Debt Consolidation Pros and Cons

Debt may not be the American dream, but it’s become the way Americans try to attain their dreams. Don’t believe it? Americans owe $16.15 trillion in household debt. That’s nearly $49,000 for every man, woman, and child in the country.

Most of that is mortgage debt, but car loans, student loans and credit card debt make up about 25% of the total. A lot of Americans struggle to manage those bills and are looking for help to get on top of their debt.

Debt consolidation can be an attractive option with the promise of simplifying and even lowering how much you pay each month.

Is debt consolidation a good deal? It can be. But, as with any financial move, there are advantages and disadvantages. Knowing the best ways to consolidate debt starts with knowing the basics.

What Is Debt Consolidation?

Debt consolidation combines multiple debts – like high-interest credit cards, personal loans, and medical bills – into a single loan with a more affordable monthly payment.

There are multiple kinds of debt consolidation programs, but they all have the same goal: reduce the interest rate you’re paying and lower your monthly payment so you can erase the debt in 3-5 years.

Pros of Debt Consolidation

Debt consolidation can make your financial life simpler and better. Done right, it will save you money each month. The benefits don’t stop there.

Pay Debt Off Faster

There are two reasons debt consolidation can make your debts disappear faster, especially if you have credit card debt. Credit cards don’t have a set time for paying off what you owe. Card companies tempt you to pay only a convenient amount each month. If you only pay the minimum monthly payments, your debt can last forever.

But debt consolidation programs have fixed payments geared to eliminating the debt in a defined time.

If your credit cards have high interest rates, as most do, a debt consolidation loan may actually offer a lower monthly payment. That alone is positive, and if you keep making the higher payment on the new loan, you’ll get out of debt even faster.

Make Debt Repayment Simple with One Monthly Payment

Simpler is better. Instead of keeping track of several due dates for multiple credit cards, you have one payment. The more monthly payments you have, the easier it is to forget one and incur late fees. Besides, who wants to think about payments more often than necessary?

Lower Interest Rates

The average credit card rate in September 2022 is 18.44%. The average rate for a personal loan – which is another name for a debt consolidation loan – with good credit is 9.68%. You aren’t guaranteed to get that rate, but there’s a good chance you can find a low-interest debt consolidation loan with a rate well below what your credit cards currently charge. Lower interest means lower payments and less interest paid over the life of the loan.

Fixed Repayment Schedule

In addition to having only one payment per month, using a debt consolidation loan means you’ll know exactly how much you owe each month and when you’ll have your debt paid off.

Boost Your Credit Score

Although applying for new credit can temporarily lower your score, you’re likely to end up boosting your credit score if you make your monthly payments on time.

Also, paying off credit card balances lowers your credit utilization ratio, a huge factor that determines your score. If you keep those credit cards open after paying them off, the credit utilization ratio and your payment history will combine to improve your credit rating.

Cons of Debt Consolidation

Debt consolidation is a good option, but it isn’t magic. Not everyone can get access to all of the benefits, and you have to be willing to change habits that got you into debt trouble in the first place. In other words: put away the credit cards until you’ve paid them off!

Not All Financial Problems Go Away

Having an uncomfortable amount of debt typically results from a history of living beyond your means. That doesn’t automatically change even if you pay that debt off. If you want to keep your financial house in order, it takes planning. Specifically, you need to create an affordable budget and commit to keeping it.

Also, instead of spending all that extra money that used to go to paying off debts, use some of it to build an emergency fund. That way, if an unexpected expense comes along, you can pay it without using credit cards again.

Not Qualifying for a Lower Rate

Is it possible to get bank consolidation loans at rates much lower than credit cards? Absolutely. Is it guaranteed? No. You need a good credit score (something above 670 is a good starting point) to take full advantage of this strategy. The better the score, the lower the rate. And vice versa.

So, if you can’t get a loan at a lower rate than you’re currently paying, debt consolidation probably isn’t for you.

Paying More in Interest Costs

Interest rates aren’t the only factor in how much you pay. The length of the loan plays a role, too. When you consolidate debt, the repayment timeline starts over. The longer the payback, the more total interest you pay. So, even though your monthly payment may decrease, the interest accrues over a longer period.

To avoid this, plan to pay more than the minimum required monthly payment. That will help you pay the debt consolidation loan down faster, saving money on interest.

Missed and Late Payments Will Set You Back

Debt consolidation works best if you make your monthly payments consistently and on time. If you’re late, you’ll pay a late fee. If your payment is kicked back for insufficient funds, you may face another fee. It’s hard to make progress paying off your debts if you’re getting fees tacked on. Also, late payments get reported to the credit bureaus after they’re 30 days past due, so that hurts your credit score.

Signing up for automatic payments is a good idea. Just make sure you can comfortably afford the monthly payments.

If you moved your debt to a balance transfer card instead of a personal loan, you need to pay it off within the zero-interest promotional period. Otherwise, the card’s interest rate kicks in, and it may be higher than what you paid before.

Up-Front Costs

Check carefully before taking out a debt consolidation loan. There may be fees that add to the cost:

• Loan origination fees
• Closing costs
• Annual fees
• Balance transfer fees

When Is Debt Consolidation a Good Idea?

Debt consolidation isn’t a one-size-fits-all proposition. Consolidation loans typically have 1- to 5-year terms. A shorter term allows you to pay it off more quickly, but your monthly payments will be higher. A longer term means your monthly payments will be more manageable, but you’ll pay more in interest over the life of the loan.

