As of the second quarter of 2023, Americans owed a staggering $16.5 trillion in consumer debt, including mortgages, car loans, credit cards, and student loans. For many people, this debt is simply unmanageable, leading them to explore other options instead of trying to chip away at an ever-growing mountain slowly.
Here we compile the pros and cons of debt consolidation to help you make the right decision about it.
Debt can be difficult to manage, but options are available to help you get out of debt. You can work with creditors to settle your debt, use a home equity line of credit, or get a debt consolidation loan. Debt consolidation is a process where you combine several debts into one new loan. This can be helpful because it allows you to make one monthly payment instead of multiple charges, and sometimes the interest rate is lower. Have you looked at CreditAssociates.com?
Debt consolidation can be a great way to simplify your finances and get out of debt sooner. However, there are some drawbacks to this solution, including upfront costs. It’s essential to weigh the pros and cons of debt consolidation before deciding.
How debt consolidation works
Debt consolidation is the process of combining two or more debts into a single, larger loan. This can be a helpful way to manage high-interest debts and reduce your monthly payments.
Debt consolidation is a popular way to pay off multiple debts with a new loan. This can be used to combine credit card debts, auto loans, student loans, medical debt, or other types of loans into a new loan. According to Katie Ross, executive vice president of the nonprofit American Consumer Credit Counseling, this allows the borrower only to pay one monthly payment instead of a separate payment for each debt.
Debt consolidation can be a great way to simplify your finances and get more favorable loan terms, such as a lower interest rate.
Five pros of debt consolidation
There are many benefits to consolidating your debts. Here are some of the main ones that may apply to you. Doing so can help you save money, get out of debt faster, and improve your credit score.
1. Faster debt repayment
Debt consolidation loans can help you pay off your debts faster, especially if you have a lot of credit card debt. With a consolidation loan, you have fixed monthly payments and a clear end date to the loan, which can help you stay on track.
Takeaway: The sooner you repay your debt, the less interest you may have to pay overall. Quickly paying off your debt also frees up more money that can be put toward other goals, such as an emergency or retirement fund.
2. Simplified finances
There are many benefits to consolidating your debt into one monthly payment. You will no longer have to worry about multiple due dates each month and know exactly how much money to set aside each month. This can help you budget more effectively and help you get out of debt more quickly.
Takeaway: Debt consolidation can be a helpful tool to simplify your budget and make it easier to keep track of your payments. When you consolidate your debts, you pay off other debts with loan funds, leaving you with one monthly payment instead of multiple charges. This can make it easier to stay on top of your finances and avoid late or missed payments.
3. Lower interest rates
The average credit card interest rate is relatively high at 18 percent. On the other hand, you can get a much lower interest rate for a personal loan – around 11 percent. The rates will differ depending on your credit score and the amount and term of the loan. However, generally, you will get a lower interest rate with a debt consolidation loan than with your current credit card.
Takeaway: Debt consolidation loans can be a great option for consumers with good to excellent credit. The interest rates on these loans are typically much lower than the average credit card, saving you a lot of money in the long run.
4. Fixed repayment schedule
There are many benefits to using a personal loan to pay off debt, including knowing exactly how much is due each month and when the last payment will be. With a high-interest credit card, you may pay only the minimum each month, which could take years to pay off in full.
Takeaway: There are many benefits to having a fixed repayment schedule for your loan. Your payment and interest rate will remain the same for the duration of the loan, which can help you budget more effectively.
5. Boost credit
Different ways of handling debt can affect your credit score in different ways. For example, taking out a debt consolidation loan may result in a slight dip in your credit score at first due to the hard credit inquiry required for the loan. However, over time, this could improve your score as it becomes easier to make on-time payments. Payment history accounts for 35 percent of your credit score, so making timely payments on a monthly bill can significantly impact you.
Keeping old credit cards open after you pay them off can also help improve your credit score. This is because it lowers your credit utilization ratio and strengthens your history with credit. Amounts owed makeup 30 percent of your credit score, and the length of your credit history represents 15 percent. Therefore, closing old cards after paying them off could hurt your score rather than help it.
Takeaway: Consolidating your debt can give your credit score a much-needed boost. This is especially true when you make timely payments on the loan, as payment history is one of the most critical factors in calculating your score.
Four cons of debt consolidation
Debt consolidation can be a great way to reduce your monthly payments and get out of debt faster. But, before you consolidate your debts, it’s essential to understand the potential downsides.
1. It cannot solve financial problems on its own
Debt consolidation may help reduce your monthly payments and provide some relief, but it doesn’t guarantee that you won’t go into debt again. To avoid this, make a realistic budget and stick to it. It would help if you also started building an emergency fund that can be used to pay for financial surprises, so you don’t have to rely on credit cards.
