Pros and Cons of Debt Consolidation

Debt consolidation is a popular debt reduction strategy that—depending on your circumstances—can be effective, or can leave you worse off than before. 

Debt consolidation means combining multiple debts into one new loan and one monthly payment. In many cases, that means rolling various debts into a loan with fixed monthly payments. You could also consolidate debt with a balance transfer onto a new credit card.

Let’s check out the pros and cons of debt consolidation so you can decide if it’s right for you. 

Debt Consolidation Pros

Debt consolidation could benefit you, but only if your circumstances are a good fit. Let’s walk through the key advantages of debt consolidation. 

Lower interest rate

Debt consolidation should get you a lower interest rate. It almost never makes sense to consolidate debt to a higher interest rate, so if you don’t qualify for a lower rate compared to what you pay now, debt consolidation might not be a good path forward.

If you have high-interest credit cards, moving their balances to a consolidation loan with a lower rate could save you money. Paying less in interest frees up more money for paying off your actual debt. 

Easier money management

Debt consolidation simplifies your finances. Instead of keeping track of several due dates, you have just one payment to focus on each month. This could make a huge difference in staying organized and on top of your finances, especially if you set up automatic payments. 

Lower monthly payment

Merging debts could lead to more breathing room in your budget. If your new loan has a lower rate or spreads payments out over a longer period of time, your monthly outlay may drop. This could free up funds for other essentials or savings goals. Just remember that extending your loan term could mean paying more in interest over time.

Higher credit score

Consolidating your debt could boost your credit score, because when you pay off credit card balances, your credit utilization ratio improves. This means you’re using less of your available credit, which could have a positive impact on your score. 

You May Like These

What Is Debt Consolidation?

Is Debt Consolidation a Good Idea?

Which Debt Should You Pay Off First?

Debt Consolidation Cons

There are some drawbacks to debt consolidation that can help you figure out if it’s right for you.

Fees and other costs

When you consolidate debt, you may incur costs such as loan origination fees or balance transfer fees. These could eat into your savings.

If you use a debt management plan to consolidate your debt, you usually pay a monthly fee. Understand what fees you're looking at when deciding if debt consolidation is worth it.

Needing good or excellent credit

If you have a high credit score, you might qualify for a low interest rate on a debt consolidation loan or an attractive balance transfer offer. But if you have a lower score, it may keep you from getting rates lower than what you're paying now. In that scenario, debt consolidation might simplify your life in terms of only having to juggle one monthly payment—but it could cost you more money.

Risk of increasing debt

If you consolidate credit card debt onto a new card or into a new loan, it frees up room on the original accounts for added spending. But using those accounts could set you back on the road to becoming debt-free.

Potential credit score damage

If you can't keep up with your debt consolidation loan payments, your credit standing could suffer. Late or missed payments could severely lower your score.

Doesn't address the root cause of debt

Some people end up with lots of debt due to temporary hardships. If your debt was caused by a medical event or other financial emergency, you may not be at risk of falling back into debt after consolidation.

On the other hand, if your debt was caused by overspending, consolidating may not be the right solution. Consolidating is merely a way to organize and potentially lower the interest rate on your debt. But it can't fix money problems, and it doesn't address financial habits that may have led to debt in the first place.

Does Debt Consolidation Hurt Your Credit?

Whether debt consolidation hurts or helps your credit depends on how you manage your debt consolidation loan payments. 

Hard inquiries on your credit report

Applying for a debt consolidation loan typically requires a hard inquiry on your credit report. Each hard inquiry may take a few points off of your credit score, but the effect of a hard inquiry should lessen over the following 12 months. After that, it won’t affect your credit score at all.

Getting preapproved for a debt consolidation loan could help you limit the number of applications you submit, resulting in fewer hard inquiries. That, in turn, could help protect your credit score.

Payment history remains the most important factor

Your payment history carries more weight than any other factor when calculating your credit score. If you pay your debt consolidation loan on time and don't miss any payments, that could have a positive impact on your credit score. However, if you miss payments or are late making them, it could have a negative effect on your credit score.

Changes in credit utilization ratio

Your credit utilization ratio measures how much of your total credit limit you're using at once. It's another big factor in your credit score. Keeping it low could help your score.

Paying off credit cards with a debt consolidation loan could have a positive impact on your credit by lowering your credit utilization ratio—as long as you don't then spend money on your credit cards and bring those balances back up. 

