6 Tips to Make Debt Consolidation Work for You
If simplicity is the key to success, then debt consolidation, where you simplify your bills by rolling several debts into a single payment, could be the key to successfully managing your debt.
The strategy involves replacing your debt — whether it be multiple credit card balances, a personal loan or something else you owe — with one new loan. Ideally, the debt consolidation loan will have a lower interest rate that can help you save money or pay off your debt faster.
As with most financial tools, taking out a new loan comes with risks. But if you’ve done your research and decided it’s the best move, here are six tips to make debt consolidation work for you.
1. Check your credit score
Before you start to consider which debt consolidation option makes sense for you, it’s crucial to check your credit score and understand what it will mean for shopping around for loans.
“Getting your ducks in a row is so important,” says Bruce McClary, senior vice president of membership and media relations for the National Foundation for Credit Counseling. “You need to be very familiar with your own circumstances and how your credit score may potentially impact a lender’s decision.”
Since every lender has different requirements, there’s no exact rule about what credit score you need to be approved for debt consolidation. But you’ll typically need a fair credit score at the very least. FICO scores are the most widely used credit scores, and a score of 580 to 669 is considered fair while a score of 670 to 739 is considered good. The higher your score, the more likely you are to be approved for a debt consolidation loan — and to snag a lower interest rate.
If your score isn’t up to par, you can potentially give your credit score a boost by paying bills on time, keeping your credit utilization score low and leaving old credit card accounts open.
2. Choose the right debt consolidation loan for you
There are four main debt consolidation loan options to consider: home equity lines of credit (HELOCs), home equity loans, balance transfer credit cards, and personal loans.
HELOCs and home equity lines of credit allow you to borrow against the equity in your home by getting a lump sum of cash (with a home equity loan) or a line of credit you can borrow from as needed (with a HELOC). You can often get better interest rates with these products because your home is used for collateral, so these can be a good option for homeowners who have significant equity in their home and are willing to take on that risk.
Balance transfer credit cards come with introductory or promotional interest rates as low as 0% , allowing you to transfer your high-interest credit card debt to a low-interest card. But after the promotional period, you’ll have to pay the standard annual percentage rate (APR), so these tend to make most sense for borrowers with smaller balances who can pay the money back within the promotional period. You also have to be disciplined enough to avoid taking on more debt on the new card.
And lastly, personal loans are commonly used for consolidating debts. The interest rates on these can vary a lot, and you’ll typically not get as good a rate as you would with something like a HELOC that has collateral. But if you don’t have home equity to tap into — or don’t want to tap into your equity — and have at least a fair credit score, this is an option worth considering.
3. Make sure you fully understand the terms
Even if a loan looks tempting, it’s important to read the fine print. Review the paperwork carefully to make sure you understand how the terms apply to every possible scenario — including if you run into trouble.
“Oftentimes, in those situations when people get approved, the mindset is one of success,” McClary says. “It’s hard to think about how you might face circumstances where you encounter financial difficulties that cause you to fall behind with these consolidation loans and lines of credit.”
Make sure you fully understand a loan agreement’s penalty and late fees, as well as options that may protect you in the event you have an unexpected financial hardship. In the case of a balance transfer credit card, pay attention to how high the APR may jump if you’re not able to pay off all your debt during the promotional period.
4. Adjust your budget to take the loan into account
Once you get approved for a loan, your work isn’t done. It’s important to understand what that loan means for your budget overall so that it doesn’t throw off the rest of your finances.
For instance, if you’re now making higher monthly payments toward your debt, you don’t want to fall behind on your mortgage, car payments, utility bills, everyday expenses or other obligations.
“You really should have a good idea of what’s going to happen once you get that consolidation loan and how you're going to achieve that goal,” McClary says. “It all needs to fit into your budget.”
If you snag a significantly lower interest rate thanks to a new loan — for instance, an 8% interest rate on a home equity loan compared to the 23% APR on a credit card — it may be tempting to make those smaller payments and relax. That could even be what you need, if you’re consolidating to free up money for other bills.
If you can swing it, though, you’re likely better off continuing to pay the same monthly payment on the new loan as you had been on the credit credit, says Mike Miller, a financial advisor at Integra Shield Financial Group.
“If you have the cash flow to be making those high credit card payments and you can continue to do that on the HELOC, you’re going to get that HELOC paid off quicker,” Miller says.
The key is to be clear about your plan before you take on the debt consolidation loan. Do you have the flexibility in your budget to maintain, or even increase, your monthly payments on the consolidation loan? Or do you need to use extra money freed up from lower debt payments for other bills? Setting a clear plan of action at the start will help you avoid making impulsive decisions later on.
5. Weigh your other options
Debt consolidation can be a critical debt management step. It helps to simplify the chore of paying monthly bills, and in doing so, can help you avoid late payments. Plus, you can often get a lower interest rate that may make it easier for you to pay off your loans faster, ultimately saving you money.
But it’s not a cure-all for your debt. If you’re really struggling to afford your debt bills before consolidation, then chances are you’re still going to struggle after. If that’s your situation, you may have better success with another path. You could consider a debt management plan in which you work with a credit counseling agency to combine your multiple debt payments into a single payment plan. You pay the agency, and the agency pays the creditors you owe. Another option is debt relief, which often involves working with a debt settlement company that can help you renegotiate the agreement you have with creditors, ideally reducing your debt.
6. Avoid new debt
The final step to successfully using debt consolidation to your advantage may be the most important: To set yourself up for long-term success, you have to avoid taking on new forms of expensive debt. It may be tempting to rack up a credit card balance once you have a handle on your existing debt, but that will only bring you back to where you started.
The more debt you take on, the more interest you'll pay and the more time it will take to pay it off.
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