Pros and Cons of Debt Consolidation

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Managing multiple monthly debt payments with different due dates and minimums can be challenging and may wreak havoc on your budget. Additionally, high-interest debt can sometimes mean that you’re accruing almost as much interest each month as you are paying down with those minimum payments, making it difficult to make a significant dent in your debt.

One solution that can make debt repayment easier and save you quite a bit in interest is combining all of your debts into one loan, so you have just one monthly payment. This is known as debt consolidation. While it may improve your financial situation, you should learn all the facts before deciding on consolidation as your best option.

What is debt consolidation?

Debt consolidation is a debt management strategy that enables you to pay off multiple existing loans with one new loan, leaving you with one interest rate and one monthly payment. The new loan may have a better interest rate than some or all of your individual loans, so consolidation could save you money. Paying less in interest can mean getting out of debt faster.

You can consolidate almost any type of debt, including credit card debt, student loans, personal loans and medical debt. If your debts haven’t negatively impacted your credit score, you can typically consolidate your debt on your own and may have several loan consolidation options available to you. Options include personal loans, balance transfer credit cards, a home equity loan or line of credit or a mortgage cash-out refinance.

However, borrowers with fair to poor credit scores might not qualify for the best debt consolidation loans. For those cases, debt consolidation programs might be a better choice. These programs — usually offered by nonprofits — can help you create an affordable debt management plan by negotiating lower interest rates and monthly payments with your lenders.

How the debt consolidation process works

The debt consolidation process varies from consolidation loans to debt management programs requiring no borrowing. However, if it involves a loan, you’ll usually begin the process by choosing a lender and completing an application. The lender will typically verify your income, pull your credit report and review your credit score, credit history, debt-to-income ratio and other factors used to determine creditworthiness.

If you’re approved, these factors will also help determine the loan amount and interest rate for which you qualify and whether the lender will pay off your accounts directly or allow you to manage that on your own.

Once your debts are paid off with the new loan, you will make monthly payments until you pay the loan in full. Depending on the type of consolidation loan, you may have fixed monthly payments, or your minimum payment might lower as your balance decreases over time.

The debt consolidation process works differently if you’re planning one using one of the best balance transfer credit cards to pay off your other high-interest credit cards. In this case, you can apply for the new card and, if approved, schedule a balance transfer from the old cards to the new one.

There are a few things to keep in mind with balance transfer cards. First, the balance transfer rate typically only applies for the first 12 to 21 months after opening the new card. If you don’t pay off your balance in that timeframe, any outstanding balance will begin accruing interest at the standard card rate. Secondly, most cards charge a fee of 3 to 5% for transferring a balance. And, finally, one late payment can cause your introductory APR to spike to the standard card rate, rendering your balance transfer useless.

Debt consolidation sounds simple enough, but it certainly isn’t the best solution for everyone, and there are pros and cons to carefully consider.

The pros of debt consolidation

These are the most common benefits you might see from consolidating your debt.

An improved credit score over time

One frequently asked question about debt consolidation is, “does debt consolidation hurt your credit?” The short answer is that it initially might. Many people see a slight drop in their credit score for a period, as happens when applying for any new loan. However, your score should gradually and steadily improve over time, provided you aren’t taking on other debt and are making your consolidation loan payment on time each month.

The potential to pay off debts faster

The one big advantage of debt consolidation is that it can enable you to get out of debt faster. By consolidating high-interest debt into a lower-interest loan, more of your money can go towards the loan principal each month rather than interest, allowing you to get out of debt sooner than when paying down multiple loans. However, if you get a long-term consolidation loan, it could extend the time it takes you to pay off your debts and possibly cost more in interest.

A simplified monthly payment

Budgeting can be challenging when you’re juggling multiple monthly debt payments. Additionally, having multiple monthly loan payments means the potential to be late on multiple loans. Having only one loan makes it easier to know exactly how much your payment will be each month and when it’s due.

The cons of debt consolidation

The downsides of debt consolidation can be costly, so it’s essential to consider them carefully.

Interest rates may not be favorable

One disadvantage of debt consolidation is that some debt consolidation loan interest rates can still be pretty high and you might not save as much in interest as you’d expect. This is especially true if you have a fair to low credit score. You might get a better rate than your high-interest credit cards, but the rate may actually be higher than other loans you already have, especially if your credit score has decreased over time.

