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Debt consolidation is when you take out a new loan to repay multiple loans, simplifying your repayment and potentially reducing the overall cost of your loan. While it’s a helpful tool for some, only three types of debt can be consolidated: credit card, student loan and high-interest personal loan debt.
Here’s what you need to know about consolidating your debt, the options you have and whether debt consolidation is the best relief option for your financial situation.
Credit card debt
Paying down your monthly credit card balance on time and in full is the best way to improve your score and avoid paying interest. However, those who have multiple high-interest credit cards and borrowers who have a hard time meeting all of the monthly payments may benefit from debt consolidation.
Due to record-breaking inflation and historic interest rate hikes, the average credit card interest rate has climbed to over 19 percent. Now more than ever, borrowers in good credit health should consolidate their debts if they’re offered a lower interest rate. Not only will consolidating your credit card debt simplify your repayment process, but it can also save you thousands of dollars in interest accrual.
When you consolidate, it makes sense to start with the most expensive debts first — and that could be your credit card accounts due to the interest rates alone. When offered a debt consolidation loan with a lower rate than your original debts, you could save a significant chunk of change due to the decreased rates.
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 16% 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:
- Nearly $1,100 in interest fees
- Nearly $50 per month
If you qualify for a low-interest personal loan, you could pay off your debt in a significantly shorter amount of time.
30 percent of your FICO Score – the most commonly used credit indicator – is made up of how much of your available credit you’re using, also known as your credit utilization ratio. If you’re using most of your available credit, it can be harder to get approved for other forms of debt and can lower your score.
With a consolidation loan the amount of debt owed would still be on your credit report, but because personal loans are installment loans, they don’t impact your score as severely as credit cards. Consolidating your debt and making the monthly payments is a sure-fire way to quickly increase your score by lowering your utilization levels.
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, because 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. Plus, if you don’t pay down the balance by the end of the offer period you could find yourself stuck with more high-interest debt down the road.
Student loan consolidation is a popular loan management option among borrowers; it simplifies repayment by condensing multiple loans and can save money on interest. However, consolidating your student debt isn’t the solution for every borrower and in the wrong situations, can cause more harm than good.
When you consolidate your student debt, you take out a new, private loan to replace your existing student loans. You can consolidate both federal and private loans, but exhausting all other repayment options first is recommended for those who have federal loans, as you’ll lose all of the benefits offered by the Education Department after consolidating.
While they may offer a more competitive rate, private lenders don’t offer the same repayment and relief options. Do your research before signing on the dotted line to ensure you don’t miss out on useful federal benefits.
Student loan consolidation may be a good fit if you:
- Only have high-interest private student loan debt
- Don’t plan on using any of the federal repayment plans or payment relief options.
- Your new loan carries a much lower APR than your current student loan debt.
The amount of interest you pay on student loans can add up over time, but consolidating can give you the financial relief you need.
Lower interest rate
You might be able to secure a lower interest rate on a student loan consolidation. 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.
One of the factors that scoring models pay attention to is the number of accounts with balances on your credit report. Known as your credit mix, it makes up 10 percent of your FICO score; while it’s not the largest scoring factor, it’s still important to keep an eye on how many accounts you have open.
By reducing your number of outstanding accounts, you’ll likely see your credit score improve. While it probably won’t jump significantly from this factor alone, it’s likely that you’ll see a credit score increase of at least a few points.
Consolidating your student debt can also save your credit report in the long-run if you miss your monthly payment and it shifts to delinquent status. Even though you’re only making one payment to your lender, you’re paying down all of your loans on the repayment plan. That being said, any delinquent payments will show up on your credit report for each active student loan and will remain on your report for seven years.
When you consolidate, you only have one loan; therefore, only one account would have a delinquent payment report. While one late payment still isn’t good for your credit score, it’s less detrimental to your credit health than if you were to have past-due payments on six accounts.
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 also make sense to consolidate high-interest personal loans.
The interest rate on personal loans is most competitive if you have good or excellent credit. But if your credit score is lower, you’ll likely receive a hefty rate that hikes up your monthly payment.
Save on interest
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. It only makes sense to consolidate if you’re offered a lower interest rate, so prequalify for as many lenders as possible before officially applying.
Prequalification is offered by many lenders and allows borrowers to see their eligibility odds and predicted rates with no hard credit-inquiry. Unless you’re certain that you’ll be offered a lower rate, don’t apply to multiple lenders that don’t offer prequalification; you risk multiple hard-credit inquiries and failed applications.
Because personal loans are installment accounts, not revolving, consolidating these loans into a new personal loan won’t lower your credit utilization rate. Your scores might benefit slightly if you reduce your number of accounts, but the credit inquiry and the presence of a new account on your report might offset that potential score increase.
However, if you can save money by consolidating your 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, your scores can bounce back in time as the account ages and you manage it properly.
You can consolidate credit card, student loan and high-interest personal loan debt to lower your interest rates and make your monthly payments more affordable. Debt consolidation also streamlines the repayment process, making it easier to manage your outstanding debt obligations, and can help improve your credit and overall financial health.
Before you apply for a loan, it’s important to educate yourself on how the process works and what debts can be consolidated. You should also analyze your budget and spending habits to ensure consolidating won’t tempt you to overspend and land you in a bigger mountain of debt.