American consumer debt has reached $14.35 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 one of these options. Debt consolidation loans are used to pay off multiple credit cards and combine those monthly payments into one, usually with a lower interest rate. Although it sounds like an ideal solution, there are pros and cons of debt consolidation.
What is debt consolidation?
Debt consolidation is the process of combining two or more debts into a single larger debt. This step is often taken by consumers who are burdened with a significant amount of high-interest debt.
“It’s often used to combine credit card debts, auto loans, student loans, medical debt or other types of loans into a new loan,” says Katie Ross, education and development manager for American Consumer Credit Counseling. “Then the borrower only has to pay one monthly payment instead of a separate payment for each debt.”
In addition to simplifying your finances, debt consolidation ideally allows for obtaining more favorable loan terms, such as a more competitive interest rate.
Why should I be interested?
There are several potential benefits associated with debt consolidation. Taking this step allows you to combine multiple debts into a single monthly payment, simplifying your finances and making life easier. Consolidation can also result in a lower interest rate on your debt, which will have long-term benefits.
“If interest rates are lowered and the consumer pays off the debt in the same or less time than they would have been able to before consolidation, they will save money,” says Michael Sullivan, personal financial consultant for Take Charge America.
Debt consolidation is generally a good idea for those with a good credit score, since a good credit score will let you qualify for the most competitive interest rates on the combined debts.
5 key benefits of debt consolidation
Debt consolidation is often the best way for people to get out of debt. Here are some of the main benefits.
1. 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.
Takeaway: Repaying your debt faster means you may pay less interest overall. In addition, the quicker your debt is paid off, the sooner you can start putting more money toward other goals, such as an emergency or retirement fund.
2. Simplify finances
When you consolidate 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 amount each month, so you know exactly how much money to set aside.
Takeaway: Debt consolidation can turn two or three payments into a single payment. This can simplify budgeting and create fewer opportunities to miss payments.
3. Lower interest rates
The average credit card interest rate is around 16.03 percent. Meanwhile, personal loans typically average around 11.88 percent. 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 with a debt consolidation loan than what you’re currently paying on your credit card.
Takeaway: Debt consolidation loans for consumers who have good credit typically have significantly lower interest rates than the average credit card.
4. Have a 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.
Takeaway: By having a fixed repayment schedule, your payment and interest rate remain the same for the length of the loan, there’s no unexpected fluctuation in your monthly debt payment.
5. Boost credit
While a debt consolidation loan may initially lower your credit score slightly, since you’ll have to go through a hard credit inquiry, a debt consolidation loan may help improve it over time, because you’ll be more likely to make on-time payments. Your payment history accounts for 35 percent of your credit score, so paying a single monthly bill when it’s due should significantly raise your 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 and a stronger history with credit. Amounts owed counts for 30 percent of your credit score, while the length of your credit history accounts for 15 percent. 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.
Takeaway: Consolidating debt can ultimately improve your credit score, particularly if you make on-time payments on the loan, as payment history is the most important factor contributing to the calculation of your score.
3 key drawbacks of debt consolidation
There are also some downsides to debt consolidation that you should consider before taking out a loan.
1. It won’t solve financial problems on its own
Consolidating debt does not 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 help avoid this, make yourself a realistic budget and stick to it. You should also start building an emergency fund that can be used to pay for financial surprises so you don’t have to rely on credit cards.
“It’s critical when considering consolidation to identify what caused the debt in the first place and make adjustments to budget and spending habits in order to prevent the situation from reoccurring,” says Bossler.
Takeaway: Consolidation can help pay off debt, but it will not eliminate the financial habits that got you into trouble in the first place, such as overspending or failing to set aside money for emergencies. You can prevent more debt from accumulating by laying the groundwork for better financial behavior.
2. There may be some upfront costs
Some debt consolidation loans come with fees. These may include:
- 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 repayment.
Takeaway: Do you research carefully and read the fine print when considering debt consolidation plans to make sure that you understand the full cost of the loan you’re considering.
3. You may pay a higher rate
It’s possible that 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.
“Consumers consolidating debt get an interest rate based on their credit rating. The more challenged the consumer, the higher the cost of credit,” says Sullivan.
Additional reasons you might pay more in interest include 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.
As you consider debt consolidation, weigh your immediate needs with your long-term goals to find the best personal solution.
Takeaway: Consolidation does not always end up reducing the interest rate on your debt, particularly if your credit score is less than ideal.
Before signing onto a debt consolidation offer, review all of your current monthly minimum payments and the expected length of time to repay the debt and compare that to the time and expense associated with a consolidation plan. If you’d like to see how a debt consolidation loan could affect your finances, you can always use a debt consolidation calculator.
And remember, when considering consolidation, it’s important to take the time to reflect on what caused the mountain of debt in the first place and address those root issues. Consolidation can feel like an immediate relief, but ultimately, it may not resolve the problem if there are issues such as overspending or a budget shortfall that remain unaddressed.
The bottom line
Debt consolidation is a good option for people who need to simplify their monthly budget or those with good credit who can qualify for a low interest rate. However, if you’re interested in a debt consolidation, also ensure that you have a plan to pay off your new loan and avoid racking up new debt in the process.