Debt consolidation is a financial strategy that involves combining multiple debts into one. It’s a promising solution for getting out of debt, and it’s also an easy way to simplify your bill payment schedule.
However, debt consolidation isn’t a perfect solution. It comes with certain drawbacks that you need to consider, which depend on the method you choose and the current state of your finances and credit.
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Is consolidating debt a good idea?
Debt consolidation can be a good idea if you have several debts with high interest rates and you’re struggling to make your payments each month. However, you’ll generally need a good credit score if you plan on taking out a debt consolidation loan (as opposed to performing a balance transfer using an existing credit card).
It’s also worth noting that debt consolidation alone won’t get you out of debt—it may make it easier for you to keep up with your payments, but it’s still up to you to pay off the debt.
Debt consolidation: pros and cons
Below, we’ll review the advantages and disadvantages of debt consolidation in more depth.
Advantages of debt consolidation
There’s a reason debt consolidation is a popular financial strategy. Here are the four main advantages that it provides.
1. Only one monthly payment
Consolidating your debts streamlines your finances by reducing the number of payments you need to make each month. This can cut out all the stress that comes with keeping track of your payment due dates and how much you owe on different accounts.
If you use an installment loan (i.e., a loan with a fixed payment schedule) to consolidate your debts, then budgeting will also become a lot easier because you’ll be paying the same amount each month.
2. Potential to get out of debt quicker
Like we just mentioned, debt consolidation loans have fixed repayment schedules—unlike credit cards, which don’t have a set repayment period. Using a loan to consolidate credit card debt could give you the push you need to pay off your debts quicker if you’re in the habit of only making the minimum payments on your credit cards each month.
3. Lower interest rates
Similarly, one of the biggest perks of debt consolidation is the opportunity to lower your interest rate on credit cards or loans.
Loans usually have lower interest rates than credit cards, so using a loan to consolidate credit card debt will probably save you money on interest. 1 This will also allow you to pay your debt off sooner because more of your payments will go toward paying down the principal (the borrowed amount) rather than interest.
You may also be able to get a special “balance transfer” credit card with an introductory 0% APR (meaning a period where you can pay zero interest). Then, you can transfer your debts to that new card. This would mean not having to pay any more interest on your debt, as long as you pay off the balance before the introductory period ends. However, note that you’ll likely need to pay fees in order to transfer the balances.
4. Potential credit boost
Consolidating your debts has several benefits that can improve your credit score:
- Fewer late payments: Because you’ll just have one bill to pay and your interest rate will ideally be lower, you’ll be less likely to make late payments. If late payments were previously an issue, then debt consolidation can improve your credit score over time by strengthening your payment history, which is the most important factor influencing your score.
- Lower credit utilization rate: If you’re consolidating credit card debt, then paying off your credit card balances in full will give your credit score a boost by lowering your credit utilization rate (the amount of credit you’re using). To take advantage of this benefit, keep your accounts open after paying them off.
- Better credit mix: If you previously only had credit cards but you take out a loan to consolidate your debts, then you’re improving your credit mix by increasing the diversity in the types of credit accounts you have. (Your credit score will go up if you have both credit cards and loans.)
Disadvantages of debt consolidation
Before consolidating your debts, you should also take a moment to consider the four main disadvantages of debt consolidation.
1. Not a cure for financial problems
Although debt consolidation can simplify your finances, it won’t solve all of your problems. If you’ve been struggling with too much credit card debt, then you may need to adopt financial strategies that address the root of the problem, such as chronic overspending or failing to save money for financial emergencies.
In some cases, you may be better off getting guidance from a credit counselor, who will be able to walk you through alternative options and maybe even work with your creditors on your behalf to help you pay off your debts.
2. Temporary drop in credit score
Although in the long term, consolidating your debts will probably benefit your credit score, in the short term, debt consolidation can hurt your credit.
This is because to consolidate your debts, you’ll probably need to open a new credit account, which will have a minor negative effect on your credit score for the following reasons:
- Hard inquiries: Most credit applications trigger a hard inquiry, and hard inquiries can lower your credit score by a few points. However, the effect is minor and temporary, and your score will recover within a few months to a year. 2
- Drop in the average age of your accounts: Credit scoring models consider the length of your credit history when calculating your credit score, and part of this factor is the average age of your credit accounts. Opening a new account will automatically lower this number, causing a small drop in your credit score.
3. Risk of paying more overall
Despite all the benefits of debt consolidation, you could end up paying more than you would under the terms of your current debt obligations if any of the following situations apply:
- Higher interest rate: If you have a bad credit score, then you might not be able to qualify for the low interest rates that would make a debt consolidation loan worthwhile. If you end up getting a loan with a high interest rate, then debt consolidation might not actually save you money.
- Longer repayment period: Even if your interest rate and monthly payments are both lower, there’s a chance that you’ll pay more in the long term if you’re repaying your debt over a longer period. To find out whether debt consolidation will be worthwhile, use a loan repayment calculator like this loan calculator from Experian to see how much you’ll be paying overall.
- Additional fees: Depending on the method you use, debt consolidation could come with extra fees, such as loan origination fees, balance transfer fees, annual fees, or loan closing costs. Make sure to research the costs of different consolidation approaches and ask your prospective lender what service fees they charge.
4. Risk of spending more without realizing
After consolidating your debts, you might not have as many reminders of how much you owe, and it can feel like you’re debt free, especially if you’ve gone from having hefty credit card bills to having credit cards with a zero balance.
If you accumulate fresh debt from purchases you wouldn’t have normally made, then debt consolidation could actually lead to more problems than benefits for your finances.
Should you consolidate your debts?
Debt consolidation may be a good option if any of the following conditions apply to you:
- You have multiple debts you’re struggling to keep track of: If you’re having trouble paying down your debts because you’re struggling to keep track of your due dates, then you may benefit from consolidating your debts so that you only have one monthly payment.
- You have a reliable income: To prevent your debt from growing, you’ll need to have enough money to make your new monthly payment. If your debt-to-income ratio is over 50%, then you may be better off exploring alternative debt relief options, such as credit counseling or bankruptcy.
- You have a good credit score: You’ll need a good credit score (usually 670 or higher) to qualify for a low enough interest rate that you’ll actually save money from consolidating your debts.
Remember that what you do after consolidating your debts will determine whether it will have a positive or negative outcome on your financial health.
How to consolidate your debts
If you decide to consolidate your debts, then you’ll need to choose a method. Here are the options you can choose from:
- Debt consolidation loan: These are essentially personal loans, and you can choose between secured loans (which require an asset for collateral) and unsecured loans (which usually have higher interest rates). 3 You can get these loans from a bank, credit union, or online lender.
- Credit card balance transfer: You can either get a new balance transfer credit card or use a credit card you already have. If you use an existing card, make sure you pick one with a low interest rate and a credit limit that’s high enough to accommodate all your debts.
- Home equity loan: A home equity loan allows you to borrow up to the amount of equity you have in your home (in other words, the total value of your home minus the amount you still owe on your mortgage). Although this approach will get you a low interest rate, you risk losing your home if you can’t repay your debt.
- Debt management plan: This is a low-risk approach you can try with any credit score. With a debt management plan, you pay a credit counselor a fixed amount each month and they pay all your bills for you. They may be able to get you lower interest rates and monthly payments, but you won’t be able to use any of the credit cards you’ve included in the plan. 4