American consumer debt — including mortgages, car loans, credit cards and student loans — reached $16.5 trillion in the second quarter of 2022, according to the New York Federal Reserve. Some Americans cannot manage their thousands of dollars of debt, forcing them to explore other options rather than trying to chip away at an ever-growing mountain.
Some options for overcoming debt include working with creditors to settle the debt, using a home equity line of credit or getting a debt consolidation loan. Debt consolidation is the process of combining several debts into one new loan. Debt consolidation allows you to streamline your monthly debt payments into one single payment, sometimes at a lower interest rate.
Although it sounds like an ideal solution, there are both pros and cons associated with debt consolidation. It could simplify finances, possibly repaying debt sooner and improving your credit score. But there will be drawbacks, including upfront costs.
How debt consolidation works
Debt consolidation is combining two or more debts into a single larger debt. Consumers often take this step 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,” said 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 benefits of debt consolidation
Debt consolidation is often the best way to get out of debt. Here are some of the main benefits that may apply.
1. Faster debt repayment
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 monthly payments with a clear beginning and end to the loan.
2. 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 payment. Furthermore, the payment is the same each month, so you know exactly how much money to set aside.
3. Lower interest rates
As of September 2022, the average credit card rate is around 18 percent. Meanwhile, the average personal loan rate is below 11 percent. Of course, rates vary depending on your credit score, 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.
4. 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 last payment will be. If you pay only the minimum with a high interest credit card, it could be years before you pay it in full.
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, over time it will likely improve your score. That’s because it’ll be easier 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.
4 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.
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 fees, including 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.
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.
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.
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
The answer to this question depends on your circumstances. That said, here are some scenarios where you might be a good candidate:
- 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.
- 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.
- 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.
- You can afford to repay the loan: Finally, a debt consolidation loan will only benefit you if you can afford to repay it. You’ll risk digging into a deeper financial hole if you can’t.
How to get a debt consolidation loan
If you believe taking out a debt consolidation loan is the best option, take the following steps to get one:
- 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 by visiting AnnualCreditReport.com.
- Determine your loan amount. Add up the debt you want to consolidate to see how much money you need to borrow. Also, factor in potential origination fees, which are taken out of the loan amount.
- 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.
- 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.
- 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.
- 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.
While debt consolidation can be an attractive option, remember there are benefits and drawbacks to taking this step. While you may be able to streamline your monthly debt payments into a single payment and lower your interest rate, you may also have to pay fees for a consolidation loan. And the loan will not solve your financial problems on its own.
Before signing onto a debt consolidation offer, review all of your monthly minimum payments and the expected length of time to repay the debt and compare that to the time and expenses 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 immediate relief, but it may not resolve the problem if issues such as overspending remain unaddressed.