Debt Consolidation 101: How to Weigh Your Pros and Cons

If you have debt in many different areas of your life — whether it be personal loans, medical bills, or credit cards — debt consolidation can combine all of the debt into one fixed monthly payment. If getting a debt consolidation loan or using a balance transfer credit card lowers your annual percentage rate, it might make sense. However, even at a lower rate, there are pros and cons to debt consolidation. 

The pros of debt consolidation:

1. You will have one fixed monthly payment

With debt consolidation, you won’t have to keep track of multiple monthly payments and interest rates. Instead, consolidation will let you combine all of the debt into one payment with a fixed interest rate that will not change over the life of the loan. If you have a balance transfer card, the interest rate won’t change during the promotional period. 

2. You might get a lower rate

Consolidating your debt means paying off your debt at a lower interest rate. This could save you money and help you pay off your debt faster. If you qualify for a balance transfer card, you would pay no interest during the promotional period which can last as long as 18 months. After that, you will probably have to pay a 3% to 5% balance transfer fee. If you did not consolidate your debt, your debt of $9,000 with a combined APR of 25%, would come out to a combined monthly payment of $500 and $2500 in interest over two years.

On the other hand, if you took out a debt consolidation loan with a 17% APR and a two-year period of repayment, you would only have to pay $445 a month. In the end, you would save $820 in interest. The money you save on monthly payments can then go toward paying off the loan sooner. 

3. You can build credit

If you make your monthly debt payments on time and in full, the net effect on your credit score will probably be positive, especially if you are paying off credit card debt. Paying off a credit card lowers one’s credit utilization ratio which is the largest factor that helps to determine your credit score. 

4. Other options like debt settlement programs will hurt your credit score

Debt settlement programs where you hire a credit counseling agency to negotiate on your behalf to lower your debt payments can actually hurt your credit score. If your debt is not paid in full or if you miss payments, your score will go down. Debt settlement programs also might have large fees and/or scams. 

Cons of consolidating your debt:

1. You could fall behind on making payments

If you miss paying off your new debt, you will most likely be in a worse position than before you consolidated your debt. If you don’t pay off your balance transfer card within the promotional period where you have no interest, you will have to pay it at a higher APR. You will rack up late fees if you don’t pay your consolidation loan on time. This will also be reported to credit bureaus which will make your credit score go down. Before you consolidate your debt, you need to make sure that you can pay off the debt every month of the repayment period. 

2. You might not get a lower rate on payments

Balance transfer cards are difficult to qualify for as you have to have a good credit score of usually 690 or higher on the FICO scale. Debt consolidation loans are easier to qualify for as there are loans for people with a bad credit score of 629 or lower on the FICO scale. However, only borrowers that have the highest scores will get the lowest rates. Unless you are being offered a lower rate than what is already on your individual debts, debt consolidation might not be the best idea. Another strategy to payoff your debt such as the debt avalanche or debt snowball methods could be a better idea. If you are looking to consolidate with a loan, you can prequalify with some lenders in order to get a sense of the rates without impacting your credit score. 

3. You haven’t solved the problem at the root

Yes, debt consolidation is helpful, but it is not going to fix recurring debt or your behaviors that led you here in the first place. If you have a problem with overspending your money or sticking to a budget, debt consolidation might be more harmful than helpful. If you take out a loan to pay off your credit cards, these cards will have a balance of zero again. A person who has a problem with overshopping might be tempted to use the cards before the debt is paid off. This would bury them in even more debt. If you have more debt than is manageable, it might be better to just see a credit counselor at a reputable nonprofit. They can help you set up a debt management plan. 

4. Debt counseling fees will add to your expenses

A debt consolidation loan might help you better pay off your debt, but this loan often means meeting with a debt counseling agency to put together a strategy to pay off the debt. You will have to pay them a fee every month. Yes, it can be helpful, but it will also be another expense to your monthly budget. Before doing this, make sure to do your research in order to avoid scams. 

Conclusion

Overall, everyone is different so everyone is going to have debt consolidation plans/strategies that best suit them. What everyone needs to take into account, however, is your budget, financial health, and living within or under your means until the debt is paid off. One might consider a home equity loan for larger debts or long-term expenses. These offer better interest rates as these loans are secured by your home. On the other hand, if you only have a small amount of debt, paying it off as a balance transfer to a new credit card might be the right option. This is only worth it if you are getting a better rate, and if you have good credit, personal and home equity loans might be better.

A personal loan is the most used option in order to consolidate debt. Your rate is dependent upon your credit history as poor credit can make your APR on your loans above 30%. One last option some people use is cash-out refinancing. This is a restructured loan for a larger amount than what you would owe on your original mortgage or any other lasting home loan. The difference between what you owe and your refinanced loan can be paid back to you in cash and put towards debt consolidation. This allows you a single bill each month. It’s unlike a home equity loan, which is an additional loan to your mortgage loan that you will have to manage and repay separately. 

Most importantly, what is best is going to look different for everyone. You need to evaluate your goals, your current position and plan out each month. Through this, you can pay off your debt and eventually be debt-free and less stressed. 

Resources

https://www.discover.com/home-loans/articles/consolidating-longstanding-debts/

https://www.nasdaq.com/articles/the-pros-and-cons-of-debt-consolidation-2021-02-10

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