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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 likely won’t solve the underlying financial issues. For this reason, it’s 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 explain the pros and cons of this popular strategy.
What is debt consolidation?
Debt consolidation is the process of paying off multiple debts with a new loan or balance transfer credit card, often at a lower interest rate.
The process of consolidating debt with a personal loan involves using the proceeds to pay off each individual loan. Although some lenders offer specialized loans for debt consolidation, you can use most standard personal loans for debt consolidation. Similarly, some lenders repay 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 a 0% introductory APR for 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 has issued the card.
Is debt consolidation a good idea?
Debt consolidation is generally a good idea for borrowers who have multiple high interest rate loans. However, this is only possible if your credit score has improved since you applied for the initial loans. If your credit score isn’t high enough to qualify for a lower interest rate, it may not make sense to consolidate your debt.
You may also want to think twice about debt consolidation if you haven’t addressed the underlying issues that led to your current debts, such as overspending. Paying off multiple credit cards with a debt consolidation loan is no excuse to build up balances again, and it can lead to bigger financial problems down the road.
Advantages of debt consolidation
Consolidating your debt can have a number of benefits, including faster and easier repayment and lower interest payments.
1. Streamlines finances
Combining multiple outstanding debts into one loan reduces the number of payments and interest rates you need 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’re working towards a debt-free lifestyle, you’ll have a better idea of when all your debts will be paid off.
2. Can expedite payment
If your debt consolidation loan earns less interest than individual loans, consider making extra 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 generally results in longer loan terms. You will therefore have to make sure to pay off your debt sooner to take advantage of this advantage.
3. Could reduce 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 have mostly low-interest loans. This can save you money over the life of the loan, especially if you’re not consolidating with a long-term loan. To ensure you get the most competitive rate possible, shop around and focus on lenders that offer a personal loan prequalification process.
Remember, however, that certain 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 may result in a lower rate than some of your debts but higher than others. In this case, focus on what you save as a whole.
4. May lower 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 may be beneficial from a monthly budgeting perspective, it means 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 credit investigation. However, debt consolidation can also improve your score in several ways. For example, paying off revolving lines of credit, such as credit cards, can reduce the credit utilization rate reflected in your credit report. Ideally, your utilization rate should be below 30%, and responsible debt consolidation can help you achieve this. Making regular, on-time payments — and ultimately repaying the loan — can also improve your score over time.
Disadvantages of debt consolidation
A debt consolidation loan or a balance transfer credit card may seem like a good way to streamline debt repayment. That said, there are some risks and drawbacks associated with this strategy.
1. May incur additional costs
Taking out a debt consolidation loan may incur additional fees such as origination fees, balance transfer fees, closing fees 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 may be a smart move. However, if your credit score is not high enough to access the most competitive rates, you could end up with a higher rate than on your current debts. This may mean paying origination fees, plus interest over the life of the loan.
3. You can pay more interest over time
Even if your interest rate drops on consolidation, you could still pay more interest over the term of the new loan. When you consolidate debt, the repayment period 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 over a longer period.
As a workaround, budget 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; they may also charge you additional fees. To avoid this, revise your budget to make sure you can comfortably cover the new payment. Once you’ve consolidated your debt, take advantage of autopay or any other tool that can help you avoid missed payments. And, if you think you’ll miss an upcoming payment, let your lender know as soon as possible.
5. Doesn’t fix underlying financial issues
Debt consolidation can simplify payments, but it doesn’t fix the underlying financial habits that led to these debts in the first place. In fact, many borrowers who take advantage of debt consolidation end up in more debt because they didn’t curb their spending and continued to take on more debt. So if you’re considering consolidating your debt to pay off several depleted credit cards, take the time to develop sound financial habits first.
6. May 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’s easy for borrowers to fall into the trap of paying off their debts, only to find that their balance has climbed again.
Set a budget to reduce expenses and control your payments so you don’t take on more debt than you started with.
When should you consolidate your debt
Debt consolidation can be a smart financial decision under the right circumstances, but it’s not always your best bet. Consider consolidating your debts if you have:
- A large debt. If you have a little debt that you can pay off in a year or less, debt consolidation probably isn’t worth the fees and credit check associated with a new loan.
- Additional plans to improve your finances. While you can’t avoid some debts, like medical loans, others are the result of overspending or other financially dangerous behavior. Before consolidating your debt, assess your habits and develop a plan to get your finances under control. Otherwise, you could end up with even more debt than before the consolidation.
- A credit score 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 qualify for a lower debt consolidation rate 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. Consolidate your debts only if you have sufficient income to cover the new monthly payment. Although your overall monthly payment may decrease, consolidation is not a good option if you are currently unable to service your monthly debt.