What Is Debt Consolidation, and Should I Consolidate?

03.03.2023
1030
19 min.

If you have an amount of debt and want to change how you repay it, pay off your bills with different interest rates and a debt repayment plan, or consolidate credit card debt, a debt consolidation loan might be a helpful option.

What Is Debt Consolidation, and Should I Consolidate?

Learn what debt consolidation is and whether it is beneficial to you by reading up on the subject.

What is Debt Consolidation?

Debt consolidation is when you pay off several debts at once with a single new loan, most of the time at a lower interest rate. Debt consolidation is often used for paying off home equity loans, credit card bills, balance transfer credit cards, or auto loans. When one takes out a personal loan to consolidate debt, one must first use the money from the loan to settle all of the existing loans. The consolidation loan is available only for unsecured debts.

Even though some creditors offer specialized loans for debt consolidation, you can use most personal loans, including regular loans, to pay off your debt. Similarly, some personal loan lenders offer debt consolidation loans and pay off loans on behalf of the borrower, while others release the proceeds so that the borrower can make the payments on their own.

Borrowers who are eligible will normally be granted access to an introductory Annual Percentage Rate (APR) of 0% for a period ranging from six months to two years when they transfer a balance from one credit card to another using the same credit card. The borrower has the option of selecting which sums they wish to transfer when they open the card, or they can transfer balances after the supplier has issued the card.

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Pros of Debt Consolidation

Consolidating your debts is often the most effective strategy for paying back your loans. Here are the most well-known advantages that could be of use to you.

  • Pay off Your Debt Quicker. If you have a lot of credit card debt, a debt consolidation loan may help you get on track to pay it off sooner. As opposed to multiple credit cards, which do not have a definitive beginning or conclusion to the repayment process, consolidation loans offer regular monthly payments and a defined starting and end to the loan. If you can reduce your debt repayment period, you can reduce your interest payments. And the sooner you have your debt paid off, the sooner you can start saving for things like an emergency or retirement.
  • Money is Easier to Manage. When you combine your debt, you reduce the number of payments you have to keep track of each month and make simply one. In addition, the monthly cost is consistent, so you may plan accordingly. Debt consolidation loan reduces your financial obligations from multiple monthly payments to just one by using the loan proceeds to settle multiple debts. Having fewer payment dates might help keep budgets on track.
  • Reduced Interest Rates. In January of 2023, the median interest rate for credit cards was 19.6%. In the meantime, the standard rate for a personal loan is just over 10.6%. Debt consolidation loans have lower interest rates than credit cards, though this does rely on factors including your credit score, loan size, and loan period. Consumers with good to excellent credit can get far more favorable interest rates on debt consolidation loans than they would receive on a regular credit card.
  • A Scheduled Repayment Plan. A personal loan may help you get out of debt by setting you up with a fixed monthly payment and a clear repayment schedule. With high-interest credit cards, it could take years to pay off the balance if you only make the minimum payment each month. Do not worry about your monthly debt payments changing due to a change in the interest rate or principal balance due to a fixed repayment schedule.
  • Improve Your Credit. A debt consolidation loan may have a short-term negative impact on your credit score due to the hard credit query required to apply for the loan. However, in the long run, they tend to have a positive impact. That is because keeping up with regular payments will not be as much of a hassle. If you have any outstanding credit card debt and you continue to use those cards, you will improve your credit utilization ratio and strengthen your credit history. With 35% of your credit score depending on your payment history, it only makes sense that keeping up with even one monthly payment would have a substantial impact. If you close your credit card accounts after paying them off, it could have a negative effect on these two categories. Maintaining them will boost your credit rating.

Cons of Debt Consolidation

Consolidating debt is not without its drawbacks, though, so think those out before applying for a loan.

  • Debt consolidation will not fix financial difficulties. Consolidating debt is not a guarantee that you will never incur additional debt in the future. If you have a history of living beyond your means, there is a chance that you will do so again after you feel like you have gotten out from under your financial obligations. Create a spending plan for yourself that is grounded in reality, and then commit to sticking to it. You should also begin establishing an emergency fund that may be used to pay for financial surprises so that you do not have to rely on credit cards. This will free you from having to rely on credit cards. Consolidation may be able to assist you in paying off your debt, but it will not change the behaviors with your money that got you into debt in the first place, such as spending more than you can afford or failing to put money aside for unexpected expenses. By instituting practices that are more responsible with money, you can avoid incurring further debt and keep it from growing.
  • There may be initial expenses. There are costs associated with some debt consolidation loans. These could include things like annual fees, fees for transferring balances, closing costs, and fees for the loan's origination. Before taking out a loan to consolidate your debts, ask about fees that may be incurred, including those for making late payments or paying off your loan early. These fees could be hundreds of dollars or even thousands of dollars, depending on the lender that you choose. Although it is possible that paying these costs will still be worthwhile, you should take them into consideration when determining whether or not consolidating your debt is a good idea for you. When considering debt consolidation loans, it is important to do your homework and read the fine print thoroughly in order to ensure that you are aware of all of their associated charges.
  • Your interest rate may be higher. It is possible that the interest rate on your debt consolidation loan will be higher than the average rate you pay on your other obligations. This may take place for a variety of reasons, including the status of your credit score at the time. If it is on the lower end, the danger of default is greater, and as a result, you will probably have to pay a higher interest rate for credit. The length of the loan and the total amount borrowed are both factors that can affect the amount of interest you pay. If you extend the length of your loan, you might be able to reduce your monthly payment amount. You might wind up paying more in interest overall. There is no guarantee that consolidating your debt would lower the interest rate you are charged on that loan, particularly if your credit score is not excellent.
  • Falling into more debt in case of late payments. If you are late with one of your loan payments on a monthly basis, you will most likely be required to pay a late payment fee. In addition, some debt consolidation lenders will charge you a returned payment fee in the event that a payment is rejected owing to insufficient loan funds in your account. These fees have the potential to significantly drive up the overall cost of your borrowing. Your credit score may take a significant hit if your lender follows the industry standard of reporting a late payment to the credit bureaus after it has been 30 days after the payment was due. Because of this, it may become more difficult for you to qualify for future loans and to obtain the lowest possible interest rate. Before you take out a loan to consolidate debt, you need first to determine whether or not you will be able to make the monthly payments. If you are late with a payment, you may incur late fees as well as see a drop in your credit score.

