Pros and Cons of Consolidating Your Debt
Managing multiple monthly debt bills with different due dates and payment amounts is a headache, not to mention a strain on your budget. Debt consolidation, where you combine multiple debts into a single payment, can make the process easier.
Here’s how this debt management strategy works, and the pros and cons of using it.
How to consolidate debt
Debt consolidation entails taking on a new loan or line of credit with a lower interest rate that’s large enough to cover the debts you want to consolidate. This enables you to pay off multiple existing loans with one new loan, leaving you with a single interest rate and monthly payment.
You can consolidate most types of debt, including credit card debt, auto loans, personal loans and medical debt. The most common methods to consolidate debt are personal loans, balance transfer credit cards and home equity loans or lines of credit (HELOCs). Which option is best for you will depend on your finances.
Homeowners can often secure lower interest rates by using their house as collateral with a home equity loan. If you don’t own a home — or haven’t built up much equity — a personal loan is an option. These fixed-rate installment loans are convenient because you pay the same amount each month, which is useful for budgeting.
A balance transfer credit card that comes with a low “teaser” annual percentage rate (APR) on balances as well as purchases for a period of time — say, one or two years — can be a useful tool for debt consolidation. But you’ll need to get a credit limit high enough to cover the debts you want to consolidate, which makes this option better for people with smaller amounts of debt.
Moreover, you have to pay off the transferred balance before the promotional period ends, and avoid the temptation to charge new debt onto that card in the future. Ultimately, the best debt consolidation option for you will be the one that saves you the most on interest while fitting comfortably into your budget.
Regardless of the method, debt consolidation typically requires a good-to-excellent credit history, which shows the lender that you have a record of on-time payments. While borrowers with fair to poor credit might get approved for some types of debt consolidation loans, the terms might not be good enough to justify moving your money.
Once you’ve researched your option, look for a lender and apply for a new loan or line of credit. Use the funds from the new loan to pay off all the balances you want to consolidate. (With a balance transfer card, note that the credit card companies usually handle the transfer of the balance.)
Then, you make a single monthly payment to pay down the consolidation loan. It’s important to pay on time and understand the loan terms, especially due dates and deadlines, (e.g. the end of a credit card’s promotional period). Debt consolidation only works if you pay off the new loan on time.
Pros of debt consolidation
If you’re looking to pay off debt as quickly as possible, it could help you save money. If you need to reduce the amount you’re spending on bills each month, it could free up money in your budget. Here’s a look at the most common benefits of debt consolidation.
Simplify your monthly payments
Remembering to pay all your bills on time can be challenging when you’re juggling multiple debt payments every month. Rolling all — or most — of your debts into a single payment can help you stay organized and avoid late or missed payments.
Save money on interest and pay off debt faster
The best debt consolidation loans enable you to get out of debt faster by freeing up money to pay down what you owe. With a lower interest rate, more of your money will go toward the loan principal each month, allowing you to save money and pay your debts down more quickly.
Reduce monthly spending on debt
Debt consolidation can help improve your monthly cash flow, too. You want to replace high-interest debt with a lower-interest loan, then take the monthly savings from the reduced interest and use it to pay other bills. But there's a tradeoff: While your monthly payment might be lower, the longer loan term means you will pay more interest over the life of the loan.
Improve your credit score over time
When you first take out a debt consolidation loan, your credit score is likely to dip slightly, since you’re applying for a new loan. But that drop should be short-lived. As you make on-time payments on the new loan and reduce your overall debt, your credit score should improve.
Cons of debt consolidation
Like most financial moves, there are potential downsides to debt consolidation. It’s important to understand them before you pursue the strategy to ensure you’re making the best decision for your finances.
Interest rates may not be favorable
Many benefits of debt consolidation hinge on getting a lower interest rate compared to the rates on your existing debts. If you have fair or poor credit, that might not work. That's why debt consolidation is a strategy best-suited for borrowers with strong credit scores. Borrowers with lower credit scores might get a loan offer that has a better APR than high-interest credit cards but is still higher than other debts you might have.
Upfront costs are likely
Most lenders charge upfront fees on products you might use to consolidate debt. Home equity loans or lines of credit have origination fees and closing costs that range from 1%-5% of the total loan amount. Personal loans have origination fees, which can be as high as 10% of the loan balance, wrapped into their APRs. Balance transfer credit cards typically charge a fee of 3%-5% of the amount transferred.
It could allow you to fall deeper in debt
Debt consolidation only works if you’re able to pay off the new loan on time. If you’re still accruing debt — especially high-interest credit card debt — taking a new loan or credit line is a risk. You could end up worse-off financially than before debt consolidation. If your debt consolidation loan is backed by your home equity, you could even risk losing your home.
Is debt consolidation a good idea?
Consolidation might seem like an easy way to get debt payments under control. For some borrowers, it certainly can be — especially if you get approved for a loan with a lower interest rate than your current debts and you have the discipline to pay it down and avoid accruing additional debt.
It’s important to keep in mind, though, that debt consolidation won’t magically eliminate your debt. You’ll still have to pay off the principal you owe, even though you’re getting a break on the interest. It’s a good idea to go over your finances and make sure that you understand why you accumulated your debts in the first place. If you’re spending more than you’re earning on a regular basis, taking out another loan won’t help.
Finally, if you’re struggling to make even the minimum payments on your debts or you’ve already missed several payments, it may be time for you to consider alternative options, such as a debt management plan, where you work with a credit counseling agency. Another option is debt relief, which often involves working with a debt settlement company that can help you renegotiate the agreements you have with creditors, ideally reducing your debt principal and eliminating penalty fees.
Looking to use your home equity to consolidate your debt? Learn about our HELOC.
This article was written by Kaitlin Mulhere and Andrea Norris from Money and was legally licensed through the DiveMarketplace by Industry Dive. Please direct all licensing questions to legal@industrydive.com.
