American consumer debt has reached $13.86 trillion, including mortgages, car loans, credit cards and student loans according to the New York Federal Reserve. Some Americans are unable to manage the thousands of dollars of debt that they have, forcing them to explore other options rather than trying to chip away at an ever-growing mountain.
Debt consolidation is the process of taking out a loan and paying off all consumer debts with one payment. Debt consolidation loans are usually used to pay off multiple credit cards, then making one monthly payment to the debt consolidation lender at, hopefully, a lower interest rate.
Although it sounds like an easy solution, there are pros and cons of debt consolidation.
Pros of debt consolidation
There are a lot of benefits of debt consolidation, and oftentimes the pros outweigh the cons.
Repay debt sooner
Taking out a debt consolidation loan may help put you on a faster track to total payoff, especially if you have significant credit card debt. Credit cards don’t have a set timeline for completely paying off a balance. A consolidation loan, on the other hand, has fixed payments every month with a clear beginning and end to the loan.
When you consolidate your debt, you no longer have to worry about multiple due dates each month because you only have one payment. Furthermore, the payment is the same each month, so you know exactly how much to set aside.
Lower interest rates
According to the Bureau of Consumer Financial Protection, the average credit card interest rate in 2018 was 18.7%. Meanwhile, personal loans typically come with lower interest rates — an average of 10.07% APR. Of course, rates vary depending on your credit score, the loan amount and term length, but you’re likely to get a lower interest rate than what you’re currently paying on your credit card.
Fixed repayment schedule
Use a personal loan to pay off your debt, and you’ll know exactly how much is due each month and when your very last payment will be. Make only the minimum with a high interest credit card, and it could be years before you pay it off in full.
A debt consolidation loan may actually help improve your score over time because you’ll be more likely to make on-time payments. Pay that monthly bill when it’s due, and your payment history will improve, as payment history accounts for 35% of your credit score.
Additionally, if any of your old debt was credit card-related, and you keep your cards open, you’ll have both a better credit utilization ratio as well as a stronger history with credit. Amounts owed counts for 30% of your credit score, while your length of credit history accounts for 15%. These two categories could lower your score should you choose to close your cards after paying them off. Keep them open to help your credit score.
Cons of debt consolidation
As you may have guessed, there may be some downsides to debt consolidation.
It won’t solve financial problems on its own
Consolidating your debt is not a guarantee that you won’t go into debt again. If you have a history of living outside of your means, you might do so again once you feel free of debt. To avoid this, make yourself a realistic budget and stick to it. Also start saving for an emergency fund to pay for financial surprises out-of-pocket rather than charging them.
There may be some upfront costs
Some debt consolidation loans come with fees. These may include the following:
- Loan origination fees
- Balance transfer fees
- Closing costs
- Annual fees
Before taking out a debt consolidation loan, ask about any and all fees, including those for late payments and early cancellation.
You may pay a higher rate
It’s possible your debt consolidation loan could come at a higher rate than what you currently pay. This could happen for a variety of reasons, including your current credit score, the loan amount and the loan term. By extending your loan term, your monthly payment could be less, but you may end up paying more in interest in the long run.
Some people choose to do this to free up a little money each month or because they only want to worry about one payment. Weigh your immediate needs with your long-term goals to find the best personal solution.
Types of debt consolidation loans
Debt Consolidation Loan: A debt consolidation loan is technically just a personal loan. You can get a personal loan from a lot of different financial institutions. There are even low credit personal loans, but these typically come with higher interest rates. If you have low credit, run the math and make sure it makes sense for you to consolidate.
Balance Transfer Credit Card: There is a range of balance transfer offers constantly available, many of which come with a 0% introductory APR for one year or more. It can be a low-cost way to knock out debt — if you can qualify. Look out for balance transfer fees and any late payment penalties when considering this option.
401(k) Loan: A 401(k) loan is technically not a loan because you’re not borrowing money from a lender — you’re borrowing money from yourself. The payment comes out of your 401(k) account on a tax-free basis. A payment plan is then set up to repay the account and restore your 401(k) back to its original amount before you borrowed from it. Not only do you get a lower interest rate, you also pay interest to yourself rather than from a lender. However, there are stipulations if you leave your job before you finish, often making the balance due in full within a short timeframe.
Home Equity Loan: Tap into whatever equity you’ve accrued on your house and use that amount to pay off your debts. As with the above options, the interest rate is often far lower than interest rates with other debts. Your house is used as collateral though, so you need to prioritize these loan payments as much as you would your mortgage payments.
The bottom line
Now that you know about the pros and cons of debt consolidation, you should be able to make an educated decision on whether to consolidate your debt. Before deciding, make a detailed list of debt consolidation loan pros and cons. If the advantages outnumber the disadvantages, strongly consider moving forward with a debt consolidation strategy to help get your debt under control.