The Pros and Cons of Debt Consolidation
Debt is a part of everyday life for many, helping us finance many of the things we want and need. But when debts add up and start to feel out of our control, they can become a source of emotional and financial stress.
If you find yourself in a position where you're affected by debt and wondering what financial decisions are best for you, consolidating your debt may be an option. But how do you know if it's worth it? First, you'll want to understand the pros and cons of debt consolidation so you can determine if it's the right path.
What is debt consolidation?
Debt consolidation is a process that allows you to turn a variety of consumer debts—often credit card debt, for example, rather than a mortgage—into one debt, which you can then pay down in one monthly payment.
Consolidation is different from refinancing, especially with credit card debt. When you consolidate credit card debt, you aren't taking out a new loan—you're merely transferring existing credit card balances onto a new card. Depending on your credit score and financial history, you might be able to secure low or even zero interest for a range of 12 to 24 months. Keep in mind that refinancing credit cards is another way to consolidate debt, but ideally, you'll want to pay off debt on that card within the low-interest grace period.
There are a variety of reasons people seek debt consolidation. For many, the primary motivation is streamlining multiple bills and repayment schedules with a range of interest rates into one manageable monthly payment.
Sometimes, combining everything can end up with a lower overall payment when compared to paying everything separately. In other cases, debt consolidation can also lower interest rates, saving money over the long term—especially if the debt gets paid off more quickly. You can use a debt consolidation calculator to determine whether consolidating is worth it for you.
How it works
The process of debt consolidation starts with an overview of your financial situation. Look at your current debts and interest rates to determine how much debt you have.
Once you do that, you can start researching your options, which often means taking out a loan that can cover all of your debts. If you get approved for a loan or a credit card balance transfer, you can begin the process of consolidation.
Types of debt consolidation loans
Here are a few common types of debt consolidation loans you might consider.
Personal loans
Personal loans are one of the most common methods. Depending on your credit rating and other factors, it might be possible to take out a consolidation loan large enough to cover all your debts, pay them off and then pay down your one monthly loan.
Debt consolidation loans
Some financial institutions and other lenders offer debt consolidation loans as well. These are specifically designed to help customers pay down several debts, especially if many have high interest rates.
Home equity loans
Many people turn to home equity loans, where your home's equity is used as collateral. For this to be a viable option, you'll need good enough credit to qualify, as well as enough equity in your home to cover the size of the loan.
Is debt consolidation a good idea?
For borrowers with multiple loans or credit card balances, debt consolidation can be a good idea—but it depends on your personal situation and financial goals.
When looking at the pros and cons of debt consolidation, there are potential drawbacks. First, be aware of the costs associated with consolidation—as with any loan, there will be fees. Also, know the interest rate and loan repayment terms as they could impact your decision.
If you choose a home equity loan for your debt consolidation, your home may be at risk if you can't make your payments.
There's also the potential influence on your credit score. Closing old credit cards, for example, can negatively impact your score. The same is true if you miss your payments. You might see an initial negative hit on your score when you first consolidate.
Deciding if it's right for you
Consolidation often works best if you have a moderate amount of debt that, if better managed, you could pay off within a few years. A key here is knowing that you have your spending under control, you won't be adding to your debt and you can afford the new monthly payment.
Your credit score is essential, too. More often than not, a good score is important to secure a loan. So make sure you check your credit score to see your starting point. The better your score, the higher the chances you'll be able to get a low interest rate.
As you consider your options, remember that debt consolidation is just one of them. Go through the pros and cons of debt consolidation to determine what's best for your financial needs now and in the future.
