Personal debt in the United States is at an all-time high, leading many Americans to look for creative ways to eliminate it. According to The Motley Fool, the average American has just over $100,000 in debt, split between personal loans, mortgages, credit card debt, student loans, and more.
Because of the high interest rates that often get tacked on top of loans, many people consider taking out a debt consolidation loan to pay off their debts. If you’re considering going this route and want to know if it’s the right option for you, keep reading!
What is Debt Consolidation?
As the name implies, debt consolidation is when you merge all your debts into a single payment. You can do this with a debt consolidation loan, which you can get as a personal loan from your bank, online lenders, credit unions, and others.
The goal of debt consolidation is to make it easier and more manageable to pay off your debt by condensing it into a single payment. However, because of how these types of loans work, they might not always the best option for everyone.
How Does Debt Consolidation Work?
There are two basic ways that a debt consolidation loan can work. First, you can go to a lender and give them detailed information about who you owe money to and how much. The lender can then pay each party what you owe them, and you’ll have to pay back the lender for the total cost of your loan plus interest.
The other option is to take a lump sum loan from a lender and pay back each of your creditors on your own. Next, you’ll make monthly payments to the lender who gave you the consolidation loan until it’s paid in full.
Essentially, you’re trading one form of debt for another. However, debt consolidation can make the repayment process easier because you only have to worry about one loan and interest rate.
Pros and Cons of Debt Consolidation
The Pros of Debt Consolidation
Streamlines Finances
The main reason that people take out debt consolidation loans is that it can help make it easier to manage your loan payments and interest rates. Rather than worrying about credit card debt, student loan payments, car payments, and many others, you have a single monthly charge.
May Expedite Payoff
If you can find a debt consolidation loan with reasonably low interest rates, you can pay off your total debt faster. You can do this by taking the money you save on high-interest debts and applying it as extra towards your consolidation loan.
Could Lower Your Interest Rate
Debt consolidation loans often have a lower interest rate than credit card and car loan payments.
May Reduce Monthly Payment
Finally, depending on your lender and the size of your debts, a consolidation loan might have a lower monthly payment.
The Cons of Debt Consolidation
You May Pay More in Interest Over Time
On the downside, debt consolidation loans can typically result in a higher overall payment. As such, paying it off usually takes longer, resulting in paying more total interest.
You Risk Missing Payments
As with any loan, if you miss a payment or two on a debt consolidation loan, your credit score can take a hit, and you might incur unwanted penalties.
May Come with Added Costs
Another downside of consolidating debt is that you may have to pay unwanted fees on your new loan, plus closing costs on your old ones.
Doesn’t Solve Underlying Financial Issues
It’s important to note that consolidating your debt won’t necessarily solve the money management and spending problems that got you into debt in the first place. You will still need to learn to manage your money to avoid massive debts in the future. A financial coach can help provide you with guidance when it comes to managing your debt.
Could Raise Your Interest Rate
While a debt consolidation loan could potentially lower your interest rate, it could just as easily result in a higher one.
May Encourage Increased Spending
Finally, when you consolidate your loans, you might be tempted to think you have less debt than before. If you lack discipline, this can lead to increased spending and more debt.
When to Think Twice About Debt Consolidation
As you can see, knowing if debt consolidation is right for you is tough. To simplify things, here’s a list of red flags to help indicate when debt consolidation is a bad idea.
- Your new monthly payment is higher than the old ones.
- You’re within a year of paying off your current debts.
- Opening a new credit account is more trouble than it’s worth.
- Your low credit score doesn’t allow for better terms than what you currently have.
- You don’t currently have a job or are thinking about seeking new employment.
- The fees involved in debt consolidation are too high.
Factors to Consider Before Consolidating Your Debt
Here are a few additional things to consider before consolidating your debt.
The Setup Fee
One of the most significant downsides of a debt consolidation loan is that you’ll typically have to pay a startup fee. On average, lenders charge anywhere from 1% to 5% of the total loan as the startup fee. Debt consolidation is not a good option if this is more than you can afford.
