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The Pros and Cons of Debt Consolidation
By Ashley Donohoe MONEY RESEARCH COLLECTIVE
If you’re like the average American — with nearly six figures of debt — managing all your monthly payments can be challenging and strain your budget. Debt consolidation can provide debt relief by combining your payments into one and helping you get a lower interest rate. However, it has some downsides and requires good discipline for the best results.
Read on to learn more about the pros and cons of debt consolidation and the different options available.
What is debt consolidation?
Debt consolidation typically involves having a single credit line or loan that you use to pay off multiple debt balances. It works for unsecured debt, such as credit cards and personal loans, and may also be an option for certain asset-backed debts (secured), such as car loans. Once you consolidate the debt, you make one payment each month until you’ve finished paying the balance off.
Note that debt consolidation differs from bankruptcy in that it doesn’t wipe away your existing debt. Instead, it aims to simplify and speed up the repayment process. Ideally, it will reduce interest costs as well.
How debt consolidation works
There are a few different ways you can consolidate your debt. Depending on the option you choose, you can directly transfer the existing debt balances to the new credit line, or you can get a lump sum to pay off debt obligations.
When you apply for a loan or credit account, the lender will check for an appropriate credit score and debt-to-income ratio. They may also require documents backing up your income. Note that these qualifications can make it hard to get a new card or loan with bad credit, so you may want to consider building your credit before consolidating debt.
If you get approved, you’ll either provide your creditors’ information to the lender so you can transfer the balances or send the payoff funds directly to each creditor.
Credit counseling agencies also offer programs that help manage debt, but these differ from traditional debt consolidation. The agency’s plan won’t involve taking out new credit but rather developing a repayment strategy for existing accounts. Credit counseling agencies are different from debt settlement companies, which work out settlements for you but can be risky.
Common types of debt consolidation options
When looking into how to consolidate debt, common options include debt consolidation loans, balance transfer credit cards, debt management plans and credit counselors. Since each option works differently, you should understand the details to determine which suits your debt situation.
Debt consolidation loans
Debt consolidation loans take the form of unsecured personal loans and range from $1,000 to $100,000. Depending on your financial situation, you may choose a loan term ranging from one to seven years. While a longer term leads to smaller monthly payments, you will pay more interest. A short term means a higher monthly payment, but it provides the advantages of getting rid of the debt sooner and paying less interest.
After you are approved and get a debt consolidation loan, you may get the lump sum deposited into your bank account. This provides flexibility since you can take the cash and pay off creditors individually. The payoff process can also go quickly since debt consolidation lenders usually provide your funds within a week. The other method involves the lender paying your creditors directly.
If this option sounds right for your situation, take some time to shop around for the best debt consolidation loans. This will help you get the best rates and find payment options that fit your budget.
Balance transfer credit card
Some credit card companies allow borrowers to transfer balances from other credit cards and certain loans to a balance transfer credit card account.
Once you submit the balance transfer request, it can take a few weeks for the credit card company to pay off the amount and add it to your current balance. This option requires continuing to make any payments due in the meantime. The card company may charge a balance transfer fee plus interest on the transferred debt.
An advantage of this option is that you can move your debts to a balance transfer card with 0% APR as an introductory offer. You could also take advantage of other benefits from the balance transfer card, such as rewards points or 0% APR offers on purchases.
However, this option is best if you only have credit card debt and is typically only available if you have a credit score of around 690 or higher.
Debt management plans
If your credit disqualifies you from taking out a consolidation loan or credit card, a debt management plan serves as an alternative for a single manageable monthly payment. A credit counseling agency would work with you to collect information about your credit accounts and come up with a plan to pay off your debts within three to five years. This option only works for unsecured debts and usually requires closing the associated accounts.
Once you apply for the debt management plan, the agency takes over your debt payments, and you make one monthly payment that the agency disburses to creditors on your behalf. It may also contact your creditors to seek ways to reduce fees or interest rates and lower your monthly payment amount. The agency charges you ongoing fees for its services and requires on-time debt payments to avoid losing the benefits you receive.
This option differs from a debt settlement program that comes with high fees but helps you only pay creditors a partial amount of what you owe. A debt settlement program is also likely to hurt your credit score.
