Even if you’re doing your best to manage your money, paying off high-interest debt every month can make it hard to reach your financial goals. It’s a situation faced by millions of Americans as their debt continues to grow.
Americans owe more than $4 trillion in debt, not including their mortgages. One method of dealing with multiple debt payments is by doing a debt consolidation. But debt consolidation isn’t the best strategy for everyone. Here’s what you need to know.
What is debt consolidation?
Debt consolidation is when you merge multiple debts into a single debt. Instead of making separate payments to multiple credit card issuers or lenders each month, you roll them into one payment from a single lender, ideally at a lower interest rate.
While debt consolidation won’t wipe out your debts, the strategy can make it easier and less expensive to pay off debt.
You can use debt consolidation to merge several types of debt, including:
- Credit cards.
- Medical debt.
- Personal loans.
- Student loans.
- Auto loans.
- Payday loans.
How does debt consolidation work?
There are several steps to debt consolidation:
- Choose which type of loan you’re going to use to consolidate your debt. Depending on your credit profile and the type of debt or loans you’re consolidating, you might consider a personal loan, a balance transfer credit card, or a home equity loan or line of credit.
- Shop around with multiple lenders and compare credit cards, then apply for the loan or credit card.
- If you decide to use a debt consolidation loan, use the proceeds from your new loan to pay off the existing balances on all the debts that you’re consolidating. If you’re using a balance transfer credit card, you will transfer your existing balances onto the single credit card.
- Make payments on your new loan. Consider setting up auto-payments on this loan, so that you never miss a payment. Direct any extra cash you have to the loan in order to pay it off more quickly.
How can you benefit from consolidating debt?
Debt consolidation can help you manage debt more effectively by saving you money on late fees, lowering your monthly payments and reducing the amount of interest that you’re paying.
The larger the difference in the current interest rates on your debts and the new rate on a consolidated loan, the larger your savings will be. Use Bankrate’s debt consolidation calculator to see how much money you could save by consolidating your outstanding debt.
Over the long term, if you’re able to lower your total balance, you may also improve your credit score, as you’ll be able to reduce your credit utilization ratio.
When debt consolidation is a good idea
Debt consolidation makes sense for people who are committed to lowering their overall debt and want to simplify their finances and reduce their monthly payments. Borrowers who have a good credit score typically benefit the most from debt consolidation, because they should be able to get better interest rates.
You should also have a plan to prioritize payments on your new loan in order to pay it off as quickly as possible. Creating a budget or spending plan can help ensure that you live within your means and avoid taking on new debt.
When debt consolidation is a bad idea
If the interest rate on your debt consolidation loan is higher than the rates on the loans you’re currently paying off, you may not save money by consolidating your loans. If you’re unable to get a loan at a rate that makes debt consolidation effective, consider other methods of tackling your debt.
Borrowers who aren’t committed to reducing their debt over the long term also won’t get the full benefits of consolidation. The reason? They may end up incurring new debt on the cards that they’ve just paid off, putting them deeper in a hole.
What are the risks of debt consolidation?
It depends on the type of consolidation you choose. Anytime you take on debt tied to your house (via a home equity line of credit or home equity loan), for example, you risk foreclosure if you default on the loan. When you use a zero-interest introductory-rate credit card as a tool for debt consolidation, the risk comes if you don’t pay off your balance before the introductory rate expires because you could owe even more interest when the interest rate resets higher.
No matter which type of loan you use to consolidate your debt, you’ll want to carefully compare the interest rates and other fees so that you know exactly how much it’s costing you.