Is Debt Consolidation a Good Idea: Pros and Cons[yoast-breadcrumb]
Is Debt Consolidation a Good Idea: Pros and Cons
Debt consolidation can seem like a great option when you’re struggling with high interest rates and multiple payments on different credit cards or loans. But is consolidating your debt really the best move? Here, we’ll go over the pros and cons so you can make an informed decision.
What is Debt Consolidation?
Debt consolidation simply means combining multiple debts into one new loan or payment plan. For example, you might take out a new personal loan to pay off five different credit cards. Now you only have to make one monthly payment on the loan instead of five payments on the cards.
There are a few main ways to consolidate debt:
- Balance transfer credit cards – Transfer balances from high-interest cards to a new card with a temporary 0% intro APR
- Debt consolidation loans – Take out a personal loan to pay off credit cards and other debts
- Home equity loans or lines of credit – Use your home equity to pay off debts
- Debt management plans – Work with a credit counseling agency to repay debts through one monthly payment
The goal is to simplify your finances by streamlining multiple payments into one and ideally lowering your interest rate. This can make repayment easier and help you pay off debt faster.
The Pros of Debt Consolidation
There are some solid advantages to debt consolidation that make it appealing for many consumers.
1. Lower Interest Rates
This is one of the biggest pros. By consolidating debt to a balance transfer credit card or debt consolidation loan, you can potentially lower your interest rate significantly. This saves you money on interest charges and helps more of your payment go toward the principal balance.
For example, if you transfer $10,000 from a credit card with a 19.99% APR to one with a 0% intro APR for 12 months, you could save around $1,500 in interest during that time. Every dollar not going to interest is a dollar you can put toward paying down your balance.
2. Single Monthly Payment
Instead of tracking multiple payment due dates and amounts each month, you’ll have one simple payment to make on your consolidation loan or credit card. This can make budgeting easier and takes some of the stress out of debt repayment.
Having just one monthly bill to pay can help you avoid late fees and keep you on track with payments. It consolidates the process.
3. Fixed Interest Rate
Most debt consolidation loans come with a fixed interest rate, meaning your rate stays the same over the life of the loan. This gives you payment stability and predictability. In contrast, credit cards often have variable rates, so your rate can go up over time as interest rates rise.
The fixed rate of a debt consolidation loan locks in your savings from lower interest and protects you from rate hikes.
4. Set Repayment Period
Credit cards allow you to carry a balance indefinitely, which can lead to years of expensive interest charges. With a debt consolidation loan, you’ll have a set repayment term such as two, three, or five years. This gives you a finish line to focus on.
Having an end date in sight can provide motivation to stick to your monthly payments. It forces you to repay the debt on a schedule instead of carrying it indefinitely.
5. Improve Credit Score
An added benefit of debt consolidation can be a boost to your credit score. As you pay down your loan balance each month, your credit utilization rate drops. Having lower utilization can improve your credit scores.
Just be sure to keep your credit cards open after consolidating to keep your overall credit limit high. Closing cards lowers your limit and raises utilization.
The Cons of Debt Consolidation
Debt consolidation also comes with some potential drawbacks to be aware of.
1. Credit Inquiries
When you apply for a new balance transfer card or consolidation loan, the lender will check your credit report. This results in a hard inquiry on your credit file, which could cause a small, temporary drop in your credit scores.
Too many new inquiries in a short period can be detrimental, so avoid applying for multiple consolidation options. Compare offers pre-qualified through a soft credit check first.
2. Balance Transfer Fees
Balance transfer credit cards often charge a fee of 3-5% of the amount transferred. On a $10,000 balance transfer, that’s $300 to $500 in fees. This cuts into the savings from the 0% APR.
However, you could still come out ahead if the fee is less than the interest you’d pay otherwise.
3. Closing Accounts
When you pay off credit card balances through consolidation, you may be tempted to close those accounts. But this can hurt your credit utilization and ultimately your scores.
Keep accounts open even if you pay them off through consolidation. Having more available credit helps utilization and average account age.
4. Loan Denial
Debt consolidation loans are unsecured personal loans, so approval is based heavily on your credit and income. If your credit is poor or your income is too low, you may not qualify for one of these loans.
Lenders want to see you can afford the new monthly payment. A cosigner or collateral like a car may help with approval odds.
5. Prepayment Penalties
One pitfall to watch out for is prepayment penalties with debt consolidation loans. Some personal loans charge a penalty fee if you pay off the loan early. This could limit your flexibility.
A prepayment penalty might kick in if you pay extra or pay off the loan entirely within the first two or three years. The fee is usually around 1-5% of the remaining balance.
Be sure to ask about prepayment policies when comparing loan offers. Opt for a lender that doesn’t charge these fees.
6. Credit Card Use After Consolidating
It can be tempting to use your newly paid off credit cards again after consolidating debts. But this can easily put you back into the debt cycle and negate the benefits.
A better strategy is to cut up old cards and refrain from using credit. Stick to only making the single monthly consolidation payment. Pay with cash or debit as much as possible.
7. Extending Loans Too Long
Personal loans allow repayment terms from two to seven years typically. It’s best to choose the shortest term you can afford.
A longer loan length means you’ll pay more total interest. And it’s easier to fall back into debt without the urgency of a short-term loan.
8. Failing to Change Habits
Consolidating debts provides a fresh start but doesn’t fix underlying issues like overspending. You need to make lifestyle changes too.
Look at your budget and find areas to cut back like dining out, entertainment, and discretionary purchases. Funnel the savings toward extra debt payments.
Debt consolidation works best for those willing to change financial habits. Otherwise, you risk racking up new debt and being in a worse spot.
The Bottom Line
Debt consolidation can make repayment more manageable through lower interest rates and a single monthly bill. But it also comes with risks like penalties and increased temptation to overspend.
Look at your specific debt situation and research options thoroughly before making a decision. Weigh the pros and cons carefully.
With smart planning, debt consolidation can be a helpful tool on the path to becoming debt-free. But it’s not a magic solution, so be realistic about its limits.