Debt consolidation is the process of combining multiple debts into one. Typically, when you employ this strategy you take out a new lower-interest loan and use it to pay off the balances on multiple high-interest accounts.
Consolidating pricey debt into one, easy-to-manage account and payment can make sense for a lot of reasons. The most obvious plus of debt consolidation is that it has the potential to save you money. It can also help you to get out of debt faster and might even have a positive impact on your credit scores.
Thinking about simplifying your debt and (hopefully) saving money? Here’s a breakdown of three of the most common types of debts you can consolidate — along with the benefits of doing so.
Credit card debt
Sound financial advice dictates that you should pay your credit card balances off in full each month. This is the best way to avoid paying interest, reduce debt and protect your credit scores from damage.
Yet for many Americans, carrying a balance on their credit cards is a normal part of life. According to Experian, the average credit card balance was $6,028 in the first quarter of 2019.
Of course, just because credit card debt is normal doesn’t mean that you have to accept that it will be a fact of life for you. You can build a solid plan to get rid of credit card debt once and for all, and debt consolidation might help you to reach your goal sooner.
When you decide to consolidate debts, it makes sense to start with the most expensive debts first — and that’s probably your credit card accounts. Currently, the average credit card APR is a high 17.72 percent.
Using a low-interest personal loan to pay off pricey credit card debt has the potential to save you a lot of money. For example, if your APR is 17.72 percent on your credit card and you consolidate $10,000 in debt with a new, 24-month personal loan with a 7.5 percent rate, you could save:
- Over $1,100 in interest fees
- Nearly $50 per month
Plus, you could pay off the debt in two years. Financially speaking, that’s a win-win situation.
When your credit reports show you have outstanding balances on your credit cards, there’s a chance it could lower your credit scores. The balance itself isn’t such a big deal from a scoring perspective. Rather, scoring models like FICO are concerned with the percentage of your credit limit being used. This is known as credit utilization, or your revolving utilization ratio.
When you use more of your card limit, your credit utilization goes up — which isn’t good for your credit scores. This is where a consolidation loan can help. Paying your card balance down to $0 with a new personal loan would lower your credit card utilization to 0 percent. Typically the lower utilization falls, the better for your scores.
With a consolidation loan, the amount of debt owed would still be on your credit report, but it wouldn’t impact your scores the same way. This is because personal loans are installment accounts, not revolving. Installment loans, which are paid off each month for a specified period of time, such as two years or five years, are treated differently by scoring models. When you use an installment loan to pay off your credit card balances, your scores are likely to increase.
You can also use a balance transfer credit card to pay off your outstanding credit card debt. If you have good credit, you may be able to qualify for a balance transfer offer with a low or 0 percent interest rate for six, 12 or even up to 24 months. However, since the new balance transfer card is still a revolving account, you probably won’t see as much of a credit score benefit if you opt for this consolidation option.
Student loans are another type of debt that often make sense to consolidate. Even if you only make one single payment to a loan servicer each month, there’s a chance you have multiple student loan accounts on your credit reports.
Each time you received a fresh disbursement of funds during college, a new loan was opened in your name. Many students take out a new loan every semester to help cover tuition, fees and other costs. In fact, it’s not unusual to rack up as many as eight or more student loans while earning a standard undergraduate degree.
If you aren’t sure how many student loans you owe, you can check your credit reports for answers.
Should you discover that you have multiple student loans filling up your report, a consolidation loan might be worth considering. Here are some of the benefits:
It’s not a given, but you might be able to secure a lower interest rate on a student loan consolidation. If this happens, you could potentially save quite a lot. In fact, the more money you owe in student loans the more money you stand to save by consolidating to a new loan with a lower interest rate.
Consolidating student loans isn’t just potentially good for your wallet. It may also benefit your credit. In fact, a student loan consolidation might help your credit in two different ways.
One of the factors that scoring models pay attention to is the number of accounts with balances on your credit report. Granted, this isn’t a huge scoring factor — certainly not as important as, say, your payment history or credit utilization. Nonetheless, it does have some impact on your credit scores. By reducing the number of accounts with outstanding balances on your reports, you might do your credit scores a favor. No, your scores probably won’t jump 100 points (or anywhere remotely close to that), but even a few points can sometimes make a difference when you’re working to improve your credit.
Combining your loans into a single account also makes it easier to play so-called “credit defense.” Consider the following scenario. You get sick or injured and have to miss work. As a result, you can’t afford to pay your student loan servicer. However, even though you’re only making one payment to a student loan servicer, that payment is actually divided between six accounts. The late payment doesn’t just show up one time on your credit reports; late payments are reported on six different accounts.Now, imagine that you had consolidated your student loans into a single new account before you became ill and missed that payment. Instead of six late payments on your credit report, only one account would be reported as past due. While one late payment still wouldn’t be good for your credit scores, it would certainly be less detrimental than six past due accounts from a scoring perspective.
High-interest personal loans
Credit cards and student loans aren’t the only types of loans you might want to consolidate. Whether you’re trying to simplify your finances or get out of debt quicker, it might make sense to consolidate high-interest personal loans as well.
If you’ve taken out personal loans in the past, you might be able to save money on interest by securing a new loan with a lower APR. Perhaps your credit has improved or interest rates are lower than they were when you originally took out your loan(s). If you can secure a new loan with a better rate, the overall interest savings might be substantial.
Remember, it’s best to compare rates before you take out any type of new financing. You can check personal loan rates through Bankrate, plus your local bank and credit union, to find the best offer for your situation.
Because personal loans are installment accounts, not revolving, consolidating these loans into a new personal loan won’t lower your credit utilization rate. (Personal loans don’t increase credit utilization to begin with.) So, you probably won’t see a big score increase when you zero out the balances on personal loans and replace them with a new one.
Your scores might benefit slightly if you reduce your number of accounts with balances. However, the credit inquiry and the presence of a new account on your report might offset that potential score increase.
Nonetheless, if you can save money by consolidating expensive personal loans with a more affordable installment option, it probably makes sense to go for it. Even if your credit scores do take a slight hit from the new inquiry and loan (and that’s the worst-case scenario), your scores can bounce back in time as the account ages and you manage it properly.
Making debt consolidation work for you
You shouldn’t take out any type of financing, a consolidation loan or otherwise, without taking a moment to consider the potential downside. With consolidation loans, one big mistake that people often make is continuing to rack up more debt after using a new loan to combine their old balances. This mistake can eventually lead to a financial disaster. Thankfully, it’s a mistake you can avoid if you determine ahead of time that new credit card debt is off limits.
Debt consolidation isn’t a magic wand. But, when used properly, it’s a powerful tool you can use to potentially improve both your finances and your credit.
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