Debt consolidation involves combining multiple debts into one debt. This reorganizes those multiple debts with varying payment amounts, dates, and interest rates. Debt consolidation streamlines these debts into one payment which offers several benefits including paying off the debt faster, improving your credit score.
How Debt Consolidation Works
There are two main ways that people can consolidate their debt, both of which bundle all debts into one. This includes:
- Debt Consolidation Loan: this strategy involves applying for a personal loan at a fixed rate. Your credit score will inform the interest rate of this loan, borrowers with higher scores will qualify for lower interest rates. Money from this loan is used to pay pre-existing debts, allowing the borrower to make one monthly payment on the new loan.
- Transfer Credit Card: this option involves applying for a new credit card, one with the lowest introductory interest rate (hopefully 0%). All debts are then transferred onto this card resulting in one single payment that is made monthly to the card lender.
Though these are the primary ways, other methods of debt consolidation include taking out a home equity loan or 401k loan. But these strategies involve a greater risk that involves your home and also retirement plan.
Should You Consolidate Your Debt?
It is important to evaluate if debt consolidation is the best option for you. A range of factors should be considered when thinking about debt consolidation, including credit score, payment history, and financial habits.
Debt consolidation is a great option if the following is true:
- The total of your monthly debt payments is not more than 50% of your monthly income.
- You qualify for a 0% interest credit card, or a debt consolidation loan with the lowest possible interest rate.
- You have enough cash to cover your payment.
- You are committed to paying off the full amount of your debt and are ready (and comfortable) to stick to a repayment plan.
Debt consolidation requires you to be ready to develop and prioritize healthy financial habits. So this strategy of streamlining debts may not be the best option for you if:
- Your debts are increasingly high and reduced payments won’t necessarily be that helpful.
- If you have habits around excessive spending or spending beyond your means that you have taken steps to address.
- You are still incurring new debts and are not ready to commit to taking the step to pay off your debts.
- If the total amount of your debts is more than half of your monthly income and you are not able to meet the minimum monthly payment amount.
Debt consolidation is also not the most suitable option if your debt amounts are small and consolidation will do very little in terms of reducing the monthly payment.
Pros & Cons of Debt Consolidation
In determining if debt consolidation is the optimal solution for you, it is useful to consider the amount of debt, your income, and capacity around monthly payments. It is helpful to be aware of a few key pros and cons of debt consolidation which can help clarify if this is the best path for you.
- Pros of Debt Consolidation:
- An effective strategy for managing debts. Debt consolidation bundles multiple debts into one monthly payment. This alleviates the responsibility of remembering and balancing several dates, payment amounts, interest rates, etc.
- Could lower overall interest rate. Consolidating debts into one payment with one interest rate through a 0% interest credit card or low-interest personal loan can reduce the interest rates of multiple debts.
- Can reduce the monthly payment. By extending the terms on the loan, people can make payments for a longer period of time which reduces the monthly payment amount. This could involve a higher interest rate though so it is important to weigh out these options.
- Pays off Debt Faster. Depending on your approach, debts can be paid off more quickly with fixed loan payments.
- Cons of Debt Consolidation:
- Possibility of high-interest rates. This is an area of concern particularly for people with lower credit scores who may not qualify for a credit card or personal loan with low-interest rates.
- Higher costs: extending the loan period to make lower monthly payments, can result in higher costs overall if dealing with higher interest rates which accumulate over time.