In fact, debt consolidation loans tend to have somewhat higher interest rates than other personal loans, since lenders consider borrowers with significant amounts of debt to be high risk.

It’s not a magical fix

If spending habits were the cause of a debt problem, a debt consolidation loan is a risk. It may provide some financial relief for a while, but if overspending continues, you’ll be even further in debt and worse off financially than before debt consolidation.

There may be extra costs involved

Consolidation loans often charge more than just an interest rate. Many consolidation loans have an origination fee to cover loan processing costs, with some as low as 0.99% of the total loan amount, but some as high as 10% or a fixed dollar amount of several hundred dollars. It depends on the lender and your credit score, but it’s certainly something to look out for. Individuals using debt management services often have a monthly fee that can be as high as $50. So make sure you fully understand all loan terms if you decide to consolidate your debt.

What to consider before taking out a debt consolidation loan

Consolidation might seem like an easy way to get debt payments under control. Still, before you begin searching for the best debt consolidation loans or fill out an application, you should first consider the following:

The root cause of your current debt situation

If you want to successfully get out of debt, it’s essential to recognize how you got into debt in the first place. Maybe unexpected medical bills or some other unplanned big expense led you into debt. However, if your debt problem is due to overspending, you’ll need to get to the root cause of the overspending and commit to changing this pattern — if not, a debt consolidation loan might only worsen your situation.

If you can’t limit your credit card usage to what you can pay in full each month, you will likely end up with a debt consolidation loan payment in addition to one or more credit card payments.

Getting advice from a financial advisor

Debt management is one of the many financial areas where an advisor can guide you. An advisor can analyze your budget and help you create a debt repayment plan that may or may not include a consolidation loan. They may recommend other options better suited for managing your debt situation. An advisor can be especially beneficial for those trying to pay off debt in retirement on a limited income.

Other ways to lower your outstanding balances

Debt consolidation isn’t the only option for paying off debt faster, nor is it necessarily a good choice for everyone. You should also consider the following alternatives.

Improving your credit score

If most of your debt consists of high-interest credit card debt and your credit score has improved since you got your card, you might be able to negotiate a lower APR from your card issuer.

There are many ways to improve your credit, but a good start is finding out whether incorrect information is impacting your score. You can request reports from all three bureaus — Experian, TransUnion and Equifax — for free once a week through AnnualCreditReport.com.

Once you have your reports in hand, make sure every account actually belongs to you and is being accurately reported. If you find any errors, you can contact the credit bureaus or creditors and dispute the information. If your credit score improves, contact your credit card and see if they will lower your interest rate.

Negotiating with creditors and debt collectors

If some of your debts are past due and that has impacted your credit, you might have a hard time getting approved for a debt consolidation loan. However, that doesn’t mean you don’t have options. Sometimes, you can negotiate with debt collectors to reduce the balance owed if you can pay off a lesser amount in full.

If you’re unsure about or uncomfortable dealing with collectors, a debt consolidation lawyer can negotiate on your behalf. A lawyer can also advise you on whether negotiation is your best option and even represent you if a creditor files a lawsuit against you.

If your debt has become unmanageable, you might be better off looking into free financial counseling services. These services can negotiate with your creditors and create a manageable repayment plan that fits your budget.

Paying it off with your savings

If you have enough saved to pay off your debts, dipping into savings might be a better option than a consolidation loan, especially if your savings are sitting in a low-interest account. You’ll likely save more by paying off your debt than you would earn in interest from savings.

However, it is not recommended to use emergency or retirement savings to pay off debt. A depleted emergency fund could land you back in debt if an unexpected expense arises and pulling money from a retirement account could result in an IRS penalty and increased tax bill. If you decide to use your savings to pay off your high-interest debt, be sure to use what was going toward those monthly debt payments to build your savings account back up.

Is debt consolidation a good idea?

Debt consolidation is a good idea if you can get a loan with a lower rate than most of your current debts and you have the discipline not to incur additional high-interest debt.

If you’re considering debt consolidation, thoroughly explore all available consolidation options to determine the method best suited to your situation. The best debt consolidation option is the one that will save you the most money and fit comfortably within your budget. If you are struggling to cover multiple monthly payments, make sure a consolidation loan will bring those payments down to an affordable amount. Some options may have shorter loan terms that make your payment higher than your combined minimum payments, even if it comes with a lower interest rate.