Keeping track of payments and balances on outstanding obligations can be challenging with credit cards, vehicle loans, and student loans. While combining many loans into a single loan could simplify your budget, it’s unlikely to address underlying financial difficulties. Because of this, it’s critical to weigh the benefits and drawbacks of debt consolidation before taking out a new loan.
We’ll go over the benefits and drawbacks of this well-liked tactic to help you choose if debt consolidation is the best approach for you to pay off your loans.
What Is Debt Consolidation?
The process of paying off several loans with a new loan or balance transfer credit card—often at a cheaper interest rate—is known as debt consolidation.
Using the money to settle each individual loan is a step in the process of using a personal loan for debt consolidation. You can use the majority of regular personal loans for debt consolidation, even though some lenders provide specialized debt consolidation loans. Similarly, certain lenders settle debts on behalf of borrowers, while others release funds so that borrowers can handle repayments on their own.
Qualified borrowers can usually take advantage of a balance transfer credit card’s 0% introductory APR for a duration of six months to two years. When opening the card, the borrower can choose the sums they wish to transfer, or they can do so after the card issuer issues the card.
How Does Debt Consolidation Work?
Consolidating your debt into a single loan is how debt consolidation operates. Your credit score may rise, your debt may be paid off sooner, your monthly payment may be reduced, or your financial situation may get easier depending on the terms of your new loan.
Consolidating debt involves these three steps:
- Get a fresh loan.
- Utilize the new loan to settle your previous bills.
- Repay the new loan.
As an illustration, suppose you owe $20,000 on three separate credit cards, each with an interest rate higher than 20%. You may pay off that debt more quickly and avoid paying as much interest if you take out a $20,000 personal loan with a five-year term and a 10% interest rate.
Is Debt Consolidation a Good Idea?
Generally speaking, debt consolidation makes sense for consumers who have multiple high-interest loans. That might only be possible, though, if your credit has improved since you applied for the initial loans. It could not be wise to combine your loans if your credit score isn’t good enough to get you a cheaper interest rate.
Also, you might want to reconsider debt consolidation if you haven’t dealt with the underlying issues—such as overspending—that resulted in your current obligations. Using a debt consolidation loan to pay off several credit cards is not an excuse to accumulate more debt; in fact, it may result in more serious problems down the road.
Pros of Debt Consolidation
Lower interest rates and a quicker, more efficient payback are only two benefits of debt consolidation.
Streamlines Finances
You can lower your interest rates and amount of payments by consolidating several existing loans into a single loan. By lowering the likelihood of skipping or making a late payment, consolidation can also help you with your credit. In addition, you’ll know more precisely when your debt will be settled if you’re aiming for a debt-free way of living.
May Expedite Payoff
Consider using the additional money you save each month to make extra payments on your debt consolidation loan, if the interest rate is lower than it would be on the individual loans. This can assist you in paying off the debt sooner, which will ultimately result in even greater interest savings. However, keep in mind that debt consolidation usually results in longer loan terms, so in order to benefit from this, you must make it a point to pay off your debt as soon as possible.
Could Lower Interest Rate
Even if you have largely low-interest loans, you might be able to lower your total interest rate by consolidating debt if your credit score has increased since you applied for other loans. If you don’t consolidate with a long loan term, doing this can save you money over the course of the loan. Make sure you compare rates from several lenders and concentrate on those who provide a personal loan pre-qualification process in order to secure the best deal.
But keep in mind that different debt kinds have different interest rates. For instance, the rates on credit cards are typically higher than those on student loans. Your rate may be higher on some of your loans but cheaper on others if you combine several obligations into a single personal loan. In this instance, concentrate on the total amount you’re saving.
Monthly Payment May Be Reduced
Your total monthly payment will probably go down when you consolidate your debt because subsequent payments will be spaced out over a longer loan term. Even with a reduced interest rate, this could mean that you pay more overall for the loan, even if it is beneficial from the perspective of monthly budgeting. Your monthly payment estimate can be obtained with the use of a loan consolidation calculator.
Can Improve Credit Score
Your credit score can temporarily drop if you apply for a new loan because of the harsh credit investigation. But there are also several ways that debt reduction might raise your credit score. Paying off credit cards and other revolving lines of credit, for instance, can lower the credit usage rate shown on your credit report. Your utilization rate should ideally be less than 30%, and you can achieve that by carefully combining your debt. Over time, you can also raise your credit score by paying off the loan and maintaining a consistent, on-time payment schedule.
Cons of Debt Consolidation
One potential solution to expedite debt payoff could be to consider a balance transfer credit card or debt consolidation loan. Having said that, there are several hazards and drawbacks to using this tactic.
May Come With Added Costs
Additional fees such as origination, closing, yearly, and balance transfer fees may be incurred while taking out a debt consolidation loan. Before signing on the dotted line, make sure you are aware of the whole cost of any debt consolidation loan while you are looking for a lender.
