If you’re trying to figure out how to get out of debt, debt consolidation can be one way to at least get all your obligations in one place, so they are easier to wrangle. Once you’ve done that, you have a better chance of paying off your debt faster — and potentially saving money.
So, is debt consolidation a good idea for everyone? As with everything else related to finance, whether it’s the right move for you depends on your situation. Here’s a look at what two experts say about debt consolidation.
- How debt consolidation works
- Pros and cons of debt consolidation
- What does debt consolidation cost?
- What type of debt should you consolidate?
- Does debt consolidation affect your credit score?
- Is debt consolidation a good idea if you have bad credit?
- Is debt consolidation safe?
- Is debt consolidation a good idea for you?
- Bottom line
How debt consolidation works
Debt consolidation works by getting your debt together in one place. When you have multiple payments to worry about and several different interest rates, your money isn’t working efficiently on your behalf. Putting all the debt in one place streamlines your monthly bills and often results in one interest rate that’s potentially lower than the average of your other rates.
In many cases, says Beverly Harzog, a consumer finance analyst with U.S. News & World Report, debt consolidation strategies fall into two broad categories:
1. Loans: This is using a bigger loan to pay off smaller debts. There are several debt consolidation options. You might be able to use a credit card balance transfer, get a personal loan, home equity loan, or 401(k) loan. Once you pay off your smaller loans, you only have one loan payment.
2. Debt management company: Rather than getting a loan, you use a third-party company to help you manage your debt. They work out a plan with you, and you send one payment to the debt management company, and they make sure your creditors are paid on time. They might even negotiate lower interest rates on your behalf.
Main goals of consolidating loans
For the most part, the goals are to:
- Get your debt in one place
- Reduce the payments you make
- Pay off your debt within a set period of time
Depending on your situation, this can be accomplished on your own or with the help of top debt consolidation providers.
Pros and cons of debt consolidation
As you try to decide if debt consolidation is a good idea, it's important to understand the advantages and disadvantages. The key is to know yourself going in and protect against the downsides while taking advantage of the possibilities.
- Only one payment each month
- If you get a lower interest rate, more of each payment goes toward reducing debt, saving you money
- You might be able to become debt-free faster
- It's easier to have a pay off date, providing you with peace of mind
- Missing or late payments can damage your credit further
- Without a plan to stay out of debt, debt consolidation can make things worse
- You might have to pay fees associated with consolidation strategies
What does debt consolidation cost?
Whenever you get involved with debt consolidation, says Leslie Tayne, a financial debt resolution attorney, you’re probably going to run into costs.
With a personal debt consolidation loan, there might be origination fees or late fees. Credit card balance transfer fees can be high. When you hire a debt management company, there’s usually a fee involved.
However, even with the costs, debt consolidation can be a good idea — especially if you have high interest rates on your debt or are struggling to make your minimum payments. If a new loan offers a lower rate and you can put more of your monthly payment toward getting rid of principal, you can save hundreds, or even thousands, of dollars on your debt.
What type of debt should you consolidate?
There are specific types of debt that should be left alone and not thrown into debt consolidation. As a general rule, avoid consolidating any debt that will experience an increase in interest rate simply because you consolidate it. With a higher interest rate, you'll end up paying more money on the same amount of debt than you would've if you kept it separate at a lower interest rate.
Grab your calculator and do the math. If it turns out that you'll pay more, consider other options or leave out some debts when you consolidate. Be sure to check your loan terms and the fine print of the repayment terms to see if you'll face prepayment penalties if you pay before your due dates.
Remember, just because you can consolidate the debt doesn't mean you have to or should — choosing the option with the lowest interest is likely your best bet. “Debt consolidation can be the right move if you’ve calculated that it will for sure cost less than your current debt repayment method,” Tayne says. The key is to be confident you'll ultimately be paying less overall.
Does debt consolidation affect your credit score?
Another concern is what debt consolidation can do to your credit report. Tayne says you’ll likely take at least a small hit in the short run, especially with the hard credit check needed for a debt consolidation loan. However, she says it’s likely to be minimal as long as you consistently make on-time payments on your new loan.
Harzog points out that for some consumers, debt consolidation can actually help a credit score in the long run. “When you pay off lines of credit, like credit cards, you'll reduce the credit utilization ratio on your credit report. You’re also showing that you can handle different types of debt,” she says. “However, you must be careful because if you miss payments or close credit card accounts, the impact could turn negative.”
Is debt consolidation a good idea if you have bad credit?
If you’re struggling with your credit and trying to figure out how to get out of debt, debt consolidation could help — as long as you can get a loan.
The difficulty, says Harzog, is that many unsecured personal loans are difficult to qualify for if you have poor credit history. And if you do get a personal loan with fair or poor credit, you’ll probably pay a higher rate. “Even then, though, you still might be in better shape if the new rate is still lower than the high rates you’re paying now,” she says.
Getting a credit card balance transfer deal without good or excellent credit is practically impossible, so using credit card refinancing is a strategy that might not be a good idea for someone with poor credit.
Bad credit and debt management
Borrowers with bad credit might have better luck with a debt management company or credit counselor that can help you tackle your debt from a different angle. Tayne recommends carefully vetting these companies before entering an agreement.
“Look for a local company that works directly with consumers and has been in business for a long time,” says Tayne. “Consider a company with a history of specializing in your type of problem.”
You can find reputable credit counselors by going through the National Foundation for Credit Counseling.
Is debt consolidation safe?
Tayne and Harzog both warn that you can get caught up in scams when you start looking for debt consolidation solutions. They recommend doing your research and working only with reputable lenders and companies, whether you’re getting a debt consolidation loan or getting help with a debt management program.
Debt consolidation can also be problematic if you don’t fix the underlying problems related to the debt. Bundling everything up into a new loan frees up more debt, especially if you’re paying off credit card debt. If you haven’t changed your habits, Harzog warns, you’re likely to just rack up more credit card debt, and now you have twice the debt.
“Be sure you’ll be able to afford your new debt without turning to credit cards to supplement your expenses,” says Tayne. “Taking out a new debt consolidation loan won’t solve your cash flow problems.”
Is debt consolidation a good idea for you?
Because there are different strategies for debt consolidation, Harzog says it’s important to pay attention to the technique most likely to benefit you.
“You can have good credit, even with a lot of debt,” Harzog points out. “That gives you more options when considering your debt consolidation choices.”
For example, if you think you can pay off your debt in less than two years and you have good credit, you might choose a 0% APR balance transfer credit card. On the other hand, says Harzog, if you know you’ll need longer to tackle your debt, a personal loan could be a better option.
Poor credit will limit your choices, says Tayne. You might not be able to qualify for a personal loan and be stuck figuring out a debt payment plan on your own or turning to a debt management or even a debt settlement company.
In the end, debt consolidation can be a good choice if you’ve already started changing your personal finance habits so you’ll stay out of debt when you finish. As long as you know what you’re getting into and you choose the strategy that fits your needs, there’s a good chance debt consolidation could help.
Debt consolidation isn't a magic fix for your financial situation, and there are a few traps you'll want to avoid while going through the process. But that doesn't mean debt consolidation is bad. In fact, it can really help improve your finances if you do it the right way. If you make payments on time, avoid overspending, and stick to a repayment plan, you can eventually reach your goal of getting out of debt and improving your credit.