Is Debt Consolidation a Good Idea?

Debt consolidation can be a powerful tool for managing your financial obligations. Like all tools, though, it only works if you use it correctly. 

Debt consolidation can lower your monthly payments and reduce the cost of your debt. It can even make your payments easier to track.

However, debt consolidation is not good for everybody, and you should recognize the risks. Knowing the pros and cons of debt consolidation helps you make the right decision.

This article covers the following:

• Why consolidate debt?

• When is debt consolidation a good idea?

• When is debt consolidation a bad idea?

• Alternatives to debt consolidation

• How to consolidate debt

• Is debt consolidation a good idea: FAQs

The goal is to help you answer the question is debt consolidation a good idea for your situation? If so, this article will show you how to get started. 

Why Consolidate Debt?

Debt consolidation means borrowing money from one source to pay off debts from multiple sources. 

Since that doesn’t reduce the amount you owe, what does debt consolidation accomplish?

There are a few potential benefits. They don’t all apply to every situation, but you may decide any of these benefits is worthwhile:

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

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

• Less interest expense. Replacing high-interest debt with a low-interest loan cuts your financing cost. It may also lower your payment. 

• Improved credit score. Debt consolidation offers short-term 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?

The benefits of debt consolidation sound good, but they may not apply in every situation. So when is debt consolidation a good idea? Here are some key conditions that can make it work:

• You have high-interest debt, like credit card debt. This creates an opportunity to reduce the interest you pay through debt consolidation.

• You’re making high monthly payments on short-term debts. If you’re having trouble affording those payments, it may help to stretch them over a longer period with a debt consolidation loan.

• It’s hard to keep track of your monthly payments. Organizing some or all of those into a single payment can help you avoid missing deadlines.

• Your credit is still in decent shape. This improves your chances of qualifying for a good debt 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 reduce debt.

When Is Debt Consolidation a Bad Idea?

Despite its many benefits, debt consolidation is not a cure-all for every situation. Here are some signs that debt consolidation may not work for you:

• You have a spending problem. Debt consolidation is the worst thing you can do if you have not addressed your problem and committed to a budget. Experts estimate the failure rate of debt consolidation to be as high as 85%.

• You can’t afford your payments even after debt consolidation. This is another reason budgeting is important. Plan ahead to see if debt consolidation would make your monthly payments affordable. If not, consider other options.

• Most of your debt has low interest rates. One of the best reasons to consolidate debt is to lower your interest rate. It’s not usually a great idea to take a loan with a higher rate than you currently have.

• Your credit is too damaged for you to get a good debt consolidation loan. If you’re struggling to make your payments, a good debt consolidation loan may make them more affordable. But if your credit is already damaged, you may not qualify for that kind of debt consolidation loan. 

Alternatives to Debt Consolidation

If debt consolidation can’t solve your problems, there are alternatives you can consider.

Debt Management Plan (DMP)

Debt management plans consolidate your debt without a debt consolidation loan. DMPs are administered by credit counseling agencies. A counselor enrolls your credit card accounts into the plan and contacts each creditor to negotiate better terms – waiving late fees, lowering interest rates, and reducing payments. You make a single payment into the plan and your counselor distributes it 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. The downside of DMPs is that payment reductions are small, which makes them unaffordable for many. Because of this, debt management plans have a success rate of only 21%, according to the Federal Trade Commission (FTC). 

Debt relief (debt settlement)

When your debt is unaffordable and your credit is already damaged, a debt relief firm may be able to provide more help than a DMP or debt consolidation lender. Debt consultants contact your unsecured creditors to negotiate a lower payoff for your debt. This is only likely if you demonstrate that you can’t afford to pay the full amount. Debt settlement completion rates, according to the FTC, “range from 35% to 60%, with the average around 45% to 50%.”

Fees for debt relief services are about 25% of the amounts enrolled and you only pay fees if you get an acceptable settlement. You will also owe taxes on amounts forgiven unless you are insolvent (your debts exceed your assets).  

Done correctly, debt consolidation offers profound benefits. In contrast, debt management plans and debt relief involve some trade-offs -- some negative consequences to go with the benefits.  

That means debt consolidation is preferable if conditions are right, but debt management or debt settlement can be the right solution for more serious debt problems. 

How to Consolidate Debt

As you might imagine, the success of debt consolidation depends on getting the right kind of debt consolidation loan. What are some good candidates for debt consolidation loans?

Here are some possibilities:

• Home equity loan. Home equity loans offer some of the lowest interest rates available. In addition, you can find terms as long as 30 years – a plus if your main goal is lowering your payments. The downside is that rates are low because lenders can foreclose on you and sell your house if you can’t make the payments.

• Zero-interest credit card. Balance transfer cards offer low or even 0% interest for an introductory period that ranges from six to 24 months. This can make them an attractive debt consolidation option. Two things to watch out for: balance transfers fees that average 3% of the balance reduce your savings, and rates after the introductory period expires can be high. Make sure you can pay off most or all of the loan within the 0% interest period.

• Personal loan. These loans generally carry higher interest rates than mortgages or balance-transfer credit cards but lower than credit cards. Terms range from one to 12 years. This may be the right 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.