Could Raise Your Interest Rate
Consolidating your debts can be a wise move if you are eligible for a reduced interest rate. You can be forced to pay a rate that is greater than what your present loans are now paying, though, if your credit score isn’t good enough to get the best deals. This could entail paying origination costs in addition to higher interest throughout the course of the loan.
Over Time, You Might Pay More in Interest
You may still end up paying more in interest over the course of the new loan, even if your interest rate drops when you consolidate. The payback period for debt consolidation begins on the first day of the repayment plan and can last up to seven years. Although the total amount you pay each month could be less than you’re used to, interest will accrue over a longer time frame.
Set aside money each month for payments over the minimum required by the loan to avoid this problem. In this manner, you can profit from a debt consolidation loan without having to pay extra interest.
You Risk Missing Payments
Not only may missing payments on any loan, including a debt consolidation loan, result in additional costs, but they can also seriously harm your credit score. Examine your spending plan to make sure you can afford the additional payment in order to prevent this. Make use of autopay and any other methods available to you to help prevent missing payments once you have consolidated your obligations. Additionally, let your lender know as soon as possible if you anticipate missing a payment.
Doesn’t Solve Underlying Financial Issues
While debt consolidation can make payments easier, it doesn’t change the underlying financial behaviors that caused the debts in the first place. In actuality, a lot of borrowers who benefit from debt consolidation end up with more debt since they didn’t cut back on their spending and let their debt accumulate. Therefore, develop sound financial habits sometime before considering debt consolidation as a way to pay off many credit cards that are fully charged.
May Encourage Increased Spending
In a similar vein, using a debt consolidation loan to pay off credit cards and other lines of credit may give the impression that you have more money than you actually do. Borrowers frequently find themselves in the trap of paying off debt only to discover that their sums have increased once more.
Create a budget to control your spending and ensure that you pay your bills on time to avoid taking on additional debt.
When Should I Consolidate My Debt?
In certain situations, consolidating your debt can be a prudent financial move, but it’s not always the best option. Think about combining your debt if you own:
- A large amount of debt: Probably not worth the costs and credit checks that come with a new loan is debt consolidation if you have a small amount of debt that you can pay off in a year or less.
- Additional plans to improve your finances: Certain debts, like medical loans, are unavoidable, while other debts are the consequence of reckless spending or other risky financial practices. Prior to consolidating your debt, assess your spending patterns and devise a strategy to gain financial stability. If not, you can accumulate even more debt than you had prior to debt consolidation.
- A credit score high enough to qualify for a lower interest rate: You have a better chance of being approved for a debt consolidation rate that is less expensive than your present rates if your credit score has improved since you took out your previous loans. Over the course of the loan, this can help you save money on interest.
- Cash flow that comfortably covers monthly debt service: Consolidate your debt only if you can afford the additional monthly payment. Consolidation is not a suitable option if you are currently unable to make your monthly debt service, even though your total monthly payment may decrease.
How to Apply for a Loan to Debt Consolidate
It can be easy to qualify for a personal loan for debt consolidation, particularly if you have a stable credit history and a high salary. This is how you do it:
- Check your credit: Verify the credit reports and scores provided by each of the three main credit agencies. Correct any mistakes that can have a negative impact on your credit score, and utilize it to determine the loans you are eligible for. There are lenders who provide debt consolidation loans for bad credit, even if your credit score is low.
- Gather your loan application documents: This can expedite the loan application process because the majority of lenders demand the same paperwork. Among other documents, you’ll need your most recent bank statements, tax returns, W-2s, and pay stubs.
- Get a payoff estimate from your current lenders: A current debt payoff statement that shows your outstanding balance and any interest that has accumulated since your last payment is usually required for any debt that you plan to consolidate.
- Shop around for rates: Search for the most affordable prices, both online and offline. If you can, prequalify to find out what rates you might be eligible for without affecting your credit score.
- Submit your application: Select the most suitable choice and submit your loan application. In the event that the lender requests more information, reply as soon as possible.
- Receive the loan funds: Your lender will get in touch with you regarding the loan money disbursement if it is approved. While some lenders ask you to pay off your previous creditors directly, others handle it for you.
Frequently Asked Questions About “Debt Consolidation”
What is the best method for debt consolidation?
The best method depends on your financial situation. Balance transfer credit cards and personal loans are popular choices, but you should compare interest rates and terms to find the best fit.
How long does debt consolidation stay on your credit report?
Debt consolidation itself doesn’t appear on your credit report, but the loans or credit cards used for consolidation will. The impact on your credit score depends on your payment history and credit utilization.
Can debt consolidation stop collection calls?
Yes, if you consolidate your debt and pay off the collection accounts, the calls should stop. However, it’s important to communicate with your creditors during the process.
Is debt consolidation a good idea for everyone?
No, debt consolidation is not suitable for everyone. It’s best for those with high-interest debt and a steady income. It’s important to assess your financial situation and consider other options if necessary.
What are the risks of debt consolidation?
Risks include the potential for higher costs if you don’t secure a lower interest rate, the risk of losing assets with secured loans, and the possibility of accumulating more debt if you don’t change your spending habits.
