Between credit cards, student loans, and car loans, it is difficult to keep track of outstanding debt payments and balances. Consolidating these debts into one loan can simplify your finances, but the strategy will probably not solve the underlying financial challenges. For this reason, it is important to understand the pros and cons of debt consolidation before committing to a new loan.
To help you decide if debt consolidation is the right way to repay your loans, we will guide you through the pros and cons of this popular strategy.
What is Debt Consolidation?
Debt consolidation is the process of repaying multiple debts with a new loan or credit card to transfer the balance, often at a lower interest rate.
The debt consolidation process with a personal loan involves using the proceeds to repay each individual loan. Although some lenders offer specialist loans for debt consolidation, you can use most of the standard personal loans for debt consolidation. Similarly, some lenders repay loans on behalf of the borrower, while others pay the proceeds so the borrower can make the payments himself.
With a balance transfer credit card, eligible lenders usually have access to a 0% introductory APR for between six months and two years. The lender can specify the balances it wants to transfer when opening the card or transfer the balances after the provider issues the card.
Is Debt Consolidation a Good Idea?
Debt consolidation is generally a good idea for lenders with several high interest loans. However, it can only be practical if your credit score has improved since you applied for the original loans. If your credit score is not high enough to qualify for a lower interest rate, it may not make sense to consolidate your debts.
You may also think twice about debt consolidation if you have not addressed the underlying problems that led to your current debts, such as overspending. Paying more credit cards with a debt consolidation loan is not an excuse to raise your balances again and can lead to more significant financial problems overall.
Benefits of debt consolidation
Debt consolidation can bring a number of benefits, including faster, simpler payments and lower interest payments.
1. Simplify your finances
Combining multiple debts due into one loan reduces the number of payments and interest rates you need to worry about. Consolidation can also improve your credit by reducing the chance of making a late payment or missing a payment altogether. And, if you’re working towards a debt-free lifestyle, you’ll have a better idea of when all your debt will be paid off.
2. Can facilitate payment
If your debt consolidation loan accrues less interest than individual loans, consider making extra payments with the money you save each month. This can help you repay your debt early, saving even more on long-term interest. However, keep in mind that debt consolidation usually results in longer loan terms, so you will need to commit to paying off debt early to take advantage of this benefit.
3. It could lower the interest rate
If your credit score has improved since you took out other loans, you may be able to lower your overall interest rate by consolidating debt, even if you have mostly low interest loans. This way, you can save money over the life of the loan, especially if you do not consolidate with a long-term loan. To ensure you get the most competitive rate possible, search around and focus on lenders who offer a personal loan pre-qualification process.
Remember, however, that some types of debt have higher interest rates than others. For example, credit cards generally have higher rates than student loans. Consolidating multiple debts with one personal loan may result in a lower rate than some of your debts but higher than others. In this case, focus on what you are saving as a whole.
4. May reduce the monthly payment
When you consolidate debt, your overall monthly payment is likely to decrease because future payments are spread over a new and possibly extended loan term. While this can be beneficial from a monthly budget point of view, it means you may be paying more over the life of the loan, even at a lower interest rate.
5. It can improve your credit score
Applying for a new loan can lead to a temporary reduction in your credit score due to the demand for hard credit. However, debt consolidation can also improve your score in many ways. For example, repaying revolving lines of credit, such as credit cards, can lower the credit utilization rate reflected in your credit report. Ideally, your utilization rate should be below 30%, and responsible debt consolidation can help you do that. Making regular and timely payments and eventually repaying the loan can improve your score over time.
Disadvantages of debt consolidation
A debt consolidation loan or a balance transfer credit card may seem like a good way to make paying off your debt easier. That said, there are some risks and drawbacks to this strategy.
1. It may incur additional costs
Taking out a debt consolidation loan can incur additional costs like startup fees, balance transfer fees, closing costs and annual fees. When shopping for a lender, make sure you understand the true cost of each debt consolidation loan before signing on the dotted line.
2. It could increase the interest rate
If you qualify for a lower interest rate, debt consolidation can be a smart decision. However, if your credit score is not high enough to access the most competitive rates, you may be stuck with a higher rate than your current debt. This can mean paying origination fees, plus more interest over the life of the loan.
3. You can pay more interest over time
Even if your interest rate drops during the consolidation, you may still pay more interest over the life of the new loan. When consolidating the debt, the repayment schedule starts on the first day and can extend up to seven years. Your overall monthly payment may be less than you are used to, but the interest will build up over a longer period of time.
To get around this problem, budget for monthly payments in excess of the minimum loan payment. In this way you can reap the benefits of a debt consolidation loan while avoiding the extra interest.
4. Risks of Lost Payments
Failure to pay a debt consolidation loan or any loan can seriously damage your credit score; it may also be subject to additional costs. To avoid this, review your budget to make sure you can pay the new payment comfortably. Once your debts are consolidated, take advantage of an automatic payment or any other tool that can help you avoid missing payments. And, if you think you will miss an impending payment, let your lender know as soon as possible.
5. Does not solve the underlying financial problems
Debt consolidation can make payments easier but does not address the underlying financial practices that led to those debts in the first place. Indeed, many lenders who take advantage of debt consolidation find themselves in deeper debt because they have not held back their spending and continued to build up debt. So, if you’re considering debt consolidation to repay multiple expired credit cards, take time to develop healthy financial habits first.
6. Can encourage more expenditure
Similarly, paying off credit cards and other lines of credit with a debt consolidation loan can create the illusion that you have more money than you actually own. It is easy for lenders to fall into the trap of debt repayment, only to find that their balances have once again increased.
Set up a budget to cut spending and stay on top of payments so you don’t run into more debt than you started.
When to consolidate your debt
Debt consolidation can be a wise financial decision in the right circumstances, but it’s not always the best solution. Consider compounding your debt if you have:
- A large amount of debt. If you have a small amount of debt that you can pay off in a year or less, debt consolidation is probably not worth the fees and credit check associated with a new loan.
- Additional plans to improve your finances. While some debts are unavoidable, such as health care loans, others are the result of overspending or other financially risky behavior. Before consolidating debt, evaluate your practices and draw up a plan to keep track of your finances. Alternatively, you may have even more debt than you had before the consolidation.
- Credit score high enough to qualify for a lower interest rate. If your credit score has risen since you took out the other loans, you are more likely to be entitled to a lower debt consolidation rate than you currently have. This can help you save on interest over the life of the loan.
- Cash flow convenient to the monthly debt service. Only consolidate your debt if you have enough income to pay the new monthly payment. While the overall monthly payment may decrease, consolidation is not a good option if you cannot pay the monthly debt service at this time.