Between credit cards, student loans, and auto loans, it can be difficult to keep track of payments and outstanding debt balances. Consolidating these debts into one loan can streamline your finances, but the strategy is unlikely to resolve the underlying financial issues. For this reason, it is important to understand the pros and cons of debt consolidation before committing to a new loan.
To help you decide if debt consolidation is the right way to pay off your loans, we’ll walk you through the pros and cons of this popular strategy.
What is debt consolidation?
Debt consolidation involves paying off multiple debts with a new loan or balance transfer credit card, often at a lower interest rate.
The process of debt consolidation with a personal loan involves using the proceeds to pay off each individual loan. While some lenders offer specialized debt consolidation loans, you can use most of the standard personal loans for debt consolidation. Likewise, some lenders repay the loans on behalf of the borrower, while others disburse the proceeds so that the borrower can make the payments themselves.
With a balance transfer credit card, qualified borrowers typically have access to an introductory 0% APR for a period of between six months and two years. The borrower can identify the balances they want to transfer when opening the card or transfer the balances after the provider issues the card.
Is debt consolidation a good idea?
Debt consolidation is generally a good idea for borrowers who have multiple high interest loans. However, this is only possible if your credit score has improved since the initial loan application. If your credit score isn’t high enough to qualify for a lower interest rate, it may not be a good idea to consolidate your debt.
You might also want to think twice about debt consolidation if you haven’t addressed the underlying issues that have led to your current debt, like overspending. Paying off multiple credit cards with a debt consolidation loan is no excuse to build up balances, and it can lead to bigger financial problems down the line.
Benefits of debt consolidation
Consolidating your debt can have a number of benefits, including faster, more streamlined repayments and lower interest payments.
1. Streamline finances
Combining multiple unpaid debts into one loan reduces the number of payments and interest rates you have to worry about. Consolidation can also improve your credit by reducing the chances of making a late payment or missing a payment altogether. And, if you work towards a debt-free lifestyle, you’ll have a better idea of when all of your debts will be paid off.
2. Can expedite payment
If your debt consolidation loan earns less interest than the individual loans, consider making additional payments with the money you save each month. This can help you pay off debt sooner, saving even more on long-term interest. Keep in mind, however, that debt consolidation usually leads to longer loan terms – so you’ll need to make sure you pay off your debt early to reap this benefit.
3. Could lower the interest rate
If your credit score has improved since you applied for other loans, you may be able to lower your overall interest rate by consolidating your debt, even if you mainly have low-interest loans. This can save you money over the life of the loan, especially if you are not consolidating with a long term loan. To make sure you get the most competitive rate possible, shop around and focus on lenders who offer a personal loan prequalification process.
Remember, however, that some types of debt carry higher interest rates than others. For example, credit cards generally have higher rates than student loans. Consolidating multiple debts with a single personal loan can result in a lower rate than some of your debts but higher than others. In this case, focus on what you are saving as a whole.
4. Can reduce the monthly payment
When consolidating debt, your overall monthly payment is likely to decrease as future payments are spread over a new, possibly extended loan term. While this can be beneficial from a monthly budgeting standpoint, it does mean that you could pay more over the life of the loan, even with a lower interest rate.
5. Can improve credit score
Applying for a new loan may result in a temporary drop in your credit score due to the difficult credit investigation. However, debt consolidation can improve your score in several ways as well. For example, paying off revolving lines of credit, such as credit cards, can reduce the rate of credit usage reflected on your credit report. Ideally, your utilization rate should be less than 30%, and responsible debt consolidation can help you achieve that. Making consistent, on-time payments – and ultimately paying off the loan – can also improve your score over time.
Cons of Debt Consolidation
A debt consolidation loan or a balance transfer credit card may seem like a good way to streamline debt repayment. However, there are some risks and drawbacks to this strategy.
1. May incur additional costs
Taking out a debt consolidation loan may incur additional costs such as origination fees, balance transfer fees, closing costs, and annual fees. When shopping for a lender, make sure you understand the true cost of each debt consolidation loan before signing on the dotted line.
2. Could increase your interest rate
If you qualify for a lower interest rate, debt consolidation can be a smart move. However, if your credit score is not high enough to access the most competitive rates, you may end up with a higher rate than your current debts. This can mean paying origination fees, as well as more interest over the life of the loan.
3. You can pay more interest over time
Even if your interest rate drops during the consolidation, you could still pay more interest during the life of the new loan. When you consolidate debt, the repayment schedule begins on day one and can extend up to seven years. Your overall monthly payment may be lower than you’re used to, but interest will accrue for a longer period.
To avoid this problem, budget for monthly payments that exceed the minimum loan payment. This way, you can enjoy the benefits of a debt consolidation loan while avoiding additional interest.
4. You may miss payments
Missing payments on a debt consolidation loan – or any other loan – can cause significant damage to your credit score; it may also put you at additional cost. To avoid this, take a look at your budget to make sure you can comfortably cover the new payment. Once you’ve consolidated your debt, take advantage of automatic payment or any other tool that can help you avoid missed payments. And, if you think you might miss an upcoming payment, let your lender know as soon as possible.
5. Does not solve the underlying financial problems
Debt consolidation can simplify payments, but it does not resolve the underlying financial habits that led to those debts in the first place. In fact, many borrowers who profit from debt consolidation find themselves in deeper debt because they did not curb their spending and continued to take on debt. So, if you plan to consolidate your debt to pay off multiple maximized credit cards, take the time to develop healthy financial habits first.
6. Can encourage increased spending
Likewise, paying off credit cards and other lines of credit with a debt consolidation loan can create the illusion of having more money than you actually have. It is easy for borrowers to fall into the trap of paying off debt, only to find that their balances have climbed again.
Budget to cut expenses and stay on top of payments so you don’t run into more debt than you started out with.
When Should You Consolidate Your Debt?
Debt consolidation can be a wise financial move under the right circumstances, but it’s not always your best bet. Consider consolidating your debt if you have:
- A large debt. If you have a small amount of debt that you can pay off in a year or less, debt consolidation is probably not worth the fees and credit check associated with a new loan.
- Additional plans to improve your finances. While you cannot avoid some debts, like medical loans, others are the result of overspending or other financially dangerous behavior. Before you consolidate your debt, assess your habits and make a plan to get your finances under control. Otherwise, you risk ending up with even more debt than before the consolidation.
- A credit rating high enough to qualify for a lower interest rate. If your credit score has increased since you took out your other loans, you are more likely to benefit from a debt consolidation rate lower than your current rates. This can help you save on interest over the life of the loan.
- Cash flow that comfortably covers monthly debt service. Only consolidate your debt if you have enough income to cover the new monthly payment. Although your overall monthly payment may go down, consolidation is not a good option if you are currently unable to meet your monthly debt service.