Takeaway: Debt Consolidation can help you become debt free, but it will not fix the financial habits that got you into trouble in the first place. You can prevent more debt from accumulating by learning how to manage your finances better.
2. Up-front costs may apply
Debt consolidation loans may come with a variety of fees. These could include:
- Annual fees
- Balance transfer fees
- Closing costs
- Loan origination fees
When considering taking out a debt consolidation loan, ask about any fees associated with the loan. These fees can vary significantly from lender to lender and can add up quickly. Be sure to factor these fees into your decision when determining whether or not debt consolidation is right for you.
Takeaway: Debt consolidation loans can be an excellent option for those struggling with multiple debts. However, it is essential to research different options and read the fine print carefully before deciding.
3. Your rate may be higher
Debt consolidation can help lower monthly payments, but it could come at a higher interest rate. This is because consolidating debt can raise a person’s credit score.
“Consumers consolidating debt get an interest rate based on their credit rating. The more challenged the consumer, the higher the cost of credit,” says Michael Sullivan, a personal financial consultant for Take Charge America, a nonprofit credit counseling and debt management agency.
Extending the loan term could get you a lower monthly payment, but you may end up paying more in interest in the long run. As you consider debt consolidation, weigh immediate needs with long-term goals to find the best solution.
Takeaway: Debt Consolidation may not always reduce your interest rate, especially if you have a poor credit score.
4. Paying late will set you back even further
Missing a monthly loan payment can result in costly late payment fees. In addition, some lenders charge returned payment fees when an amount is returned due to insufficient funds. These fees can substantially increase borrowing costs.
Additionally, lenders typically report late payments to credit bureaus after they become 30 days past due. This can damage your credit score and make it difficult to qualify for future loans with favorable interest rates.
Consider enrolling in the lender’s automatic payment program to reduce the likelihood of missing a payment.
Takeaway: Debt consolidation loans can be a great way to get your finances in order, but you need to be sure that you can afford the monthly payments before you take one out.
When should you consolidate your debt?
There is no one-size-fits-all answer to this question, as it depends on your circumstances. However, here we share some scenarios where you might be a good candidate for editing text to improve its quality:
- You have a good credit score: You may get a lower interest rate on your debts, which could save you money, with a good credit score. A score of at least 670 is considered good.
- You prefer fixed payments: A debt consolidation loan might be the right choice, depending on your preferences for interest rates, repayment terms, and monthly payments.
- You want one monthly payment: Debt consolidation loans can be a good idea for people who don’t like keeping track of multiple expenses.
- You can afford to repay the loan: A debt consolidation loan can help you get out of debt, but only if you can afford the monthly payments. Otherwise, you could end up in a worse financial position than before.
A guide to debt consolidation loans
There are many benefits to taking out a debt consolidation loan. By consolidating your debts, you can save money on interest, simplify your monthly payments, and pay off your debt faster.
- Check your credit score and reports. Viewing your credit score is an excellent way to determine whether you meet the minimum requirements set by lenders. You can also check your credit reports for any inaccuracies or incomplete information that could damage your score. You can view all three of your credit reports for free every week by visiting AnnualCreditReport.com.
- Determine your loan amount. To see how much money you need to borrow to consolidate your debt, add the total amount you owe. Make sure to factor in any potential origination fees, as these will be deducted from the loan amount.
- Research different lenders. Many online lenders offer debt consolidation loans. Each lender has additional eligibility requirements, loan terms, and fees. It is important to compare all of the options before choosing a loan.
- Get prequalified. Prequalifying for a loan is a great way to estimate your possible loan rate and terms. By prequalifying, each lender will give you an idea of what your loan could look like. This process usually only requires a soft credit check, meaning your credit score won’t be affected.
- Apply. The application process for a debt consolidation loan varies by lender, but you will likely need to submit personal information such as your name, date of birth, and income. Some lenders may require an online application, while others may require an in-person or phone application.
- Receive funds. After you’re approved for a debt consolidation loan, your lender could deposit the funds in as little as one business day. You can use the funds to pay off your existing creditors and then repay the consolidation loan according to the terms of the agreement. This will help avoid any damage to your credit score.
Debt consolidation can be a helpful tool to get your finances in order. By consolidating your debt, you can make one monthly payment instead of several, and you may get a lower interest rate. However, there are also some potential drawbacks to consolidation. For example, you may have to pay fees for taking out a consolidation loan, and the loan will not solve your financial problems on its own.
Before signing up for any debt consolidation offer, take the time to review your monthly minimum payments and the expected length of time to repay the debt. Compare this information with the time and expenses associated with a consolidation loan. Use a debt consolidation calculator to see how a loan might affect your finances. And remember, when considering debt consolidation, reflect on what caused the mountain of debt in the first place and address those root issues.