Borrowing money can be a great way to build credit and achieve goals like higher education or buying a house. But with the costs of everything increasing, more people are taking on debt. Debt isn’t inherently bad, but for some people, it can get overwhelming quickly. If you’re dealing with multiple payments, then debt consolidation may be the solution for you. Need more information? Keep reading to learn the ins and outs of debt consolidation.
What is debt consolidation?
As the name suggests, debt consolidation involves consolidating—or combining—your outstanding debt or loan balances into a singular payment, often through a new loan. While consolidation doesn’t eliminate your debt, it does aim to make repayment a little easier. Instead of managing multiple loans and payments, consolidation allows you to make just one payment, usually with a lower interest rate. This helps you reduce your cumulative interest—lowering your overall payments so you can pay off what you owe more quickly. Depending on the type of debt you have and your overall financial goals, there are a few different options for you to consolidate.
Debt consolidation loan
The most common way to consolidate is through a debt consolidation loan, which is a type of personal loan. These loans offer lower interest rates and, by aggregating your payments into one, may lower your monthly payments as well.
With a consolidation loan, you borrow enough to cover the balances you want to consolidate and then once approved, use the funds to pay off your other debts. In some cases, lenders may be willing to pay off your balances directly. Debt consolidation loans are unsecured, meaning you don’t have to put up any collateral but are instead based on your credit score, credit history, and debt-to-income ratio.
Balance transfer
If you’re dealing with a lot of credit card debt, a balance transfer is another way to consolidate your debt. With balance transfers, you move your existing credit card balances onto a new card, often with a 0% APR promotional period. During this time, you can pay down debt transferred from another credit card without paying any interest. Balance transfer credit cards may also offer welcome bonuses, rewards, and other perks.
With a balance transfer credit card, you’ll usually request a balance transfer with your new card issuer, who will pay off your included balances directly. However, it’s important to note that balance transfers may charge an upfront fee, which may count towards your credit card limit. Additionally, you won’t know your credit limit until you’re approved, which means you may not be able to transfer your entire balance.
Does consolidation hurt credit?
The short answer is that mostly depends on you. When applying for a new loan or credit card, financial institutions will do a hard pull which will cause a small temporary dip in your credit score. Pre-qualifying for a loan doesn’t require a hard pull and won’t impact your score. Opening a new account lowers the average age of your credit history, which can also cause a temporary dip. However, in the long run, your credit score should improve—especially if you make your payments on time. You should also try to keep your accounts open, even after using your consolidation loan to pay them off, as this reduces your utilization ratio and also has a positive impact on your score. On the flip side, if you miss your payments, this will negatively impact your score. And if you run up those credit cards again after paying them off, you’ll increase your utilization ratio, lower your credit score, and likely end up with more debt than when you started.
When to consider debt consolidation
The big reason to consider debt consolidation is if you have multiple high-interest debts and you’re struggling to track payments. If you’re looking to simplify, debt consolidation may be right for you. But what strategy is best depends on your financial situation.
A debt consolidation loan is best if you’re dealing with a mix of unsecured debts, like credit card debt and medical bills, or you’re managing a significant amount of debt that may require several years to repay. These are also available if you have a lower credit score, though a higher score may get a better rate. Balance transfers are best if you have a smaller amount of debt, especially if it can be paid off during the 0% promotional period, and only for borrowers with good to excellent credit.
Comparing Debt Consolidation Strategies |
|
|---|---|
| Debt consolidation loan | Balance transfer card |
| Best for paying off multiple types of unsecured debt, like medical bills and credit cards. | Best for paying off credit card debt. |
| Best for larger debts that may take more time to pay off. | Best for smaller debts that can be paid off within the promotional period, usually 15 to 21 months. |
| Available to borrowers across the credit spectrum, including those with fair or bad credit. May be able to pre-qualify. | Available to borrowers with good to excellent credit. |
| Includes fixed monthly interest. May charge an origination fee. | Includes zero-interest promotional period. May charge 3% to 5% balance transfer fee. |
Pros and cons of debt consolidation
There are several advantages to consolidation, one of which is simplification. It can be overwhelming trying to manage multiple payments and due dates, and consolidating makes it much easier by only having to manage one bill. Another benefit of consolidating is a lower interest rate, saving you money over time. Additionally, it may also reduce your credit utilization ratio, which combined with consistent on-time payments—made easy thanks to one bill instead of many—can increase your credit score.
Alternatively, there are some downsides. Some consolidation options may come with upfront fees, which may not be feasible for you. You may also end up extending the terms of the loan, which could cost you more over the life of your loan, even with lower interest rates.
It’s also important to remember that this isn’t a long-term solution for overspending. If you’re constantly living above your means and refuse to change, you’ll likely end up with additional debt instead of less. Whether you consolidate or not, you should review your finances and your spending habits to see how you can make changes to your overall financial strategy.
Key takeaways
- Debt consolidation is when you pay off one or more debts by taking out a new loan with a better interest rate.
- There are several options for debt consolidation, including a loan, a balance transfer, and a HELOC.
- Debt consolidation won’t change your spending habits.
Overall, debt consolidation can be a helpful way to manage multiple debts, and with a few options for consolidation, you can find a method that works best for reaching your financial goals.