Effects on overall credit mix

Adding a type of credit account that you don’t have yet could have a positive impact on your credit score. If your current credit mix is solely credit cards and you take out a debt consolidation loan, that could have a positive impact on your credit score.

Types of Debt You Can Consolidate

Debts you could consolidate include:

• Credit cards. Credit cards often have high interest rates, so consolidating into a loan may make your balances easier to pay off.

• Personal loans. Consolidating debts into one loan with a lower interest rate could result in some savings. If you're juggling multiple loans, consolidating could make your debt easier to manage.

• Medical bills. Juggling multiple medical debts could be stressful. Consolidating could help you get a better handle on them.

• Auto loans. Some lenders may allow you to consolidate your auto loan into a new loan, but check your loan terms or ask. Make sure your new loan’s interest rate is lower than your current loan rate.

• Store credit cards. Like with regular credit cards, you might lower the interest rate on your debt by consolidating store credit cards into a new loan.

• Payday loans. Payday loans tend to come with extremely high interest rates. Consolidating is likely to lower your interest rate.

• Private student loans. Consolidating private student loans could be a source of savings if your new loan has a lower interest rate. But be careful about consolidating federal student loans—you could be giving up some protections and repayment plans that only apply to federal loans.

• Small business debts. You could consolidate small business debts into a single loan you make one monthly payment on. 

For the most part, you could consolidate almost any debt. Most people don't consolidate mortgage debt, because it requires taking out a new loan large enough to cover their mortgage balance. Also, secured debt, like mortgage debt, often comes with a lower interest rate than what you could get on a consolidation loan. 

If you're not sure which debts of yours to consolidate, ask yourself:

• Will consolidating lower the interest rate on my debt?

• Will consolidating lower my monthly payments?

• Will consolidating give me more time to repay my debt?

• Will consolidating mean I go from a variable interest rate to a fixed rate?

• Will consolidating simplify my finances?

If the answer to at least one is yes, your debt may be a good candidate for consolidation.

How to Choose a Debt Consolidation Option

You have several options for consolidating debt. Here are some common ones to choose from.

Personal loans

Personal loans tend to have lower interest rates than credit cards. They also offer the benefit of fixed, predictable monthly payments that may be easier to fit into your budget than credit card payments, which can change over time.

Personal loans tend to be good for borrowers with steady, reliable income. That's because being late on personal loan payments usually damages your credit score.

Personal loans also tend to be suitable for people with good to excellent credit. If your credit is poor, you may have a hard time getting a competitive interest rate on a personal loan, or getting approved to begin with.

Personal loans are unsecured, which means you don’t need to own a home or other collateral to qualify. Lenders usually look at your credit score, debt-to-income ratio, and income when deciding whether to approve you.

Home equity loans or HELOCs

With a home equity loan or home equity line of credit (HELOC), your loan is secured by the equity in your home. A home equity loan is good for borrowers who want fixed, predictable monthly loan payments. As with a personal loan, you should ideally have stable income before taking out a home equity loan.

A HELOC could offer you the lowest interest debt compared to your other debt consolidation options. With a HELOC, though, your interest rate is typically variable, so your monthly payments aren’t set in stone. 

You need steady income for a HELOC to be a good idea—and, ideally, room in your budget in case your payments rise. A HELOC may also be your better option if you're looking to borrow a large amount.

Balance transfer credit cards

Many balance transfer credit cards offer 0% introductory ARP periods for paying off high-interest credit cards. Usually, you get anywhere from six to 21 months to pay off your balance without accruing interest.

However, if you don't pay off your entire balance by the time your introductory period ends, the interest rate on your remaining balance could skyrocket. For this reason, a balance transfer is generally only a good way to consolidate debt when you're confident you can pay everything off in a short-enough period of time. If you feel you need more time than an introductory period, a personal loan, home equity loan, or HELOC could be a better choice.

Also, balance transfer limits tend to be lower than personal loan or HELOC limits. If you have a lot of debt, a balance transfer may not work for you. And if you don't have steady income, you may be less likely to pay your balance before your introductory period ends.

You generally also need good credit to qualify for a competitive balance transfer offer. Typically, balance transfers are not recommended for hardship situations. 

How to Consolidate Debt Successfully

The first thing to recognize is that after debt consolidation, you still owe the same amount of money—perhaps even more if there are loan fees involved. Debt consolidation is not a routine financial tool. It's a warning you that your finances could get out of control—and an opportunity to take back control.