Your financial situation and your preferences for how you make payments play a part in whether consolidation is right for you. Here are situations that might make it a good strategy:

• It doesn’t have exorbitant fees: Origination fees for personal loans usually range from 1% to 8%. So, a $10,000 loan might have a fee as high as $800. Some balance transfer credit cards have a transfer fee from 3% to 5%. Even if the card has a low or 0% introductory offer, the transfer fee will add to your balance. If you don’t pay the card off before the introductory period expires, you’ll be paying interest on those fees as well as your existing debt.
• Your credit score is good: A score of 670 or higher gives you the best chance to get an interest rate lower than you’re currently paying.
• It’s important for you to have a single, fixed payment: If keeping track of multiple payments is difficult for you, debt consolidation simplifies things.
• You’re able to repay the loan: There’s no sense making a difficult financial situation worse. If you can’t fit the monthly loan repayment comfortably into your budget, this isn’t the right choice.

Options to Consolidate Debt

There are several ways to consolidate debt, each with advantages and disadvantages. Not all of them even require a new loan or balance transfer.

Debt Management Plans

Nonprofit credit counseling agencies such as Incharge.org offer debt management plans that help you pay off your debts while learning about good financial habits. The agency works with creditors to lower your interest rate to somewhere around 8%, sometimes lower. You make a monthly payment to the agency, which pays your creditors on a schedule. This may require you to close credit card accounts, but that can help you break the cycle of uncontrolled debt.

A big difference between debt consolidation vs. debt management is that debt management doesn’t require you to take out a loan, so your credit score isn’t a factor in being qualified.

Personal Loans

Personal loans are borrowed from brick-and-mortar or online lending institutions, and you pay back the money in fixed monthly payments. The loans, as mentioned above, are another name for a debt consolidation loan. They typically have fixed rates, which keeps your rate and monthly payments the same.

Personal loans are unsecured, which means they are not backed by collateral. The lender will assess your credit score, credit history, debt-to-income ratio, and free cash flow to decide whether you qualify. Loan origination or late payment fees may apply.

These are different than secured loans, which are backed by assets such as a home or car that the lender can repossess if you default. Secured loans typically have lower rates and can be paid back over longer periods of time, making monthly payments lower.

It’s possible to get a small personal loan from a wide variety of lenders, and it’s important to choose wisely. Banks, credit unions and online lenders offer personal loans. You should avoid those with high interest rates combined with a final balloon payment.

Balance Transfer Cards

Balance transfer cards are credit cards that offer a low – sometimes 0% introductory interest rate – on money you transfer from other credit cards. Those introductory rates last as long as 21 months, so if you can pay off the debt in that time, it’s a good deal. Any amount you haven’t paid off when the introductory rate expires is charged a higher interest rate.

So, to use such balance transfer cards effectively, be aggressive. Plan on paying well above the minimum due during the introductory rate period because every payment reduces the principal.

Home Equity Loans

If you’ve been a homeowner for very long, you may have built up enough equity (the difference between your home’s market value and your mortgage balance) to borrow against it using a home equity loan to consolidate debt.

The interest rate on such a loan should be much lower than what your credit cards are charging because you’re putting your home up as collateral.

Another advantage is that your equity may allow you to borrow a significant amount of money at fixed rates, and you don’t have to borrow from your mortgage lender, so shop around. Expect to pay closing costs, and if you fail to pay, your home can be foreclosed upon.

That is the biggest difference between a home equity loan vs. a debt consolidation loan. With the latter, there is no collateral, so your home is not at risk if you’re unable to repay the debt consolidation loan.

401K Loans

Even if you don’t own a home, you may have another resource that can provide the money to consolidate your debts: You can take out a 401K loan. Check with your company’s human resources department to see if your 401K plan allows this.

Because you’re borrowing your own money, no credit check is required. Interest rates are usually low, and the interest you pay will be to yourself rather than a lending institution.

However, payments are made with after-tax dollars, so you’ll get taxed again during retirement. If you default on the loan, the amount you borrowed will be taxed as income, and you’ll pay a 10% penalty, too. If you lose your job, you may be required to repay the entire loan in a short time.

How Can I Obtain a Debt Consolidation Loan?

Before looking for a lender, decide what your priorities are in a debt consolidation loan. Is it the lowest interest rate available? Is it an affordable monthly payment? Then, research what lenders are offering. Don’t limit yourself to traditional lending institutions. There are many companies that offer online debt consolidation.

• To see what’s available, try to prequalify with more than two lenders. They’ll want to know about your income, employment, and your debts.
• Compare the offers, which may have different repayment terms, interest rates and fees. The rates will vary based on your credit score and history.
• Apply for the loan that fits you best. You’ll have to provide more financial and personal interest, and the lender will do a credit check that may temporarily affect your credit score. Then, wait for a decision on whether you get approved.
• Once you’re approved and get your money, pay off your debt and begin making timely payments on the consolidation loan.

Approval isn’t guaranteed. The main reasons debt consolidation loans are denied include low credit scores, lack of credit history, low income and too much debt.

Get Help Deciding if Debt Consolidation is Right for You

Debt consolidation may be just what you need. Then again, there may be better alternatives. If you’re not sure, credit counseling can help you choose the best option.

Credit counseling is offered by nonprofit agencies and starts with a 30-minute interview with a certified counselor who gets your financial information to work up a plan that helps you achieve debt relief.

The service is free and can be done over the phone or online. And, if your counselor agrees that debt consolidation is right for you, you’ll move forward with confidence.