Pros and Cons of Debt Consolidation
If you find yourself searching for ways to pay down debt, reduce your monthly payments, or combine several accounts into one, debt consolidation is one potential solution to consider.
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When you owe multiple high-interest debts, such as credit cards or personal loans, reducing those debts can be a challenge. Depending on your financial situation, it might even be a struggle to stay on top of your monthly payments. If you find yourself searching for ways to pay down debt, reduce your monthly payments, or combine several accounts into one, debt consolidation is one potential solution to consider.
Using a loan or a balance transfer credit card to consolidate your debt could benefit you if you can qualify for a lower interest rate than you're paying now. In some cases, this strategy might empower you to pay down your debt faster as well. Yet with any type of financing there is a measure of risk involved, and debt consolidation is no exception to this rule. As a result, it's important to review the pros and cons of debt consolidation before you decide whether this type of financial streamlining could work for you.
What Is Debt Consolidation?
Debt consolidation is the process of rolling multiple financial obligations (e.g., credit card debts, loans, medical bills, student loans, etc.) into a single account. In an effort to save money, a consumer may try to secure a lower interest rate on the new account they use for debt consolidation purposes. But there can be other motivations for debt consolidation as well, such as reducing the number of payments a consumer must manage on a monthly basis.
Ways to Consolidate Debt
There are multiple ways to consolidate debts. Some of the most popular options are as follows.
- Debt Consolidation Loan: A debt consolidation loan is a type of personal loan you can use to pay off outstanding balances you owe to other lenders, creditors, and credit card issuers.
- Balance Transfer Credit Card: Some credit card issuers will allow you to use a portion of your credit limit to consolidate debt. Some balance transfer credit card offers may give qualified cardholders access to a 0% or low APR for balance transfers on a temporary basis. However, additional balance transfer fees will often apply as well.
- Home Equity Loans: Eligible homeowners may also consider using the equity in their homes to qualify for a home equity loan or home equity line of credit (HELOC) to use for debt consolidation purposes. Since the equity in your home secures these financing options, lenders may be willing to offer lower interest rates and longer repayment terms. However, you put your home at risk if you cannot repay the debt as promised.
Pros of Debt Consolidation
Debt consolidation isn't ideal for everyone. But under the right circumstances it may offer several potential benefits.
1. Save money
If your FICO® Scores have improved since you last applied for financing or if lower interest rates are available, it might be possible to save money through a lower APR on a new debt consolidation loan or balance transfer credit card. A lower APR could reduce your overall interest costs by hundreds or even thousands of dollars depending on the situation.
You can use myFICO's online calculator to crunch the numbers and see how much money you might save through debt consolidation. Here's a simple example to illustrate the savings potential a debt consolidation loan might offer.
Imagine you want to consolidate the balances on the following three credit cards.
- Credit Card #1: $2,500 Balance, 18% APR
- Credit Card #2: $2,500 Balance, 19% APR
- Credit Card #3: $5,000 Balance, 20% APR
If you can qualify for a 24-month debt consolidation loan with a 10% APR and 3% origination fee, you could save $44 per month and $1,052 overall (assuming you paid your credit card accounts with the intention of wiping out your total debt over the next 24 months).
Of course, if you're able to lock in a lower interest rate the savings potential could be even more pronounced. A debt consolidation loan with an 8% APR and no origination fee, for example, could save you $53 per month and $1,272 in the same scenario.
2. Get out of debt faster
Another possible perk of debt consolidation is the possibility of paying off your debt faster. If you qualify for a lower APR on a new loan or balance transfer credit card, you could opt to use the money you save in interest and pay down your debt at a more rapid rate.
Revisiting the example above, let's imagine that you qualify for an 8% APR on a debt consolidation loan with no origination fee. However, instead of pocketing the $53 savings per month or applying the funds toward another area of your budget, you apply those funds toward the principal balance of your loan. This decision could shorten your repayment term and save you additional money in interest charges.
3. Improve your FICO® Scores
Debt consolidation might also have a positive impact on your FICO® Scores in certain situations. Imagine you use an installment loan (like a personal loan or a home equity loan) to pay off revolving credit card balances and reduce your credit utilization ratio in the process. In many cases, lowering your credit utilization may influence your FICO Scores in a positive way.
Of course, it's important to manage your new debt consolidation loan or balance transfer credit card in a responsible way. Otherwise, the new account could have a negative impact on your FICO® Scores rather than a positive one. Payment history is a major factor in FICO Score calculations—worth 35% of your score. Therefore, on-time payments are essential both before and after debt consolidation.
Cons of Debt Consolidation
Although debt consolidation may appeal to many people, there are drawbacks to deserve your consideration as well.
1. A lower interest rate isn't guaranteed
Lenders often reserve their best interest rate offers for applicants with exceptional FICO® Scores. And credit card issuers often require good to excellent credit to qualify for balance transfer credit card offers as well. If your credit isn't in the best shape, you might be unable to qualify for a lower interest rate on a debt consolidation loan or balance transfer credit card compared to what you're paying current creditors.
2. You could pay more over time
Even if you qualify for a lower interest rate when you apply to consolidate debt, that doesn't guarantee you'll save money in the long run. With debt consolidation loans and home equity loans, your new repayment term could extend longer than your original loan term. Your new repayment term might also be longer than you would have taken to pay off your credit card debt. In such scenarios, you could find yourself paying a lower monthly payment, but more interest overall.
There's another factor that could increase your total borrowing costs when you consolidate debt—fees. Origination fees and other costs are common among certain lenders (especially for borrowers with less-than-perfect credit). And with balance transfer credit card offers, you may incur balance transfer costs as well. These fees can vary but are commonly 3%-5% of the total balance you transfer to your new account.
Debt consolidation can be a helpful way to save money and expedite debt elimination efforts under the right circumstances. But it's not a one-size-fits all solution for everyone.
Before you apply for a loan or credit card to combine your high-interest debts, take the time to consider the benefits and drawbacks above. You should also crunch the numbers to make sure debt consolidation make sense for your specific financial situation.
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