The federal Consumer Financial Protection Bureau (CFPB) recommends a three-step approach before you consolidate. Here, word for word, is what its website says:

• “Take a look at your spending. It's important to understand why you are in debt. If you have accrued a lot of debt because you are spending more than you are earning, a debt consolidation loan probably won't help you get out of debt unless you reduce your spending or increase your income.

• “Make a budget. Figure out if you can pay off your existing debt by adjusting the way you spend for a period of time.

• “Try reaching out to your individual creditors to see if they will agree to lower your payments. Some creditors might be willing to accept lower minimum monthly payments, waive certain fees, reduce your interest rate, or change your monthly due date to match up better to when you get paid, to help you pay back your debt.”

That first CFPB point—take a look at your spending—is crucial. But if you’re struggling financially because you've been sick or unemployed or have faced some exceptional bills, that's less of an issue.

Create a Debt Consolidation Budget

If you're simply spending more than you earn to prop up your lifestyle, that's unsustainable. And, eventually, you run out of road. So move on to the CFPB's second point and make a budget. Yes, it could be boring, or hard work. But making one and sticking to it is a really good way to move forward so that you control your money, and it doesn’t control you.

How to Decide If You Should Consolidate Your Debt

To decide whether debt consolidation makes sense for you, take these steps. 

Assess your debt level

Take a close look at your total debt. If you face high interest rates and juggle multiple payments, consolidation might help. 

Compare interest rates

Next, compare the interest rates of your current debts with the rate you qualify for on a consolidation loan. If the new rate is significantly lower, you’ll save money over time, making consolidation a smart move.

Evaluate your credit score

Your credit score plays a role in the rate you receive from a lender. If your score has improved since you took on your original debts, you might qualify for better rates now.

Consider your monthly budget

Review your budget and consider whether you can comfortably afford the new consolidated payment. Consolidation often lowers monthly payments, but make sure that applies to your situation. 

Review long-term financial goals

Think about your long-term financial goals. If you prioritize being debt-free, consolidation might get you there faster. If you have other high-priority financial goals, make sure debt consolidation aligns with your plan to reach those milestones. 

Understand the costs

Find out about any fees for the consolidation loan, including origination fees or prepayment penalties. Be sure the benefits of consolidating outweigh these costs.

Explore alternatives

Before making a final decision, explore other debt relief options. Sometimes, a debt management plan or negotiating with creditors could also provide relief, so find the best fit for your situation.

Get professional advice

Finally, don’t hesitate to seek professional advice. A debt expert could offer personalized guidance, help you weigh the pros and cons, and decide if debt consolidation fits your goals.

Remember, you’re not alone in this. Taking these steps could help set you on a path to financial freedom. 

Debt Consolidation Failure: What Are Your Options?

What happens if you've careened down that slippery slope we mentioned earlier? What if you tried debt consolidation and then wound up with more debt? Or you turned to a debt management plan, but that didn't work out. Perhaps your circumstances changed, and you couldn't stick to the plan. 

Debt consolidation is not guaranteed to work for everyone. It may not work if you don't qualify for a consolidation loan, or if you can't afford the new monthly payments. Sometimes, debt consolidation doesn't work because it’s easy to overspend. 

If you can’t afford to repay your debt, here are a couple of options worth looking at:

• Debt settlement. You or a debt settlement specialist negotiate with your creditors to settle your debts for less than you owe.

• Personal bankruptcy. The legal process of bankruptcy can sometimes provide relief from the grind and stress of unmanageable debt.

Debt settlement may be a good choice for you if your debts are already in collections or past due, or if your balances keep growing despite your best efforts to reduce them. But there are some downsides. First, no company is required to negotiate with you or settle. Your creditors might sue you if they think you can afford to repay them. Second, forgiven amounts could be taxable if the IRS doesn’t consider you insolvent. 

If you choose debt settlement, take care in choosing your debt settlement specialist. Disreputable companies are in the minority, but they exist. Never pay any debt settlement provider a fee unless it arranges a settlement that you approve and want to pursue. Reputable companies never ask for payment before settling a debt. 

How do you know who's trustworthy and who isn't? The CFPB suggests that you contact your state Attorney General and local consumer protection agency. You can also read about other consumers’ experiences by checking out review sites like TrustPilot or the Better Business Bureau.