Why consolidate your debt
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If you’re carrying a heavy debt load, you’re not alone. According to a survey by CreditCards.com, a Red Ventures company, 70 percent of U.S. consumers hold some form of debt. Not only that, but 72 percent of those with credit card debt reported adding to their balances in 2022.
With interest rates on the rise, making new and variable debt more expensive, many are searching for ways to find relief. A viable option to get out of debt faster is consolidating, which can be done through a personal loan, balance transfer credit card or home equity product. Before you move forward, weigh the benefits and drawbacks to determine if it’s sensible for your financial situation.
What is debt consolidation?
Debt consolidation involves combining two or more outstanding balances into a single debt product, preferably with a lower interest rate than you’re currently paying. So, you’ll get one predictable loan payment each month, making your debt load much easier to manage.
Reasons to consolidate your debt
Debt consolidation is the preferred choice to eliminate those overwhelming debt balances for several reasons, including the following.
It can be overwhelming to keep track of payment due dates when you owe several creditors. But when you consolidate outstanding debt balances into a loan or credit card product, you’ll only make one payment to a single creditor per month. This minimizes the chances of making late payments that result in excessive fees or damage to your credit score.
Lower interest rates
Consumers with good or excellent credit scores generally qualify for competitive interest rates on debt consolidation loans. As of April 19, 2023, the average credit card interest rate was 20.60 percent, compared to between 10.73 percent and 12.5 percent for personal loans for borrowers with excellent credit.
Even if you have good credit, the average rate is between 13.5 percent and 15.5 percent, which is lower than what you’ll find with most credit card products. And the less you pay in interest, the greater the amount applied to the principal balances each month, making it easier to get out of debt faster.
Fixed repayment schedule
A debt consolidation loan gives you a set payment schedule and predictable monthly payments. Plus, it’s far easier to work the payments into your budget since there won’t be any guesswork regarding how much the minimum payments will be each month.
When you apply for a debt consolidation product, your credit score may drop a few points due to the hard credit inquiry. However, you could see credit score improvements sooner than later for a few reasons.
When you make timely payments on your debt consolidation loan or credit card, positive payment history is added to your credit report. Payment history accounts for 35 percent of your credit score, so you’ll likely see an increase over time.
Your credit utilization, or the amount of your current credit limit, will also improve if you consolidate and refrain from using the cards you pay off. It’s a component of amounts owed and makes up 30 percent of your credit score, and keeping this figure at or below 30 percent gives you the best chance at a solid credit score.
To illustrate how it works, assume you have five credit cards with $1,000 limits. You owe $500 on each, bringing your utilization to 50 percent. If you take out a $2,500 loan and pay off the balances, your utilization will drop to zero. But if you use a balance transfer credit with a credit limit of $5,000, your utilization will decrease to 25 percent.
Faster debt payment
If you’ve been stuck making the minimum payments on your credit card each month, repaying what you owe could take several years. To illustrate, assume your credit card balance is $5,000, and the Annual Percentage Rate (APR) is 18.9 percent. Paying only $200 each month will cost you $3,109.16 in interest, and you’ll spend 137 months repaying what’s owed.
However, a debt consolidation loan helps fast-track your debt payoff efforts by giving you a fixed interest rate, loan term and monthly payment. Using the example above, if you take out a $5,000 debt consolidation loan with a three-year term and 11 percent fixed interest rate, you’ll pay $164 per month and $892.97 in interest over the life of the loan.
When not to consolidate your debt
There are also instances where consolidating your debt may not be a good idea. If your credit score is low, you’ll likely find it challenging to secure a debt consolidation product with a lower interest rate than you currently have.
You should also steer clear of debt consolidation if you don’t have a realistic budget. The same applies if you’re not yet disciplined with your spending. Both issues put you at risk of racking up even more debt, mainly if you take out a loan to pay off credit card balances and use the credit cards again.
It’s equally important to confirm that you can afford the payments on a debt consolidation loan. Otherwise, you risk damaging your credit rating if the account becomes delinquent. If you’re curious as to whether a debt consolidation loan fits within your budget, a personal loan calculator could help.
How to consolidate debt
There are many options for consolidating debt. Some of the most common approaches to streamlining your payments and lowering your interest include certain types of loans and credit cards.
Debt consolidation loan
A debt consolidation loan is another option. Loan proceeds can be used to pay off multiple debts so that you have just one debt payment each month. This is a particularly good choice for those with good credit who qualify for a low interest rate.
Home equity loan or home equity line of credit
For homeowners who have good credit, opening a home equity line of credit (HELOC) or taking out a home equity loan are options that often come with competitive interest rates.
Home equity loans provide a lump sum of cash that can be used to pay off debts and the loan repaid at a fixed interest rate. A HELOC is a credit line with a variable interest rate that you can draw from to repay debts.
When using peer-to-peer lending platforms, borrowers are connected with individual investors willing to provide unsecured loans. Those with better credit scores are also likely to qualify for the best interest rates.
Zero percent balance transfer credit card
If you’re mainly struggling with credit card debt, then a balance transfer card may be a great option to cut down on debt fast. Most credit card companies offer a 0 percent introductory rate to consumers with good-to-excellent credit. Transferring your credit card debt to a 0 percent card allows you to pay off those debts, interest-free.
On the downside, once the offer expires, you’ll be applied an ordinary interest rate on any remaining balance. Additionally, most of these cards charge a balance transfer fee of 3 to 5 percent of the total amount transferred.
When your debt becomes unmanageable, debt consolidation can help streamline monthly bill payments and often lower the total interest you’re paying. This step can also help establish a fixed repayment timeline and allow you to get out of debt more quickly.
Before pursuing consolidation, however, review your credit profile. It may not make sense for those with a lower credit score, as it will be difficult to secure better interest rates. If your credit score is less than ideal, improve your credit profile first. And when you’re ready to proceed, be sure you can afford the new payments that come with a debt consolidation loan.