With consumer debt totaling over $15 trillion in 2021, it’s no surprise that many people are looking to make their loans more affordable. One of the ways people do this is through debt consolidation.
Consolidating your debt lets you turn multiple debts into one. This can reduce the overall interest rate of your loans and turn multiple monthly payments into a single one that’s more affordable.
Debt consolidation may help you get your financial life on track and make your payments more affordable. However, only some kinds of debt can be consolidated.
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 your 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. The average credit card balance was $5,525 in 2021.
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, 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 roughly 16%.
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
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 score. 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 score.
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.
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.
Other credit benefits of consolidating your debt include:
- Reducing your total debt more quickly
- Adding another account to your report, boosting your payment history
Private 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. It’s not unusual to rack up as many as eight or more student loans while earning a standard undergraduate degree.
Note that consolidating federal student loans using private lenders can mean losing benefits like income-based repayment. It may be worth keeping federal loans separate and consolidating only your private student loans.
Should you discover that you have multiple student loans filling up your report, a consolidation loan might be worth considering.
You might be able to secure a lower interest rate on a student loan consolidation. If this happens, you could potentially save a lot. 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. 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 score a favor. Your score probably won’t jump up significantly, 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 the 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.
If you had consolidated your student loans into a single account, only one account would be reported as past due. While one late payment still wouldn’t be good for your credit score, it would be less detrimental than six past-due 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 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.
Because personal loans are installment accounts, not revolving, consolidating these loans into a new personal loan won’t lower your credit utilization rate. 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, that’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.