Taking out multiple loans at the same time can be overwhelming as you add different monthly payments and due dates, making it difficult to budget your monthly expenses. This often happens with high-interest credit card debt, which is why some borrowers turn to debt consolidation to simplify their debt repayments.
Let’s learn what debt consolidation is and how it works, and we’ll look at the different types of debt consolidation and consider when debt consolidation is a good idea.
What is debt consolidation?
Debt consolidation means combining all of your debts – like medical bills or credit card balances – into one monthly payment. Consolidating your debt may also give you the opportunity to reduce your interest rate and the amount you owe each month. This strategy can make it easier to pay off your loans faster while saving on interest.
How does debt consolidation work?
The most common way to consolidate debt is a debt consolidation loan. With this type of loan, you use the money to pay off your existing loan and repay the loan amount under new terms over time. Apart from simplifying your repayment plan, the loan will ideally offer you a lower interest rate.
Debt Settlement Vs. consolidation
Debt settlement differs from debt consolidation because it involves negotiation. Some people may hire a company to negotiate with their creditors, in the hopes of convincing them to settle the debt for less than the original amount owed.
With debt settlement, you typically deposit money into a special account every month. Once your balance reaches a certain amount, the debt settlement company will reach out to your creditors and negotiate a lower settlement amount.
The downside of debt settlement is that you will have to make monthly payments, your credit score will be affected and the debt settlement company will charge you fees which can be 15% to 25% of your total nominated debt.
Types of Debt Consolidation
There are several debt consolidation strategies available for borrowers who want to simplify their loan payments. However, each strategy has its own advantages and disadvantages, so it’s a good idea to review your options and choose the one that best suits your budget and lifestyle needs.
Debt Consolidation Loan (Personal Loan)
You can use a debt consolidation loan to pay off outstanding debt and replace it with one monthly payment. Ideally, your new loan will have a lower interest rate than your previous loans, potentially saving you money in the long run.
Debt consolidation loans are often personal loans obtained from a traditional bank, credit union, or online lender. However, it’s important to note that personal loans often require a minimum credit score to qualify for a lower interest rate, and you’ll need a good or excellent score to get the rate you want.
The personal loan application process is relatively simple, and once approved, you can receive your funds in 1 – 7 business days. Some lending platforms, including Rocket Loans℠, even offer same-day funding in some cases.*
Home Equity Loans and HELOCs
Home equity loans and home equity lines of credit (HELOC) are both available to consolidate debt, but both can carry significant risks for borrowers. To secure a home equity loan, the borrower must borrow against the equity of their home – making the home itself collateral. If a borrower fails to make his payments or defaults on the loan, the lender can take the home through foreclosure.
It’s a similar process with a HELOC, but instead you get a line of credit that you can borrow from and repay over time. Then, your home is at risk if you fail to make payments on time.
Balance transfer credit card
With a balance transfer card, you are transferring your existing credit card balance debt to a new credit card with a promotional interest rate that can be as low as 0%. However, keep in mind that this method has some drawbacks.
If you go this route, you’ll probably have to pay a balance transfer fee, which will be 2% – 5% of your total balance. Plus, after the 12- to 18-month promotional period ends, you’ll be left with a steep interest rate that can go as high as 14% – 26%. Compared to personal loans, balance transfers may offer more risk than reward.
Student loan consolidation
Student loan debt consolidation involves combining multiple federal loans into a single government-backed loan, potentially lowering the interest rate and making the repayment process easier for many people. This process is similar to student loan refinancing, which combines multiple federal or private loans into a single private loan.
When is debt consolidation a good idea?
If you feel overwhelmed with multiple debts, debt consolidation is a good idea and can be simplified into one monthly payment with a lower interest rate. It may also be a wise move if you can qualify for a 0% interest balance transfer card and are confident you can pay off your loan during the promotional period.
Also consider your financial situation. If any of the following are true then debt consolidation may be the way to go:
- Your debt-to-income ratio (DTI) is less than 36%.
- Your credit score improves and you may qualify for a better interest rate.
- You have enough cash flow to continue making your loan payments.
- You can repay the loan comfortably in a fixed period.
When is debt consolidation not a good idea?
Debt consolidation is not a cure-all, and you may run into trouble in the future if you attempt debt consolidation without a strategic plan. If any of the following are true, it may not be worth attempting to consolidate debt:
- Your loan amount is small enough to manage.
- Your consolidation options do not offer a lower interest rate than your current one.
- Additional fees and upfront costs will eat away at your potential savings.
- You are struggling to repay the loan amount you already owe.
It’s also important to remember that debt consolidation doesn’t solve the initial cause of your debt or make it magically disappear. It is just a simple financing tool that can help you manage your loan and its payments. Therefore, if your debt is the result of careless spending, you cannot rely on debt consolidation to improve your financial situation.
Also, if you don’t have a lot of debt and you’re confident you can pay it off quickly enough, debt consolidation may not be worth it.
Pros and Cons of Debt Consolidation
Debt consolidation comes with its fair share of payback and drawbacks. Take a look below at some of the pros and cons of debt consolidation.
Pros
You may enjoy the following benefits of debt consolidation, depending on your situation:
- One single monthly payment: You’ll combine multiple debts into one monthly payment, simplifying your bill-paying process.
- Lower interest rates: You may be able to secure a lower interest rate with the debt consolidation option, especially if you have good credit.
- Longer repayment period: A consolidation option may offer a longer repayment period than your previous loans, giving you more time to repay them.
- Better credit utilization ratio: If you pay off credit cards with a personal loan, you can lower your credit utilization ratio and improve your credit score over time.
- Consistent Payments: Personal loans usually come with a fixed interest rate. So, if you use a personal loan to consolidate debt, your minimum payment will likely be the same every month, unlike a credit card.
Cons
Debt consolidation can also come with some drawbacks, including:
- Potentially higher interest rates: Your existing loan may have a lower interest rate than consolidating your loans. For example, many student loans may have lower rates than personal loans.
- Hard Inquiries: Whenever you apply for a loan, the lender will take into account your credit history with hard inquiries. This can go down your credit score by up to five points.
- Additional fees: Lenders may charge you an origination fee for obtaining a personal loan, or they may add a balance transfer fee on a credit card.
- Collateral requirement: If you choose a secured loan – such as a HELOC or home equity loan – you will use your home as collateral and risk possible foreclosure if you default.
- Unchanged spending habits: Your debt may come back if you don’t improve your spending habits.
Final thoughts
Debt consolidation can help streamline your finances by converting multiple monthly loan payments into a single payment, which may have a lower rate and thus save you money in interest. However, this strategy isn’t for everyone, so be sure to carefully assess your financial situation before taking out a new loan.