Pros and cons of debt consolidation: Is it a good idea?

Debt consolidation is a popular repayment process that involves combining several debts into one new loan. While convenient, it’s only best for borrowers who can score a lower interest rate on their new loan and those who are offered better loan terms.

Taking out a debt consolidation loan isn’t an easy or fast fix to your current debt load. It can be a stepping stone to financial freedom or a way to incur more debt and credit damage. Weighing both the pros and cons after evaluating your own financial habits, future goals and current debt load.

Pros and cons of debt consolidation

You can consolidate nearly every type of consumer debt, including medical debt, personal loans, credit cards and student loan debt. However, consolidation loans aren’t an immediate fix. You must still pay them off, and terms sometimes last up to seven years.

That said, investigate the following pros and cons to see if consolidation is practical.

Pros

• Potentially lower interest rate.
• Pay down your debt faster, depending on your term.
• Organize your debts.

Cons

• Generally need good credit for a lower interest rate.
• Another credit check on your report.
• Upfront fees and costs.

Benefits of debt consolidation

Debt consolidation is often the best way to organize your current debt and simplify repayment. Consolidation, if used correctly, offers benefits that could save you money.

Faster debt repayment

Taking out a debt consolidation loan can help put you on a faster track to total payoff and may help you save money in interest by paying down the balance faster. This is especially true if you have significant credit card debt you carry from month to month.

Plus, consolidating offers a streamlined approach to credit repayment. Credit cards don’t come with a set repayment term and loans do.

Lower interest rates

As of April 2024, the average credit card rate is 20.75 percent. Meanwhile, the average personal loan rate is 12.18 percent.

Of course, rates vary depending on your credit score, loan amount, and term length. But if you have average credit or better, you’ll likely get a lower interest rate with a debt consolidation loan than what you’re currently paying on your credit card.

Those with excellent credit often get the lender’s lowest rates, which are significantly lower than the average credit card debt.

 Simplified finances

When you consolidate all your debt, you no longer have to worry about multiple due dates each month because you only have one monthly payment. Plus, the payment is the same each month, so you know exactly how much money to set aside.

Fixed repayment schedule

With a fixed repayment schedule, your payment and interest rate remain the same for the length of the loan, and there’s no unexpected fluctuation in your monthly debt payment. Since most personal loan rates are fixed, you’ll know exactly how much is due each month and when your last payment will be.

On the other hand, if you pay only the minimum with a high interest credit card, it could be years before you pay it in full.

Boost credit

Consolidating debt can improve your credit score. This is particularly true if you make your loan payments on time. Payment history is the most important factor in calculating your score.

A debt consolidation loan may temporarily lower your credit score by a few points due to the hard credit inquiry. But, over time, consolidation could improve your score.

You may find that it’s easier to make on-time payments with a single consolidation loan each month versus multiple debt streams. Payment history accounts for 35 percent of your credit score. So, consistently making that on-time monthly payment should grow 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 against revolving credit contribute 30 percent of your credit score. The length of your credit history accounts for 15 percent. So if possible, keep your paid-off cards open.

Drawbacks of debt consolidation

The following downsides are important to consider before signing on for debt consolidation. Debt consolidation may still be worth it for you.

It won’t solve financial problems on its own

Consolidating debt doesn’t guarantee you won’t go into debt again and won’t eliminate your current debt or underlying financial habits. 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. With an emergency fund, you don’t have to rely on credit cards.

There may be upfront costs

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

• Annual fees.
• Balance transfer fees.
• Closing costs.
• Loan origination fees.

Before taking out a debt consolidation loan, ask about any fees, including ones for making late payments or paying your loan off early. Depending on your lender, these fees could be hundreds if not thousands of dollars. While paying these fees may still be worth it, you’ll want to include them in deciding if debt consolidation makes sense for you.

You may pay a higher rate

Your debt consolidation loan could come with more interest than you currently pay on your debts. This can happen for several reasons, including your current credit score. If it’s on the lower end, lenders see you as a higher risk for default. You’ll likely pay more for credit and be able to borrow less.

Beware of extending your loan term, too. Extending your loan term could lower your monthly payment, but you may pay more interest in the long run.

As you consider debt consolidation, weigh your immediate needs with your long-term goals to find the best solution or consider debt consolidation alternatives.

Missing payments will set you back even further

Make sure you can afford the monthly payments before you take out a debt consolidation loan. Missing a payment can hurt your credit score and lead to late fees.

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.

Enroll in the lender’s automatic payment program if it has one to reduce your chances of missing a payment.

How to decide if you should consolidate your debt

If you have multiple streams of high-interest debt and a good credit score, consolidating may be a good way to save money. Consider the following factors below and use a debt consolidation calculator to determine if consolidating is right for you.

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 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: 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: A debt consolidation loan will only benefit you if you can afford to repay it. You’ll risk getting into a deeper debt cycle if you’re not 100 percent sure you’ll be able to afford the monthly payment down the road.

Bottom line

While debt consolidation can be attractive, remember there are benefits and drawbacks.

It’s possible to streamline your monthly debt payments into a single payment, lower your interest rate, improve your credit health and pay down credit cards faster. Still, you may also have to pay fees for a consolidation loan, and there is no guarantee that you’ll get a lower rate than you currently have.

Debt consolidation can feel like immediate relief, but it doesn’t eliminate the debt or resolve long-term problems. Before consolidating, evaluate why debt built up to discover any financial habits that need to be addressed.