credit cards off individually may take longer, and may cost more in interest.
  • On "universal default" cards, interest rate can unexpectedly increase.

 

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