Is Debt Consolidation a Good Idea?

If you feel overwhelmed and in need of debt relief, consolidating your debt is one possible solution. 

Debt consolidation involves taking out a new loan and using it to pay off multiple debts you already have. For example, if you owe money on three credit cards, you could apply for a personal loan large enough to pay off all three.

When you consolidate debt, you can make it easier to repay what you owe. There are many reasons why, including the fact that you'll have one payment instead of many. Also, you may be able to lower your monthly payment and get some relief in your monthly budget. Plus, a consolidation loan should have a lower rate than what you're paying (or it wouldn’t make sense to take the new loan). That means more of each payment goes to your principal balance.

For all of these reasons, consolidating debt can be a good idea—especially under the right circumstances.

Why Consolidate Debt?

Debt consolidation involves getting one new loan to pay off multiple debts. While debt consolidation doesn't reduce the total balance you owe, it does accomplish other important goals. Here are some of the benefits you might enjoy if you consolidate your debt:

• Fewer payments. It can be tough to track multiple payments with different due dates. Consolidating some of those debts into a single payment makes keeping up with your monthly bills easier. 

• Lower monthly payments. Debt consolidation could lower your monthly payments. You can reduce your monthly obligations by choosing a debt consolidation loan with a longer repayment period or a lower interest rate.

• Lower interest expenses. Replacing high-interest debt with a low-interest loan could cut your financing costs. It may also lower your payment. 

• Improved credit score. Debt consolidation offers short- and long-term benefits for your credit score. It can improve your credit utilization ratio and help you avoid adding late payments to your credit history. 

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When Is Debt Consolidation a Good Idea?

Debt consolidation is a good idea in many different situations. Here are some examples of when consolidating your debt may be right for you:

• You have high-interest debt, such as credit card debt. Consolidation creates an opportunity to reduce the interest you're paying if you can qualify for a loan at a lower rate.

• You’re making high monthly payments. If you’re having trouble affording your bills, consolidating can provide relief by lowering your rate and allowing you to pay off your loan over a longer time.

• It’s hard to keep track of your monthly payments. When you consolidate multiple debts and end up with just one payment to make, it's much easier to keep track of

• You can qualify for an affordable consolidation loan. Usually, you'll need at least a fair or good credit score, or a cosigner, to get an affordable consolidation loan 

• You’ve made a commitment to rein in spending. Debt consolidation works best when it’s part of a broader program to follow a budget and pay off debt.

When Should You Think Twice About Debt Consolidation?

Despite its many benefits, debt consolidation isn't the best option for everyone. Here are some signs that you may want to explore other options for debt relief.  

• Your spending isn't in your control yet. Debt consolidation won't work well if you end up spending more after you consolidate your debts and free up room on your credit cards. 

• You can’t afford your payments even after debt consolidation. Make a detailed budget and plan ahead to decide if debt consolidation would make your monthly payments affordable. If not, you'll need to consider other options.

• You won't lower your interest rate. Reducing your rate is one of the biggest benefits of consolidation. If your rate were to stay the same, or even be higher, consolidation loses this advantage. 

• Your credit would make qualifying for a consolidation loan challenging. If you've missed payments or have other black marks on your credit record, you may not qualify for an affordable consolidation loan and should think about improving your credit before you borrow if you can.  

Alternatives to Debt Consolidation

Debt consolidation isn't the only way to tackle debt. Here are two other solutions that have helped many people to get rid of debt and build a brighter future.

Debt settlement

If you can’t afford to fully repay your debts, you may need to look into other options for debt relief, including debt settlement. 

Debt settlement means your creditors agree to accept less than the total amount you owe, then forgive the rest. 

When you settle your debt, you (or the debt relief company helping you) will negotiate with creditors to get them to accept payment for less than the full balance due. Usually, they'll only do this if they don't think they'll get paid otherwise. 

To afford to save up money to offer creditors, most people in a debt settlement program choose to stop making their debt payments. This lets you build up funds, and it also sends a clear financial distress signal to your creditors. It is very likely, however, to damage your credit.

Settled debt is usually reported as settled instead of fully paid. You'll also owe taxes on the forgiven amounts unless you are insolvent (your debts exceed your assets). 

In the end, you might be able to substantially reduce what you owe, which makes debt payoff much more affordable. You can start rebuilding your credit immediately the debt has been resolved. 

Debt Management Plan (DMP)

Like a debt consolidation loan, debt management plans allow you to stop making multiple payments to different creditors and to make one payment instead. However, with a DMP, you don't do this by getting a new loan and fully paying off your existing debt. 

Instead, when you enter into a DMP, you work with a credit card counseling professional who enrolls your credit card accounts into the plan and contacts each creditor to negotiate better terms. This could include waiving late fees or lowering interest rates. 

As part of participating in a debt management plan, you make a single payment, and your counselor distributes the money to your creditors. You usually have to close your credit cards so you can’t run up additional debt while paying off what you already owe. 

While DMPs can help make debt more affordable, you usually won't get a reduction in your balance. The monthly payment can be very high because it’s designed to clear your unsecured debts in three to five years. You can help make your DMP a success by finding the right credit counselor and by committing to avoiding new debt.  

How to Consolidate Debt

The success of debt consolidation depends on getting the right kind of debt consolidation loan. The good news is, you have many options for loan types, including the following:

• Home equity loan. Home equity loans offer some of the lowest interest rates available. Repayment terms last as long as 30 years—a plus if your main goal is lowering your payments. The downside is that home equity loans are secured loans. The home is the collateral. If for any reason you fail to repay the loan, you could lose your home. 

• Zero-interest credit card. Balance transfer cards allow you to pay 0% on a transferred balance for a limited time. You’ll typically pay a 3-5% fee for each balance that you transfer over to the new card. Balance transfers could work for someone who is prepared to fully pay off the debt during the low-interest promotional period. After that, any remaining balance jumps to a very high APR. A common pitfall with balance transfers is running the balances back up on the paid-off credit cards after you transfer the balances. This could leave you more deeply in credit card debt.

• Personal loan. Personal loans generally carry higher interest rates than home equity loans, but the rates are lower than credit cards. This could be a good option if you don’t have equity in a home, or if you’ll need more time to pay off your debt than the 0% period of a balance transfer card. 

Your situation is likely to determine the right kind of debt consolidation loan for you. In any case, consider whether the terms you’re able to get will work before you borrow.