What Is Debt Consolidation?

Some of us juggle multiple debt payments each month, like credit card bills or a loan payment. But instead of keeping tabs on all the different balances, interest rates and due dates, it’s possible to combine multiple debts into one. This strategy is called debt consolidation. 

Debt consolidation can come with a few possible benefits: For one, you could get a lower interest rate than what you’re currently paying on your credit cards and other debts. Some borrowers may also score a lower monthly payment.

There are two common ways of consolidating debt – via a personal loan or a credit card balance transfer (we'll go over how they work later). 

Keep in mind, however, that debt consolidation is not always right for everyone. So before you jump into it, consider the pros and cons.

Pros of debt consolidation

You could streamline your monthly debt payments

If you have multiple bills each month, it can be hard to stay on top of them, especially if they all have different due dates and terms.

Debt consolidation could help simplify your finances by consolidating your bills into one recurring monthly payment (be sure to check with your specific lender about any exclusions).

You could save on interest

One common way of consolidating debt is with a personal loan. To do this, you’d apply for a personal loan and use the borrowed money to knock out your existing debts. Then you’d pay off your debt consolidation loan in monthly installments over a set term.

Personal loans are typically unsecured loans, meaning you don’t have to put up any personal items as collateral to qualify for one.

Personal loans can be helpful for debt consolidation because their rates may be lower than those on your credit cards or other debt if you have good credit. This means you could be saving on interest in the long term.

Another way to consolidate debt is by transferring your higher interest rate credit card debts to a new credit card with low or no interest. This is called a balance transfer.

By moving your existing credit card balances to a balance transfer credit card, you gain a buffer period to pay down your debt without having to pay interest – or very little interest. That could mean a lower monthly payment (depending on how much interest you were being charged previously). The key is you’ll want to pay down the transferred debt before that promotional period ends.

Good to know: With a balance transfer credit card, once that promotional period ends, your interest rate could go up dramatically.

You could get a fixed interest rate

If you have debt with variable interest rates, switching to a debt consolidation option with a fixed rate could get you more predictable monthly payments. In other words, you'll know exactly how much you owe each month.

Having a fixed rate on your debt could also be an attractive option if interest rates are on the rise.

Variable rates change depending on the market. Many credit card interest rates are based off the US prime rate, the commonly used short-term interest rate charged by banks. Credit card APRs are usually the prime rate plus an additional percentage – known as the spread – which is different for everyone.

So if you're subject to a variable rate, any rise in market interest rates could result in you paying more on your debt over time. However, with a fixed rate, your interest rate won't change for the life of the loan and you could end up with a lower monthly payment.

You could improve your credit score over time

In some cases, consolidating debt could improve your credit score.

Your credit utilization ratio is one of the major factors in determining your credit score. If you’re close to the credit limit on all or most of your credit cards, then your credit utilization ratio is high.

And if you have a high utilization ratio – in both your overall credit usage and the usage of each card individually – it could damage your credit score. But by paying off your debt with a new loan or balance transfer credit card, you’ll be knocking down your balances and therefore, lowering your credit utilization ratio, too.

Good to know: It may be tempting to close credit card accounts after paying them off. Just keep in mind that this could also affect your credit utilization ratio.

Cons of debt consolidation

Depending on your individual situation, consolidating debt could come with a few possible downsides.

Credit score check

While debt consolidation could boost your credit score over time, applying for a personal loan to do so could also cause your score to dip temporarily.

Here’s one reason why: Any time you apply for a loan, lenders make a hard inquiry on your credit. Too many inquiries (i.e. by putting in too many loan applications) could lower your credit score. To avoid this, do some research on your loan options first, and try to find one with the best terms before you apply.

Good to know: Some lenders do what’s called a “soft check” for pre-qualification which won’t affect your score.

Potential fees

In addition to paying interest, personal loans may come with other costs such as an origination fee.

When you’re shopping around for a debt consolidation loan, all other things being equal, be on the lookout for one that has few, if any, fees.

Taking on new debt

One thing that shouldn’t be overlooked is that a personal loan is still a form of debt – only now your existing debts are consolidated in a single spot.

If you currently struggle with carrying lots of debt, consolidating it could be part of a larger money management strategy that includes not only paying off balances but also making some changes to your budget or spending habits.

In other words, debt consolidation alone won’t change your debt habits if you haven’t addressed the reasons why you accumulated debt in the first place.

Is debt consolidation right for you?

Debt consolidation isn’t for everyone. If you’re someone with a lot of outstanding and overwhelming higher-interest debts, debt consolidation could be right for you.

If you’re someone who only has a few debts here and there, it could just take a well-crafted budget and money management strategy to tackle your bills.

Since everyone's financial situation is different, it's a good idea to consult a financial coach or advisor to see if debt consolidation makes sense for you. Either way, staying on top of your debt is key to finanical wellness. Remember, the quicker you're able to pay off your debt, the sooner you can free up your dollars to focus on other financial goals.