Debt consolidation, as its name implies, is the process of combining multiple debts into one.
But how is this useful? Well, there could be a few possible benefits. Consolidating your debt could result in having more favorable terms than what you are currently paying on your credit cards and other debts. There’s also the appeal of simplicity. Instead of having numerous payments, you could have just one recurring monthly payment.
That being said, it’s not always right for everyone. So, before you jump right into consolidating your debt, consider these pros and cons.
A common way of consolidating debt is with a personal loan. To do this, apply for a personal loan to pay off your old debts. Personal loans can be an advantageous instrument for debt consolidation because the rates may be lower than those on your credit cards or other debt. This could be beneficial because if your rates with debt consolidation are lower, you could be saving on interest in the long term.
Another way to consolidate debt is by transferring your debts to a new credit card with low or no interest. This is called a balance transfer. Balance transfer credit cards offer periods of low or no interest on transferred balances for a limited time. With a balance transfer 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 is, if you can in fact pay down the transferred debt before that promotional period ends.
If you have debt with variable interest rates, switching to a fixed rate debt consolidation option could make for predictable monthly payments, which could be an attractive option if interest rates are on the rise. With a personal loan, your rate could be fixed, so you’ll always know exactly how much you owe each month. Another option is going with a balance transfer credit card, which could provide a temporary fixed interest solution. But once that promotional period ends, your interest rate will go up dramatically and likely will become variable again.
Variable rates change depending on the market. Many credit card interest rates are based off the U.S. prime rate, the commonly used short-term interest rate charged by banks. Credit card APRs are usually the prime rate plus an additional added-on percentage–known as the spread–which is different for everyone. So if the prime rate is 4.75 percent and your APR is 14.75 percent, the bank is charging U.S. prime plus 10 percent.
What this all means is any rise in market interest rates could leave you vulnerable to paying more on your debt over time. With a personal loan, though, your rates could be fixed–meaning your rate won't change for the life of the loan.
Sometimes it is hard to stay on top of payments. You could have everything from rent to phone bills that you have to pay each month. According to a 2017 study by credit reporting agency Experian, the average American has 3.1 credit cards. What’s worse, if you have multiple credit cards and other debts, they could all have different due dates, which is a lot to keep up with. Debt consolidation with a personal loan helps remove part of that problem.
By taking all your debts–including credit cards, medical expenses, or bills–and lumping them into a single debt, you may only have to make a single monthly payment. It’s that simple. And simple can be a really good thing.
Consolidating debt could improve your credit score in some cases. If you are close to the credit limit on all or most of your credit cards, then your credit utilization ratio is high. Your credit utilization ratio is one of the major factors in determining your credit score. 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, you will be lowering your credit utilization ratio. Personal loans are treated differently from credit card debt in the credit scoring model. It is sometimes tempting to close credit card accounts after paying them off. Just keep in mind that this could also affect your credit utilization ratio because it would be lowering the amount of credit you have.
There are also possible downsides to consolidating debt, which may depend on your individual situation. Here are some of the reasons why:
Consolidating could have positive and negative effects on your credit score. It could provide a boost in some scenarios, but consolidating could also cause a dip in your score in other cases.
For example, any time you apply for a loan, lenders make a hard inquiry on your credit. Too many inquiries could lower your credit score. To avoid this, do some research first on your loan options. Try to find one with the best terms before you apply. Some lenders do what’s called a “soft check” for pre-qualification that doesn’t affect your score.
Consolidating with a personal loan could incur some fees. Besides paying interest, there may be other costs such as a sign-up fee.
If you decide to shop around for a personal loan for debt consolidation, all other things being equal, be on the lookout for one that has few, if any, fees.
One thing that shouldn’t be overlooked is that a personal loan is still a form of debt. While it could help to pay off other forms of debt, you are still holding on to debt, only now it’s in a single spot.
If you currently struggle with carrying lots of debt, consolidating it could be part of a larger debt management strategy that includes not only paying off debt but also making some changes to budget or spending habits. Debt consolidation alone won’t change your debt habits if you haven’t addressed the reasons why you accumulated debt in the first place.
As previously stated, debt consolidation isn’t for everyone.
Maybe you’re someone who really only has a few debts here and there, and with a well-crafted budget you can tackle your debts. But if you’re someone with numerous outstanding and overwhelming higher-interest debts, debt consolidation could be right for you.
If you decide debt consolidation is right for you, that’s great! And even if not, it’s a good thing that you’re trying to figure out your options for getting on top of your debt. No one has to stay in debt, and getting out of it could be the most freeing feeling in the world.