If you’re dealing with debt and are looking for a way to simplify the payoff process, debt consolidation may be right for you.
Debt consolidation is a way to refinance your debt by taking all your unsecured debts and combining them into one payment. There are a few different ways you can do this, like taking out a debt consolidation loan or through a credit card balance transfer.
But before making a decision, it’s best to do your research to see if it’s the right move for you. Here’s a quick overview of how debt consolidation works, the pros and cons of your options, and how it could affect your credit.
How does debt consolidation work?
Debt consolidation combines your high-interest loans into a single payment that has a lower interest rate. The idea is to simplify your debt payment by focusing on one, new loan payment.
Debt consolidation can help reduce the amount you’ll pay in interest during the lifetime of your loans, which can help save you money. It can also help you pay off your debt faster.
The two most common ways to consolidate debt
- Debt consolidation loan: You take out a fixed-rate loan to pay off all your existing debts. Then, you pay back the loan over a specified amount of time. Because the loan has a “fixed rate,” your monthly payments stay the same throughout the lifetime of the loan.
- Balance transfer: You open a new credit card (often called a balance transfer card) that offers a 0% APR promotional rate during an introductory period. Then, you transfer your existing debts onto the credit card, so they don’t accrue interest — just remember to pay off the balance off in full before the introductory period ends.
Other ways to consolidate debt include using a home equity loan or a 401k loan, though these can come with additional risks.
Debt consolidation vs. balance transfer
A debt consolidation loan is a type of personal loan in which you use the loan proceeds to pay off existing debts. You then have a single loan payment and can focus on paying it back. You pay back the loan at the agreed interest rate over a specified amount of time.
The benefits of a debt consolidation loan are having one constant loan payment amount and, often, a lower interest rate than what you were paying before.
A balance transfer is a way to move your existing debt to a credit card with a lower introductory interest rate (often called a promotional rate). If you’re able to transfer your entire balance, you then have a single payment to focus on. You also have a specified amount of time to repay your balance before the introductory interest rate expires.
Keep in mind: Once the introductory interest rate expires, you should expect to face a higher APR. Read the fine print carefully because you may also face penalties and could lose out on the entire introductory offer if you miss even one payment.
What types of debt can be consolidated?
Most people use debt consolidation for credit cards, but you can use it for most types of unsecured debt, including:
- Auto loans
- Payday loans
- Personal loans
- Student loans
- Medical bills
Why should I consider debt consolidation?
Debt consolidation isn’t right for everyone; it’s typically best for people with a reasonable amount of debt who are looking to simplify payments. Debt consolidation is also a good option if you have a decent good credit score and a plan to pay off your debt in a timely manner.
Having a good credit score will help you get the most favorable rates possible. This is important because it doesn’t make sense to consolidate debt if the new interest rate is higher than what you’re already paying.
And if you’re considering a balance transfer, credit card issuers typically pick the most “creditworthy” individuals — the ones with the highest credit scores.
Whichever option you choose, debt consolidation works if you make a solid plan on paying it back. If you fear falling behind on payments and are fairly certain that having one lower payment will help you tackle your debt, then consolidating your loans can help.
What’s the downside to debt consolidation?
There are a few cases when debt consolidation isn’t a good idea.
If your debt is minimal and you won’t save that much by consolidating your loans, you’re likely better off staying the course and not pursuing debt consolidation. Work to pay it off on your own and set up a realistic timeline to hold yourself accountable.
Debt consolidation might also be wrong for you if you find that you’re barely making your debt payments or haven’t yet addressed the real reason you got into debt — for some, freeing up cash flow is an invitation to spend more.
If your credit score is below average, then a debt consolidation loan could end up costing you more money. That’s because you might end up with a high interest rate, which defeats the purpose of consolidating your debt in the first place.
In all cases, you run the risk of falling further into debt and risk missing payments, which can do further damage to your financial situation.
Will debt consolidation hurt my credit?
For better or worse, there are a few instances in which debt consolidation can affect your credit:
- When you apply for a loan: Creditors conduct what’s called a “hard inquiry,” which can temporarily lower your credit score.
- When you pay off your debts: Making regular, on-time payments can increase your credit score over time.
- When you close your accounts: Your credit score could be lowered if you close your accounts as you pay them off through debt consolidation. Remember: Older accounts help to build your credit score.
Choose what’s best for you.
Debt consolidation may seem like the silver lining to your financial problems. However, making the best decision for yourself requires assessing your situation carefully That includes taking a look at your credit score, your spending habits and your debt situation. Once you’ve done it all, then make a decision — doing so could save you thousands of dollars.