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Debt Consolidation Has Its Pitfalls

Jennifer Woods,|Special to CNBC.com
Tuesday, 12 Aug 2008 | 12:49 PM ET

With more Americans taking on more debt, debt consolidation may seem like a good way out. If so, do it sooner, rather than later.

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While this may be a good idea for some, if you are one of the many that are considering turning to debt consolidate as your way out, there are some things you should know.

First off, consolidation works just as it sounds; You take various debts -- such as credit card balances or personal loans -- and combine them into a single loan, which carries an interest rate that is hopefully lower than the average of what you were paying before.

Arnold Graf, a certified financial planner with NEBSCO Financial Services, says debt consolidation may be a good idea for people who have sufficient equity in property and are credit worthy, but adds “usually people that consolidate are close to bankruptcy and are trying to push their debt further out as long as they can.”

Consolidating debts is basically just buying time, he says, adding that “you have to consider whether you are willing to pay less now but for a longer period of time.”

Gail Cunningham, a spokesperson for the National Foundation for Credit Counseling, says, “Debt consolidation is always a good idea on paper. You are presumably taking higher interest credit card debt and rolling it into a lower interest loan [so] instead of paying many different debts each month you are paying one.”

However, she said “in practice, unless you are a very disciplined person debt consolidation isn’t going to work.”

“We see the most well-meaning people trying to be financially savvy and roll all their bills into a debt consolidation loan,” says Cunningham, but come the next year they are back to running up debt on a credit card that they rolled into the loan while still having to paying the debt consolidation payments.

Mistakes To Avoid

If you want or need to consolidate, be aware of the following..

Don't use a home equity loans, says Roberta Lee-Driscoll, a certified financial planner in Honolulu; “if someone has five credit card debts and they consolidate it into a home equity line of credit that is a no-no.”

That's because credit card debt is considered unsecured debt, meaning – there is no collateral to back it up. If you wrap it into a home equity loan, you are offering your home as collateral. If you don’t pay off the home equity loan a lien will be imposed against your home.

Another mistake, she says, is consolidating credit card debt from multiple cards into another card. People are often attracted to deals claiming “no interest” the first year. The problem there, she says, is that in many cases the new cards have hidden charges.

“People should look at the fine print on the new card they’re transferring to, to make sure they understand all the terms, says Lee-Driscoll. "A lot of times they will find its not as easy as simply having no finance charge.”

As unwise as either option may be, neither is as easy as it used to be, says Cunningham --which may actually be a good thing.

These days, she says more people either have little or no equity in their home. They have either tapped it already, failed to build any in the first place because of their choice of mortgages or the property is now worth less than what is owed on it.

As for the practice of transferring credit card balances, that joined the casualty list of the credit crunch. “Credit is only being extended to those who are truly credit worthy,” says Cunninham. A more sound but also more difficult course is to go to a bank and get a personal loan.

A more sound course is to go to a bank and get a personal loan, but that may not be easy.

“In today’s environment you will have to have very good credit to take out that loan and you’ll have to put up some collateral,” explains Cunningham.

All of this may be discouraging -- as well as incentive enough -- to avoid getting too deep into debt and live within in your means in the fist place -- which happens to be the first piece of advice any financial expert will give you.

The National Foundation for Credit Counseling recommends that your housing not take up more than 30% of your take home pay and that your debts, including car payments, not represent more than 20% of it. (This does not include living expenses such as food, utilities, child care and insurance.)

If you are already in trouble with debt, experts agree your best bet is to get outside help.

Speak with a financial advisor or a legitimate credit counseling agency. They will review your situation and help you create a budget, adjust your spending patters and find ways to help you pay down your debt.