When it comes to paying off debt there’s one useful tool that can not only simplify your finances but also reduce the amount of interest you pay. Debt consolidation takes some or all of your small debts and combines them into one loan or line of credit. This results in just one payment and if you can get a lower interest rate, can add up to big savings.
While this is a good idea, there’s also a big problem. Many people will consolidate their credit card debt but then fall back on the habit of using the now open credit lines to make purchases again. This is bad news because now you’re just making your debt problem even worse. What happens is that people have a hard time breaking habits. If they are consolidating debt then there must be a reason there is debt to begin with. So when this consolidation now frees up more available credit these habits can creep back in and make the debt problem even worse.
Be Careful if Using Home Equity to Consolidate Debt
Tapping into home equity has been a common debt consolidation method over the past few years, but you should really think twice before going this route. I don’t need to remind you about the problems right now regarding falling home prices, but there’s another danger when you go this route.
Credit cards are unsecured debt meaning there is no collateral backing the card. If you fail to pay off your credit card you might have to put up with collection calls and damage to your credit score, but that’s about the extent of it in most cases.
If we’re talking about a mortgage or car loan we’re dealing with secured debt. This just means that the underlying asset is used as collateral for the loan. Now if you fail to make payments the bank is going to take your house away. If you can’t repay the home equity loan or line of credit you might be forced to sell the house so the bank can recover the money. If you find that you start racking up more credit card after you’ve tapped the equity in your home to consolidate your existing debt you could be faced with losing your home thanks to your credit card problems.
To Close or Not to Close
You may be thinking that simply closing or canceling the old credit cards will be a great solution so you won’t find yourself tempted to use the card again. Not so fast. Some of the factors in your credit score have to do with the length of time you’ve had accounts and your credit utilization ratio.
When you close out an account you will not only hurt your credit ratio but you may be eliminating years of credit history from your account. Before closing any accounts you should carefully examine your credit report to see what, if any cards should be canceled. If it is a new department store card you opened last Christmas to get a discount and had a limit of $500 it may make sense to just get rid of the card. But the last thing you want to do is cancel a card you’ve had for a few years with a higher credit limit. That may ultimately do more harm than good.
How to Stop Using Old Cards
So, if you don’t want to cancel all of your old cards what can you do to ensure you don’t get into the habit of using them? The simplest and most dramatic thing you can do is to simply get a pair of scissors and cut the card up. Problem solved. The account is still open but you can’t just swipe a new purchase. Of course if this was a card for emergencies that may not be the best idea.
Some people find it useful to lock their cards up in a lock box. If you have one at home you can do that, but an even better way that makes them even harder to get to is to lock them up in a safe deposit box at your local bank. Either way, if they aren’t in your wallet and aren’t easily accessible you are far less likely to use them.
Use Debt Consolidation Wisely
Don’t fall into the endless cycle of debt. If you are thinking about consolidating your debt make sure you stop using the old credit that you are trying to consolidate. Consolidation can be a great step towards getting rid of debt, but simply continuing to use credit will just dig you into a deeper hole. It seems like common sense, but leaving those cards in your wallet or even considering that open credit line as a means for buying something will just perpetuate the cycle.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
