February 21, 2020

Is Debt Consolidation a Good Option?

Debt consolidation is a sound approach to making what you owe more manageable. In this blog, we discuss debt consolidation basics including what it is, how to begin consolidating your debt and what types of debt work best for debt consolidation.

What Is Debt Consolidation?

Debt consolidation is a way to take high-interest debt and roll them into one single, lower-interest payment, known also as a consolidation loan, says financial services platform Intuit Turbo. The goal of debt consolidation is two-fold:

  1. To better manage what you owe
  2. To lower the amount of interest you pay

When Is It A Good or Bad Idea?

There are circumstances where debt consolidation makes sense, says KeyBank. If most of your monthly payment goes towards interest vs. principal then you should consider debt consolidation.

For example, if you pay $100 a month on a high-interest credit card balance and half (or $50) is going to interest. With debt consolidation, most of your payment could go towards the principal balance vs. interest allowing you to get out of debt sooner.  Consolidation can also help you manage multiple payments. Instead of having multiple credit cards with multiple payments, you could combine all of your payments into one, making debt repayment more manageable.

However, this alternative is not necessarily for everyone. In 2019, consumer debt surpassed $4.16 trillion, according to the Federal Reserve.  During this time many people considered transferring everything into one single payment, but it does not work out the same for all.

Consider what consolidation does to your credit score. A balance transfer does not reduce the amount of credit utilization. It will zero out the balances on your high-interest cards, but your utilization rate will remain the same. If you start charging on those cards again, your credit score will continue to drop.

What Are the Requirements for Debt Consolidation?

Consolidation works best with banking debt such as:

  • A student loan
  • Home loan
  • Credit card debt
  • Other debt — car or boat loans, for example.

Now, before signing up with a debt consolidation plan, review the following requirements to make sure you qualify.

  • Some consolidation programs that require you to have a certain amount of debt, such as $10,000. In other words, the total amount of all your debts would have to exceed this amount before you qualify for the loan.
  • Other debt consolidation companies may also limit the type of debt they cover, i.e. they may cover all types of debt excluding store credit cards.

You can find debt consolidation companies on the internet, via mobile apps and/or in-person at financial institutions such as credit unions or banks. There are two primary kinds of debt consolidation plans:

  • A refinancing personal loan — Secured or unsecured
  • Balance transfer via a credit card company

What Are the Loan Terms?

Before signing up for debt consolidation, consider asking the following questions (which according to NerdWallet are some of the most important questions to ask):

  • Period — How long will you be paying on the loan?
  • Period interest rates — What is the interest rate on the loan? Is it better than the interest rate on your original debt?  Will the interest rate change after a certain period of time and is it still better than the interest on your original debt?
  • Monthly fees and other costs — There may also be additional costs beyond interest like an application charge or transfer fee that you need to consider.

Which are the Best Debt Consolidation Programs?

That depends on many factors, including your credit history. A mainstream banking program like Bank of America would make sense for someone with good credit who could get a lower rate. Those with less than perfect scores, however, might end up paying more in interest.

Some credit card companies also provide personal loans with minimal questions asked and no fees, but they will set the interest rate based on your credit history. Still, the rate may be less than other financial companies or high-interest credit cards.

Also, some credit cards offer balance transfer programs that will give you as much as two years with no interest, Better Money says. After two years, though, a high-interest rate will kick in, so only transfer as much as you can pay off during the discounted period.

Ideally, you look for a loan program that provides no fees and has an interest rate that is less than what you currently pay. So, if you have high-interest credit cards, a loan that offers no fees and even a 12 to 15 percent interest rate is a money-saving choice.

Key Differences With Other Ways to Pay Off Debt

Debt consolidation is just one way to pay off your existing debts, but it is different from other ways that you might consider, such as:

  • Refinancing — Refinancing refers to replacing an existing loan with a new one. Refinancing is common with home or auto loans. While refinancing can save you money, it is typically a time-consuming process.
  • Personal loan — A personal loan helps to consolidate debt, according to Banks.org. It’s an option that can improve your credit score, too because it lowers your credit card utilization rate.
  • Debt settlement — When negotiating a debt settlement company or your bank, you agree with a creditor to reduce the balance of the debt. Settling your debt should be a last resort because it will affect your credit score.
  • Loan forgiveness — With loan forgiveness, the creditor agrees that the debtor does not have to pay back the loan. It is not an option with many kinds but is sometimes a choice for student loans or smaller debt, and always depends on you meeting the requirements that make your case eligible for forgiveness.

Learn more about these alternatives with our How-to Super Guide to Pay Off Debt.

Do It if You Really Need It

Consolidation is a practical choice if you want to take the balances owed and reduce them to a lower interest payment plan. If you are in debt, you are not alone. The question is, what are you going to do about it? Debt consolidation may be the answer.

Ready to get serious about paying off debt?

Start Your Free Trial