Credit counselors
A credit counselor is a good resource if you’d like advice on handling your debt and managing your money. After looking at your current debts and income, this type of professional can help you explore debt consolidation options that fit your situation and explain the effects on your credit score and budget. Alternatively, the counselor can assist you with a debt management plan.
Using a credit counselor gives you access to other services as well. For example, the counselor can help you access your credit report. That way, you can spot issues and learn how to remove collections and remove charge-offs from your report. Credit counselors also help set up a personal budget to reduce the risk of taking on too much debt.
The pros of debt consolidation
Debt consolidation programs do a lot to help you manage your finances easier, pay off burdensome debts sooner and save money over time. They also provide overall benefits to your credit score that can make achieving future financial goals easier. Here are all the advantages of debt consolidation.
One single payment
One of the main advantages of debt consolidation is the simplicity of just one payment each month. You’ll find it easier to remember to pay one creditor versus several, so the chance of missing a due date decreases. Avoiding late payments cuts down on fees and prevents damage to your credit score. In addition, your budget becomes easier to plan and track with just one debt payment that may be lower than what you currently pay.
Affordable interest rates
Especially if you currently have high-interest debt, choosing a debt consolidation option could lower your rate. The savings particularly add up if you need a long time to pay off your debt. Generally, loans for debt consolidation have lower interest rates than balance transfer credit cards, but you can shop around for competitive rates with either option. In addition, your credit history affects your rates, so you’ll pay less if you have a good credit score. Keep in mind, though, that if you have a low credit score, you may get a higher interest rate than your current one.
In some cases, you might avoid interest entirely. For example, you could get a new credit card with 0% interest on a balance transfer. As long as you pay off your transferred debts before the promotional period runs out, you’ll only incur the one-time balance transfer fee.
Faster debt repayment
Depending on your debt consolidation method, you may cut months or even years off your debt payoff time. Putting everything in one payment with a lower interest rate helps you pay down the principal more quickly since less interest adds up. You’ll just need to avoid going off track by taking out new debts or falling behind on current obligations.
It’s a step toward building better credit
If you want to improve your credit score, consolidating debts and practicing good financial habits will help over time. When you first consolidate debt, your credit score may fall slightly. This is due to adding another line of credit, having a hard credit inquiry performed and lowering your average credit account age, all of which influence your credit score. But as time passes and you make timely monthly debt payments, your score will go up.
Getting the best results requires not taking on more credit and avoiding delinquencies. You’ll likely see small increases at different intervals rather than a large jump during your consolidation period. A credit score simulator can estimate the changes you could see.
The cons of debt consolidation
Debt consolidation disadvantages involve some extra costs and risks that can further harm your finances and make it harder to recover.
One late payment could be a major setback
Missing a debt consolidation loan or credit card payment can result in extra charges and hurt your credit. Lenders usually charge a late fee for either option. Some credit cards feature penalty interest rates that can even void a 0% financing offer. These charges can make it harder to pay down your debt.
Additionally, after 30 days of missed payments on a credit card, your credit score can drop a significant amount of points. The longer you don’t pay, the higher the risk that your account goes to collections and you face long-term financial damage.
It often involves extra costs
Even if debt consolidation saves you on interest, you’ll likely pay a fee, especially when you get started. A debt consolidation loan usually has an origination fee that is calculated based on a percentage of the loan amount. You may also incur a prepayment penalty if you pay it off early. A balance transfer fee for a credit card can cost up to 5% of the amount, while debt management plans usually have both setup and monthly participation fees. Compare your options before choosing a lender.
The root problem still exists
Debt consolidation helps you tackle your current debt situation, but it doesn’t stop you from taking on more credit card debt and loans and ending up back in the same place. It also doesn’t make your debt disappear.
While you can get into debt for various reasons, it may come down to not properly budgeting your income and borrowing too much money due to overspending. If you don’t make changes, debt will become an ongoing issue. Working with a credit counselor alongside debt consolidation can help.
Is debt consolidation the answer to your financial woes?
As long as you change your financial habits to prevent future debt issues, debt consolidation can help you out of your debt trap if you qualify. However, it may not be the best option for everyone, especially if your new loan has a higher interest rate than you currently have. Be sure to review the pros and cons of debt consolidation options carefully and understand the terms and fees involved. In addition, make timely payments to avoid penalties such as fees, higher interest rates and negative credit score effects.