Pros and Cons of Debt Consolidation

Debt consolidation is a popular debt reduction strategy that can be effective – or it can leave you worse off than before. You can improve your odds of success if you understand the pros and cons of debt consolidation. 

What Are Debt Consolidation Pros and Cons?

So what are the pros and cons of debt consolidation? Well, done correctly, you should see all pros and no cons. 

But many people don't get their debt consolidations right. And, for them, the cons can easily outweigh the pros. 

How much debt?

The Federal Reserve Bank of New York reports that, by the end of 2021, American debt among consumers had risen to $4.33 trillion. And that consumer debt excluded housing debt, primarily mortgages and second mortgages, of $11.25 trillion. So, we're looking at $15.58 trillion in total. 

Of course, most people can stay comfortably on top of their commitments most of the time. But it's not surprising many can't. So don't be embarrassed if you're one of those who are struggling. Take a breath and explore your options. 

Debt consolidation may ease your burden. But make sure you consolidate your debts with great care. Because it's really easy to end up worse off than you already are.

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Debt Consolidation Pros

Your debt consolidation's benefits can be enormous, and its drawbacks zero. But only if you use the process wisely. Those benefits often include:

Lower interest rate

You'll probably want to consolidate only those debts that carry a higher interest rate than your debt consolidation loan. So, your new loan will have a lower interest rate than your old loans. 

That's why balances on credit cards are the most common type of debt to benefit from debt consolidation. Most forms of borrowing have lower interest rates than those. 

But, especially if your credit score has improved recently, you may find that the rates you're paying on your auto loans, personal loans, and other types of debt are higher than the rate you'll pay on your new loan. If that's the case, by all means, consolidate those at the same time. 

The main exception to that is consolidating student debt. It can be a good idea. But sometimes it isn't because you could lose valuable protections like income-driven repayment plans. So make sure you understand the implications before going ahead. 

Easier money management

The more active accounts you have, the harder it is to manage your money well. And, during busy or difficult times, you might even accidentally skip a payment.

After you've consolidated your debts, you have only one payment to worry about each month instead of one each for all the accounts you've cleared. Set up an auto-pay arrangement for that, and you can really relax. 

Lower monthly payment

You will probably have a lower monthly payment if you consolidate only debts with higher interest rates than your new loan. (However, that’s not always the case if the payoff is faster.) If you choose a consolidation loan with a lower payment, you’ll have more money left over at the end of each month for yourself.

And you can make that monthly payment even lower if you change your repayment schedule. Because the longer the period over which you spread your payments, the lower each of those payments should be. So choose a longer term for your new loan if your debts are a real burden.

However, be aware that the longer your new loan lasts, the longer you'll be paying interest. And that increases the loan’s cost in the long run. So try to balance your need for a lower payment with your desire to keep your borrowing costs down. 

Higher credit score

Your "credit utilization ratio" plays a big part (30%) in determining your credit score. It's the proportion of a store or credit card's credit limit that you're using. So a card that's maxed out has a 100% ratio. And a card with a zero balance has a 0% one. 

According to FICO, the company that builds the most widely used scoring technologies, the golden rule is never to let a balance exceed 30% of that card's credit limit. Because every month it's higher will harm your credit score. So, if your limit on a card is $1,000, you need to keep your balance at or below $300 ($1,000 x 30% = $300).

Of course, if you consolidate the debt on all your credit cards, you'll zero all your balances. And, assuming at least some of your balances are currently above that 30% level, you should see your score materially improve within a few months.

Naturally, that won't work if you mess up your score in some other way: by making a late payment, for example. But debt consolidation should make late and missed payments less likely. So you should see a higher score soon, which means easier and less costly borrowing in the future. 

Note that your credit score is most impacted (35%) by your credit history. And it can take seven (or sometimes 10) years for bad things to disappear. But those adverse items become less and less important as time passes. 

So, never give up on your credit score as a lost cause. With determination and patience, everyone can transform a poor score into a good one.

Debt Consolidation Cons

By far the biggest pitfalls in debt consolidation occur when people run up debt again. It's easy to do. 

When you consolidate, it can feel like an enormous load has been lifted from your shoulders. And, suddenly, you have credit and store cards with zero balances. What's the harm in indulging yourself with an occasional treat?

There may be no harm in that. But it rarely ends there because people forget that debt consolidation doesn’t magically wipe out their debts. It merely reorganizes them. This is a slippery slope with a disaster waiting at the bottom. And all too many people who consolidate their debts careen down that slope.

Debt Consolidation the Right Way

The first thing to recognize is after debt consolidation, you still owe the money. Perhaps even more if there are loan fees involved. Understand that debt consolidation is not some routine financial tool that everyone uses from time to time. It's a huge red flag warning you that your finances are out of control. And it's an opportunity to take back that control.

Federal regulator the Consumer Financial Protection Bureau (CFPB) recommends a three-step approach before you begin to consolidate. Here, word for word, is what its website says:

1. 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.

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

3. 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 is crucial. Of course, you may be struggling financially because you've been sick or unemployed or have faced some exceptional bills. That's less of an issue.

Budgeting

But, if you're simply spending more than you earn to prop up your lifestyle, that's unsustainable. And, eventually, you're inevitably going to run out of road. 

So move on to the CFPB's second point and make a budget. Yes, it's boring and can be hard work. But making one (and sticking to it) may be your only way to move forward so that you control your money rather than the other way round.

Debt Consolidation Loan vs. Debt Management Plan

What can you do if your budget reveals that your income is too small to support your debt payments and essential living expenses even after debt consolidation? It happens. 

That's when you might have to try a debt management plan (DMP). With one of these, you work with a credit counselor, who may negotiate lower payments and interest rates on your behalf. And that should reduce your monthly debt costs. There are downsides to this. You'll have to close your credit card accounts, and you'll likely see a temporary reduction in your credit score. 

A DMP doesn't reduce the amount you owe. So, it has that in common with debt consolidation. But it does simplify debt repayment by combining several accounts into one plan with one payment. And it can make your debt more affordable. However, debt management plans do not have a high success rate (only about one in four clear their debts in a DMP) because many cannot afford the monthly payment.

Debt Consolidation Failure: What Are Your Options?

What happens if you've careened down that slippery slope we mentioned earlier? In other words, you tried debt consolidation and then blew it by building up yet more debt.

Well, the obvious choice is to turn to a debt management plan. But what if that, too, didn't work out? Perhaps your circumstances changed so you couldn't stick to the plan. 

If you can’t afford to repay your debt, you’re typically left with only two choices:

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

2. Personal bankruptcy – Most of us see that as a last resort. But, if you've run out of options, it can provide welcome relief from the grind and stress of managing unmanageable debt.

Many see debt settlement as the preferable alternative. And it can certainly work well. But there are some downsides – first, no company is required to negotiate with you or settle for less. Your creditors could decide to 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 will 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.