What Is Debt Consolidation & What Should You Know?
Sarah Li Cain7-minute read
February 23, 2022
Whether you’re struggling with debt payments or want to pay less on your personal loans overall, debt consolidation can be the answer. No matter how much you’re paying in interest now, a debt consolidation loan can simplify multiple payments and possibly lower what you’ll pay each month.
It works by taking all your high-interest debt, like credit cards and other types of personal loans, and rolls it into one loan, usually with a lower interest rate. You can also refinance for a longer or shorter term to help make your monthly payments more manageable.
If the prospect of saving money on your high-interest loans or paying it off faster sounds enticing, keep reading. You’ll learn more about what debt consolidation is, how it works and whether it’s the right move.
How Does Debt Consolidation Work?
Debt consolidation works by merging multiple loans into a single one – you’ll owe one lender instead of multiple. Ideally, you’ll find a lower interest rate to save money when paying off your remaining debt.
Let’s say you still have $15,000 to pay back on your personal loan with a 10-year term and it’s currently at an interest rate of 15%. If you were approved for a debt consolidation loan for 9%, you’re looking at pretty significant savings —$410 a month!
People typically use a debt consolidation loan to lower their monthly payments or because they are struggling with remembering all the due dates for multiple loans. Types of debt you can consolidate include auto loans, credit card debt, personal loans, student loans and payday loans.
There are a few different types of debt consolidation options, which we’ll discuss in the next section.
Which Type of Debt Consolidation is Right for You?
There are four main types of debt consolidation, each with its advantages and disadvantages. The right one for you depends on factors like your credit score, income and the amount you want to consolidate.
Credit Card Debt Consolidation
Credit card debt consolidation refers to using a credit card to combine debt. This method is often used to consolidate debt from multiple credit cards onto one with a lower interest rate, making the process of paying off debt faster and easier.
Also known as balance transfers, you’ll simply open a credit card with a lower interest rate. If you have an excellent credit score you might be able to qualify for an introductory 0% APR for a specified period of time, like 12 months. Then all you need to do is to transfer the balance from the initial credit card over to the new one.
If you qualify for these offers, you’ll save a lot of money since you’re effectively paying off a loan without any interest. This is especially true if you’re willing to be more aggressive with your debt payoff within the introductory period. If not, the interest rate will go up, meaning you’ll be back where you started – paying off high-interest debt. Be sure to check the interest rate before you sign up.
Credit card issuers typically charge a balance transfer fee, which is usually a flat fee or a percentage of the total transferred amount, whichever is greater. Calculate the fee to see if it’s worth it, because if it’s high it, could negate the money you’re trying to save on interest.
Consolidating debt using a credit card balance transfer has another downside — your credit score can be affected. If you close your other credit cards, or even have a high balance on one credit card, it can increase your credit utilization, negatively impacting your score. It’ll recover as you pay it back down.
Debt Consolidation Loan
Also referred to a personal loan, this type of debt consolidation entails you taking out a loan that covers the balances of all your other loans. Once approved for a debt consolidation loan, the money will be disbursed – typically to your bank account – and you’ll pay off your other loans. Then all you’re left with is the one loan to your most current lender.
A personal loan is typically an unsecured loan that offers fixed rates, meaning you’ll pay the same amount monthly throughout the duration of the loan.
This type of loan isn’t your best choice if you have lower credit scores, as it may not offer a more favorable interest rate, if you’re approved at all. Some personal loan lenders also charge what’s called an origination fee, which is basically a processing fee. Depending on the terms of your current loans, you might be subject to prepayment penalties, so check to see whether the savings you’ll receive from a lower interest rate truly offset fees you could be paying.
Home Equity Consolidation
A home equity loan (not to be confused with a home equity line of credit) is a popular way to tap into your home equity to consolidate your debt. It’s a type of secured debt where you use your home as collateral, but it means you may be able to get a lower rate compared to other types of loans.
The amount you can borrow is typically larger. However, it is limited to factors such as the amount of home equity you have, which is calculated using the current value of your property subtracted by how much you still owe on your mortgage.
Your debt-to-income ratio is another factor that can affect how much you might qualify for. To calculate yours, add up all your monthly debt payments and divide it by your gross monthly income.
Since your home is considered collateral, you’re putting your property at risk if you can’t manage your payments.
401(k) Loan Consolidation
Taking out a 401(k) loan to consolidate your debt can be much riskier than the other options – that is, if your plan allows you to take out a loan.
It sounds like a great idea: borrowing money from your own funds (assuming you’ve contributed enough to qualify for a loan) and paying yourself back – with interest, of course – but falling behind on your payments means paying more than you bargained for.
First, your unpaid balance can count as a distribution – basically a withdrawal in the eyes of the IRS – and if you’re not 59 ½ years old or older, you may have to pay penalties since it’ll count as an early distribution. That’s on top of the interest you still need to pay for your loan. In addition, if you decide to leave your job (or you’re laid off), you will most likely need to pay back the loan in full immediately.
Something else to consider is that you’re taking out money from your retirement account. Sure, you could be saving money on interest, but you could be losing out on letting your retirement funds grow.
When Is Debt Consolidation A Good Idea?
If you’re willing to commit to paying less overall for your debt, simplifying your finances or get aggressive with paying it all off faster, then debt consolidation can be for you. That, combined with an excellent credit score, a low DTI and a plan to avoid unnecessary debt in the future, will help you reap the financial benefits of a debt consolidation loan.
To make sure you’re really saving money on interest rates, look for loans that don’t charge an origination fee. If you’re taking advantage of a 0% introductory APR offer, make sure you have a plan in place to pay it off before that period is over. Same goes for any type of loan – see if you can make more than the minimum payment, assuming you won’t be slapped with fees for doing so and that you can afford to.
Debt consolidation is also a good idea if you have a clear plan. In other words, you’ve created a budget that helps you spend within your means and avoid taking on debt in the future.
When Is Debt Consolidation A Bad Idea?
Remember, debt consolidation isn’t the answer to all your problems, nor will it work for everyone. For instance, if you have bad credit, you most likely won’t qualify for a new loan. Even if you do, the rates lenders offer might not be lower than what you’re currently paying.
It also doesn’t take into consideration your spending habits. If you decide to take out a consolidation loan but haven’t curbed the reason you got into debt in the first place, you could find yourself right back where you started. Or let’s say you haven’t stopped using our credit cards after a balance transfer – you could easily max out your card, making it difficult to make on-time payments.
Worse yet, you’re already overwhelmed with payments and can’t even afford the minimum payments. In this case, debt consolidation may not be the right solution – perhaps a debt management plan is more suited to your needs.
Even with good financial habits, debt consolidation may not make sense if you don’t have a lot left to pay off. If you think you can pay the balance off in less than a year, you’re probably not going to save much in interest. Besides, paying things like origination or processing fees may not be worth it, and may in fact even negate what you could save on interest. In this case, consider reassessing your current budget to see if you can be more aggressive with your debt payoff plan.
Debt consolidation is a great way to help you pay off expensive high-interest loans and other forms of debt, saving you money in the process. Depending on factors like your credit score, income and the amount of debt you want to consolidate, there are plenty of options to choose from such as a credit card balance transfer all the way to a 401(k) loan.
However, it’s not a catch-all solution – you’ll still need to address the underlying financial habits that got you into debt in the first place. That means making some significant lifestyle changes to ensure your spending plan stays on track.
Before applying with any debt consolidation lenders, learn the process and the pros and cons of each option. Then do your research and shop around so you know you’re getting the best deal.
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