The average American household has multiple forms of debt, often including not just mortgages and car loans but student debt, credit card balances, and personal loans, as well. Keeping track of bills and making sure everything gets paid on time to avoid late fees and damage to credit scores can be a challenge. For some consumers, debt consolidation may provide a solution. But is debt consolidation a good idea?
Before moving on to discuss what debt consolidation is, how it works, and whether it’s a worthwhile strategy for getting personal finances back on track, it’s worth noting that everyone’s situation is different. There’s no single right solution for getting out of debt, and consolidation is just one of many options for paying off loans and managing finances responsibly.
What Is Debt Consolidation?
The term debt consolidation refers to the process of using a new loan or credit card to pay off multiple debts at the same time, typically with lower interest rates. There are several ways to consolidate your debt, including taking out a personal loan or a balance transfer credit card. They include:
Balance-Transfer Credit Cards
Balance-transfer credit cards allow users to transfer all of their debts onto one card and pay back the balance during an initial promotional period with 0% interest. This type of credit card is only available to consumers with good or excellent credit scores, usually 690 or higher, and it’s only helpful if debtors can pay off their balances in full before the credit card issuer begins charging a higher APR.
Fixed-Rate Personal Loans
If a debtor’s credit score has gone up since taking out credit cards or loans, consolidating the debts by taking out a low-interest, fixed-rate personal loan and using it to pay off other creditors may be a good option. This approach is only useful if the borrower can find lenders willing to offer lower interest rates, which means it’s only really feasible for people with good credit.
Specialized Debt Consolidation Loans
Debt consolidation loans may be the best option for people with fair or bad credit and scores below 689. They’re offered by specialized debt relief companies and are available to just about any borrower, although those with higher credit scores usually qualify for lower rates.
Debt relief companies can consolidate a borrower’s loans and bills in one of two ways. They can either purchase the loans from creditors and pay them off on behalf of the borrower or disburse the proceeds so that borrowers can make their own payments, as with a personal loan.
Home Equity and 401(k) Loans
Debtors who are willing to take on a good deal of extra risk sometimes use home equity or 401(k) loans to borrow against their homes or retirements. Unfortunately, while providing collateral can lower interest rates, people who can’t pay off these types of loans stand to wind up in an even worse financial situation. Try to avoid taking out home equity or 401(k) loans to consolidate debt if at all possible.
The Pros of Consolidating Debt
For many borrowers, debt consolidation is an effective option for simplifying payments, reducing interest, and getting out of the red sooner. Here are a few of the primary advantages of debt consolidation loans:
1. Get Out of Debt Faster
Debt consolidation can help consumers get their financial lives back on track sooner, especially for people trying to pay off significant amounts of credit card debt. Because credit cards don’t have fixed timelines for total payoff, it’s easy to continue accruing debt even as you try to pay the balance down. Consolidation loans are different since they have fixed interest and terms.
Repaying debt faster means being able to start saving for retirement, emergencies, vacations, and other goals sooner. It often saves debtors money, as well, since a shorter repayment term typically involves paying less interest overall.
2. Simplify Complex Financial Situations
Trying to keep track of multiple personal lines of credit, loans, medical bills, and other debts can be incredibly challenging. Each of the lenders has different due dates and accepts different methods of payment, and some even charge different amounts each month.
Consolidating diverse debts into one loan means you’ll only have to worry about one due date and will know how much money to put aside to cover the payment in advance. The result will be a simpler budget and fewer opportunities to miss payments and accrue late fees and damage credit scores.
3. Take Advantage of Lower Interest Rates
The average credit card APR at the end of 2021 was 20.45%. Although that’s down from the prior year, it’s still much higher than the interest rates associated with specialized debt consolidation loans. As with any kind of loan, interest rates vary depending on the borrower’s credit score and other factors, but as a general rule, people pay less in interest after they consolidate debt.
4. Follow a Fixed Repayment Schedule
Just about all debt consolidation loans have fixed payments and interest rates for the duration of the repayment period. There won’t be any unexpected fluctuations to deal with, and borrowers will know exactly when to expect the loan term to end. In comparison, the minimum payments on a high-interest credit card vary month-by-month, and borrowers don’t get a clear idea of when they’ll be finished paying them off.
5. Boost Credit in the Long Run
Borrowers who take out debt consolidation loans may notice that their credit scores dip slightly immediately following the initiation of the loan. The reason for this dip in credit score is that lenders almost always make hard credit inquiries. Once debtors recover from that minor setback, they almost always see improvements in credit scores over time.
The primary reason that debt consolidation loans are better for credit scores than maintaining multiple, separate loans and lines of credit is that it’s easier to make on-time payments, which account for 35% of your credit score. If you choose to consolidate credit card debt along with loans, then keep the cards open, it can have an even more dramatic impact. Keeping those credit cards open and learning how to use them responsibly can improve both credit utilization ratios and credit history.