When You Should Consolidate a Debt

When certain conditions are met, choosing to consolidate one's debts into a single payment can prove to be an astute financial move. However, this strategy is not always the best available option. Take into consideration the option of combining your debt if you currently have the following:

  • A significant quantity of monetary obligations. If you only have a modest amount of debt that you know you can pay off in a period of twelve months or less, it is highly unlikely that the costs and credit checks that are associated with obtaining a new loan will be worthwhile for you to consolidate your debt.
  • Extra measures to help you better your financial situation. Some debts, such as those for medical expenses, are unavoidable. Nevertheless, some debts are the direct result of irresponsible spending or other actions that are harmful to one's financial situation. Before you decide to consolidate your debt, it is important to take stock of your behaviors and formulate a strategy to get your finances under control first. If you don't pay attention to this warning sign, you could end yourself with an even larger amount of debt after consolidating than you had before.
  • A good enough credit rating to get a better loan interest rate. If your credit score has improved since you got the other loans, you have a better chance of being approved for a consolidation loan at a rate that is lower than the rates you are currently paying on those loans. Because of this, you may be able to reduce the total amount of interest you pay throughout the course of the loan.
  • Sufficient monthly income to pay all bills in full without going into debt. You should only consider consolidating your debt if you are confident that you will be able to afford the increased monthly payment after doing so. If you are currently unable to pay your monthly debt service, consolidating your debts may result in a lower total payment, but this does not make it a smart alternative for you if you want to get rid of debt. Consolidation shines a bright light at the end of the tunnel for a great number of people. If you take out a loan with a loan term of three years, you are aware that the loan will be paid off in that amount of time, provided that your payments are made on time and you are able to keep your spending under control. On the other hand, if you only make the minimum payment on your credit card, it might be months or even years before the balance is paid off, during which time you will have accumulated more interest than the original amount.

How to Consolidate Debts

Take the following steps to obtain a debt consolidation loan if you think that a new loan to consolidate your existing debts is the best option:

  1. Check your credit score and credit reports. Checking your credit history will help you evaluate whether you match the minimal credit score criterion set by the lender. In addition to this, you should visit AnnualCreditReport to obtain a copy of your credit report and examine it for any errors. Dispute errors as soon as possible with the relevant credit bureaus. There is a possibility that a response from a bureau could take up to one month.
  2. Find out the loan amounts. You may determine how much money you need to borrow by first adding up all of the debts that you wish to combine into one lower monthly payment. Consider also the possibility of incurring origination fees, which are deducted from the total amount of the loan.
  3. Research different lenders. Examine the websites of a variety of online lenders to familiarize yourself with the eligibility conditions, loan terms, and costs that are associated with their offerings. Check with your neighborhood financial institutions, such as banks or credit unions, to see whether they provide consolidation loans for existing debt.
  4. Get pre-qualified. During the prequalification process, each lender will provide you with an estimate of what the terms and interest rate of your potential loan would be. In most cases, the lender will do only a light credit check as part of the prequalification process. This implies that your credit score will not be affected in any way.
  5. Apply for debt consolidation. You can either submit an official application for your debt consolidation loan through the internet, in person or over the phone, depending on the financial institution that you decide to work with. You will be required to provide personal information such as your name, date of birth, and income at some point during the process.
  6. Acquire the finances. In the event that your application is accepted, the money from your loan could be deposited into your account as quickly as the next working day. Make use of the money to settle your outstanding debts with your present creditors. After that, you should make payments on the loan to consolidate your debt according to the terms you agreed to. This will prevent any damage to your credit score.

FAQ

Is it a good idea to consolidate your debts?

Consolidating your obligations into one manageable loan will help you save money on interest and payments. You can save money and time by consolidating your debts on a home equity loan, balance transfer credit card, and other unsecured loan options. Use a debt consolidation calculator to see how much you can save.

Does consolidating your debt affect your credit score?

Consolidating debts can temporarily lower credit scores. When you apply for a consolidation loan, the lending institution will evaluate your credit. A rigorous inquiry will be made into your credit, which might drop it by 10 points. Credit reports are only affected by hard queries for a single year.

What do you need to qualify for debt consolidation?

When it comes to debt consolidation loans, each lender has their own set of criteria for approval. If you have an excellent or good credit score (at least 670) and a stable income, you have a better chance of being approved.

How long does a debt consolidation stay on your credit?

More than 100 points might be wiped off your credit score due to debt settlement, and the negative mark will remain for seven years. Your credit usage ratio will likely increase if your creditors shut accounts as part of the settlement procedure.

Is debt consolidation good for getting out of debt?

Consolidating your debt may help you save money and time if you pay off many loans or credit card balances at once. However, a consolidation loan does not eliminate debt and can actually increase your total interest paid. What you need to know about the various debt consolidation loan options is provided here.
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