The Monthly Fee
If the monthly payment on your debt consolidation loan is lower than the total monthly payments of your old debts, debt consolidation may be a good option.
The Package
Finally, it’s essential to consider the debt consolidation package as a whole. If there are minimal fees, a low setup cost, and a lower overall interest rate and monthly payment, you should consider debt consolidation.
Is Debt Consolidation a Good Idea?
Debt consolidation is a good idea if you’re having trouble keeping track of your monthly payments and think you’re overpaying. However, you should take the time to compare multiple lenders and loan options. If you end up with a higher interest rate, monthly payments, or overall payment, debt consolidation is not a good idea.
How Debt Consolidation Affects Your Credit Score
Because debt consolidation means taking out a large loan to pay off multiple smaller ones, your credit score will likely see a small dip. However, this dip is usually less than 10 points, and your credit score can bounce back within a year as long as you make your payments on time.
If you miss payments, however, your credit score will dip lower, and the information will stay on your credit report for up to 10 years.
Here’s a closer look at how exactly a debt consolidation loan can affect your credit score.
Hard Credit Inquiry
During a hard credit inquiry, a lender pulls your credit report to determine whether or not they want to lend you money. These are typically performed to determine if you are trustworthy in repaying your debts.
Unfortunately, hard credit inquiries tend to hurt your credit score ever so slightly. Therefore, the more hard credit inquiries you have, the lower your credit score can dip.
Credit Utilization
The second aspect of your credit score is your credit utilization ratio. This refers to how much credit you use versus how much is available. You can calculate it by dividing your total balances by your credit limit. Understanding your credit utilization ratio is important because lenders will use it to determine your debt management ability.
Payment History
Finally, the most important factor in determining whether or not a debt consolidation loan hurts your credit score is your payment history. If you have a reputation for making your payments on time and in full, your credit score likely won’t take a hit. On the other hand, expect a dip in your credit if you have a history of late payments.
When Debt Consolidation Isn’t Worth It
Because of the risks involved in debt consolidation, it isn’t always worth the cost or hassle. For instance, if you won’t be able to make monthly payments on your new loan, debt consolidation is a bad idea. Instead, focus on paying back loans with the highest interest rate and use whatever money is left to pay other debts.
Additionally, if you’re close to paying off your current debts and the interest rate on the consolidation loan is higher than the rates on your current loans, debt consolidation isn’t worth it.
Remember, debt consolidation isn’t a cure-all for your money problems and isn’t the right solution for everyone.
Frequently Asked Questions (FAQs)
Does consolidation hurt your credit?
In general, debt consolidation loans may hurt credit scores ever so slightly. In most cases, however, the damage to your credit score is minimal and barely noticeable.
When is debt consolidation not a good idea?
If you plan to pay off your debt within a year, have very manageable interest rates, or won’t be able to afford the new monthly payments, debt consolidation is not a good idea. The last thing you want is a debt consolidation loan that increases your debt amount or interest rate.
What is debt consolidation vs. a settlement?
Debt consolidation and debt settlement are two very different things. With debt consolidation, you merge all your existing debts into a single payment, but the result is that you pay each one in full. With debt settlement, you barter with each of your lenders in the hopes of having your debts reduced.
How long does debt consolidation stay on your record?
On average, debt consolidation loans can appear on your credit report for seven to ten years. In most cases, however, if you make monthly on-time payments in full, your credit score will bounce back within one year, and your debt consolidation will appear as a good thing on your credit report.
Will a consolidation loan affect me getting a mortgage?
In most cases, debt consolidation won’t affect your ability to get a mortgage. However, your credit score can take a hit if you fail to make your payments or require frequent hard credit inquiries. If it dips too low, it can affect your chances of getting a mortgage.
Bottom Line
As you can see, debt consolidation loans are a lifesaver for some people but can be a mistake for others. It all depends on whether or not consolidating your debt will result in lower interest rates, a lower overall payment, or more manageable monthly payments. If it doesn’t, and you’ll save money paying off your debts as-is, steer clear of debt consolidation.
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