Pros and cons of debt consolidation

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American consumer debt — including mortgages, car loans, credit cards and student loans — reached $14.64 trillion in the first quarter of 2021, 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 debts and combine those monthly payments into one, usually with a lower interest rate. Although it sounds like an ideal solution, consider the 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, executive vice president of the nonprofit 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 gives the borrower more favorable loan terms, such as a more competitive interest rate.

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 paying off a balance, but a consolidation loan 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: Because you use the loan funds to pay off other debts, debt consolidation can turn two or three payments into a single payment. This can simplify budgeting and create fewer opportunities to miss payments.

3. Get lower interest rates

As of July 2021, the average credit card rate is around 16 percent. Meanwhile, the average personal loan rate is below 11 percent. Of course, rates vary depending on your credit score and 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

If you use a personal loan to pay off your debt, you’ll know exactly how much is due each month and when your very last payment will be. Pay 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. That’s 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 from credit cards and you keep your cards open, you’ll have both a better credit utilization ratio and a stronger history with credit. Amounts owed account 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 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 in the calculation of your score.

4 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 beyond 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.

Takeaway: Consolidation can help you pay debt off, 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 up-front costs

Some debt consolidation loans come with fees. These may include:

Before taking out a debt consolidation loan, ask about any and all fees, including those for making late payments or paying your loan off early.

Takeaway: Do you research and read the fine print carefully when considering debt consolidation loans to make sure you understand their full costs.

3. You may pay a higher rate

Your debt consolidation loan could come at a higher rate than what you currently pay on your debts. 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 Michael Sullivan, personal financial consultant for Take Charge America, a nonprofit credit counseling and debt management agency.

Additional reasons you might pay more in interest include the loan amount and the loan term. Extending your loan term could get you a lower monthly payment, 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 solution.

Takeaway: Consolidation does not always end up reducing the interest rate on your debt, particularly if your credit score is less than ideal.

4. Missing payments will set you back even further

If you miss one of your monthly loan payments, you’ll likely have to pay a late payment fee. In addition, if a payment is returned due to insufficient funds, some lenders will charge you a returned payment fee. These fees can greatly increase your borrowing costs.

Also, since lenders typically report a late payment to the credit bureaus after it becomes 30 days past due, your credit score can suffer serious damage. This can make it harder for you to qualify for future loans and get the best interest rate.

To reduce your chances of missing a payment, enroll in the lender’s automatic payment program if it has one.

Takeaway: Before you take out a debt consolidation loan, make sure you can afford the monthly payments. Missing a payment can lead to late fees and a lower credit score.

Should I consolidate my debt?

The answer to this question depends on your circumstances. That said, here are some scenarios where you might be a good candidate:

  1. You have a good credit score: If you have a good credit score (at least 670), you’ll have a better chance of securing a lower interest rate than you have on your current debt, which could save you money.
  2. You prefer fixed payments: If you prefer for your interest rate, repayment term and monthly payment to be fixed, a debt consolidation loan might be right for you.
  3. You want one monthly payment: Also, taking out a debt consolidation loan could be a good idea if you don’t like keeping track of multiple payments.
  4. You can afford to repay the loan: Finally, a debt consolidation loan will only benefit you if you can afford to repay it. If you can’t, you’ll risk digging yourself in a deeper financial hole.

How do I get a debt consolidation loan?

If you believe getting a debt consolidation loan is the best option for you, take the following steps to get one:

  1. Check your credit score and reports. Some lenders have minimum credit score requirements. To see if you meet those requirements, view your credit score. Also, check your credit reports to see if they have inaccurate or incomplete information that could hurt your score. You can view all three of your credit reports for free weekly through April 20, 2022, by visiting AnnualCreditReport.com.
  2. Determine your loan amount. Add up the amount of debt you want to consolidate to see how much money you need to borrow.
  3. Research different lenders. Review the websites of different online lenders to see eligibility requirements, loan terms and fees. Also, check with your local bank or credit union to see if it offers debt consolidation loans.
  4. Get prequalified. When you prequalify, each lender will give you an estimate of what your loan rate and terms could be. Typically, the lender will only do a soft credit check for prequalification, which means your credit score won’t be impacted.
  5. Apply. Depending on the lender you choose, you’ll submit a formal application for your debt consolidation loan online, in person or by phone. You’ll be asked for personal information such as your name, date of birth and income.
  6. Receive funds. If you’re approved, your lender could deposit your funds in as little as one business day. Use the funds to pay off your existing creditors. Afterward, repay the debt consolidation loan as agreed to avoid damage to your credit score.

Final considerations

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 loan. If you’d like to see how a debt consolidation loan could affect your finances, use a debt consolidation calculator.

And remember, when considering debt consolidation, reflect on what caused the mountain of debt in the first place and address those root issues. Debt consolidation can feel like an immediate relief, but it may not resolve the problem if there are issues such as overspending that remain unaddressed.

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Written by
Jerry Brown
Contributing writer
Jerry Brown is a contributing writer for Bankrate. Jerry writes about home equity, personal loans, auto loans and debt management.
Edited by
Associate loans editor