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Consumer debt — from credit cards and student loans to personal loans and auto loans — reached record highs in the second quarter of 2022, according to the Federal Reserve Bank of New York. If you’re among the group of Americans carrying high debt loads, chances are you’re seeking creative solutions to find relief from those overwhelming balances.
Debt consolidation is a popular option that can help streamline the repayment process if you owe several creditors. You can organize your accounts in one place and possibly save money by securing a lower interest rate. Still, this approach is not without drawbacks, so you should familiarize yourself with what debt consolidation entails and ways to minimize the potential negative effects.
How does debt consolidation work?
Debt consolidation is taking multiple loans and refinancing them into one loan with a new lender. There are multiple ways to consolidate your loans. The most popular way is to take out a personal loan and use those proceeds to pay off your other debts, but some consumers prefer to use home equity loans or HELOCs.
The process is largely the same regardless of the type of loan you choose. You’ll start by comparing interest rates among a few lenders to see which offers you the best deal, and you’ll apply for enough money to cover your existing debts. Once you receive your loan funds, you’ll pay off your debt and begin making payments on your new loan.
To illustrate with Bankrate’s debt consolidation calculator, assume you have the following outstanding balances:
- Credit card #1: $5,000 balance, 15.9% interest rate, $141 monthly payment
- Credit card #2: $7,500 balance, 17.9% interest rate, $220 monthly payment
- Credit card #3: $10,000 balance, 19.9% interest rate, $304 monthly payment
- Auto loan: $12,500 balance, 6% interest rate, $350 monthly payment
- Personal loan: $4,000 balance, 11% interest rate, $250 monthly payment
If you take out a 48-month debt consolidation loan with an interest rate of 7.5 percent, your total monthly payment will drop from $1,265 to $943. Plus, you’ll save $5,164 in interest.
Does debt consolidation hurt your credit?
Debt consolidation loans can hurt your credit, but it’s only temporary. The lender will perform a credit check when you apply for a debt consolidation loan. This will result in a hard inquiry, which could lower your credit score by 10 points. Hard inquiries will only affect your credit score for one year.
Your credit score could also be negatively impacted if you close your credit accounts after consolidating the balances. The average age of your credit accounts makes up 15 percent of your credit score, with a higher age being better for your score. When you open a new account or close an older account, the average age of your credit history will decrease. So, it’s best to keep your old cards open — even if you never use them.
Despite the potentially negative impacts of debt consolidation, this debt management approach can improve your credit score over the long term. Payment history is 35 percent of your credit score, so making on-time payments will increase your score. If you only have revolving credit like credit cards, adding a personal loan for debt consolidation can improve your credit mix and boost your score.
Furthermore, your credit utilization — up to 30 percent of your credit score — could drop significantly by consolidating your debt. This figure is calculated by dividing your current card balance by your total credit limit. If you have a credit utilization ratio greater than 10 percent, you may see a ding on your credit score. However, if you pay off that balance with a personal loan, the utilization percentage will drop, and your credit score will improve.
When it makes sense to consolidate your debt
The most common reason to consolidate your debt is to save money on interest. If you can consolidate your debt and get a lower interest rate, you could save hundreds or even thousands of dollars in total interest.
Another popular reason to consolidate debt is to simplify your monthly payments. If you struggle to pay your bills on time because of different due dates, consolidating could make it easier to manage your finances.
The smartest way to consolidate your debt
The most efficient strategy to consolidate your debt starts with making a list of your current loans and credit cards. Include the total balance, interest rate, minimum monthly payment and total remaining payments.
Next, decide what kind of debt consolidation option you’d like, whether that’s a personal loan, home equity loan or balance transfer credit card. You should get quotes from multiple lenders and compare APRs, terms and total interest paid.
Make sure to apply for these loans and credit cards within two weeks to avoid multiple hard inquiries on your credit report. Once you have all of your offers, you can compare them with this debt consolidation calculator to see which lender you should choose.
3 alternatives to debt consolidation loans
If debt elimination is your goal but you’d rather not take out a debt consolidation loan, there are a few alternatives you can consider:
- Debt management plan: These are offered by nonprofit credit counseling agencies who will attempt to negotiate more favorable terms on your behalf. And instead of making payments to your lenders directly, you’ll make one monthly payment to the agency, which will then pay your creditors.
- Credit card balance transfer: You could save even more in interest with a balance transfer credit card. These cards come with a balance transfer fee of 2 to 5 percent, but the cost savings are still likely greater than if you took out a personal loan.
- Budget overhaul: Create a realistic spending plan incorporating your debt payoff goals. Trim expenses where you can, search for ways to earn more and allocate those extra funds towards your debt balances.
The bottom line
A debt consolidation loan is one option to pay down your debt. The best way to consolidate your debt without hurting your credit is to create a plan and stick to it. While your credit score may decrease temporarily, managing your debt and making on-time payments will help improve your score.
Though a debt consolidation loan is a great choice for some, you also have other options. Creating a debt management plan, taking advantage of a credit card balance transfer or overhauling your budget are other ways to consolidate your debt with minimal hurt to your credit.