The Cons of Debt Consolidation
Like all things in life, debt consolidation comes with both benefits and drawbacks. Every borrower needs to consider both carefully before deciding if taking out a consolidation loan is the best solution. Here are a few things that could tip the scales in favor of seeking an alternative form of debt relief:
1. The Potential for Up-Front Costs
Some debt relief companies charge up-front fees for debt consolidation services, which can include loan origination, balance transfer, and annual fees, plus closing costs. Before taking out a new consolidation loan, ask the lender about fees, and shop around some. The right debt relief company will offer consolidation services at prices that won’t do more harm than good.
2. Higher Interest Rates for Some Borrowers
In most cases, debt consolidation loans have lower interest rates. However, borrowers with fair to low credit scores may not be able to access the industry’s most competitive rates. Pay close attention to both interest rates and loan terms. If it’s too difficult to determine whether a debt consolidation plan will lead to lower costs, reach out to a debt relief professional for advice.
To complicate matters further, consumers can wind up paying more in interest over the term of a debt consolidation loan than they would have paying off multiple monthly bills, even if the interest rate goes down. This problem only tends to come up if loans have long repayment terms. Budgeting for monthly payments in excess of the loan’s minimum requirements can help to reduce the amount of interest you’ll pay over time, but only if the lender doesn’t charge early repayment fees.
3. Missing One Payment Can Have a Dramatic Negative Impact
Missing just one month of payment on a consolidation loan can lead to late fees, returned payment fees if the bill is returned due to insufficient funds, and other added costs. Plus, lenders that specialize in debt consolidation still report late payments to credit bureaus after 30 days of delinquency. Choosing a lender that offers an automatic bill pay program and making sure the monthly payments will be sufficiently low can make it easier to avoid late fees and damage to credit scores.
4. It’s Not Always Worth the Hassle
Consumers who don’t have large amounts of debt from many sources usually find that debt consolidation is more of a hassle than a help. As a general rule of thumb, even multiple debts that can be paid off within six months are best addressed by consumers themselves. Going through the hassle of finding a debt consolidation company and paying the associated fees just won’t be worth it.
Who Should Apply for Debt Consolidation?
Consolidation loans are popular among consumers who have significant amounts of high-interest debt, often from multiple sources. The process allows people to combine different types of debt, including everything from credit card debts to student loans, into one new loan. Instead of paying off each bill individually, increasing the chances that one of them will go unnoticed and start accruing late fees, the borrower will make just one monthly payment moving forward.
Debt consolidation isn’t right for everyone. Consider it your first option only if all of these circumstances apply:
- Your monthly debt payments comprise less than 50% of your gross income.
- Your credit score is high enough to qualify for a low-interest loan.
- Your cash flow will allow you to cover 100% of the new payments.
- You expect to be able to pay off the consolidation loan within five years.
If these circumstances don’t apply, you may want to consider other options.
Alternatives to Debt Consolidation
The primary alternative to debt consolidation loans is debt settlement. Unlike debt consolidation, which only cuts interest rates, debt settlement can reduce a borrower’s principal balances. The process involves applying for help through a debt relief company whose representatives will negotiate with creditors on the borrower’s behalf to have the remaining balance of each loan or bill reduced in return for immediate payment.
Engaging in negotiations with creditors and applying for partial debt forgiveness via a settlement plan is no more of a silver bullet than debt consolidation. It can lower a consumer’s credit score, so this approach is only appropriate for those with poor credit, to begin with, or monthly payments higher than 50% of the family’s income.
Tips for Avoiding Future Debt
Neither debt consolidation nor other debt relief measures will solve underlying financial problems. Consumers who wind up drowning in debt often have poor financial habits, and failing to curb spending after paying off credit cards and loans will only prolong a negative cycle. Follow these tips after paying off loans to avoid winding up in more debt:
- Build and maintain an emergency fund to cover unexpected expenses that you would otherwise have to put on a credit card.
- Create a budget that accounts for each dollar earned and spent and get into the habit of expense tracking to ensure that you’re not spending more than you earn.
- Adopt an automated savings strategy to set aside money for emergencies, retirement, and other goals and keep the money separate from your checking account.
- Pay off your credit cards in full every month.
- Only take out loans to cover absolute necessities and don’t borrow more than what’s required.
- Check your credit score frequently and prioritize keeping it high enough to take advantage of beneficial loan terms.
Get Debt in Check
Debt consolidation can be a good option for getting out of debt, but it’s not the right choice for every borrower. Other debt relief options are available, so look into all options and choose the one that makes the most sense given your credit score, amount of debt, and long-term financial goals. If you’re still not sure whether debt consolidation is the best option for you, reach out to a debt relief expert for advice.