Between credit cards, student loans and auto loans, it can be difficult to keep track of payments and balances on outstanding debts. Consolidating these debts into a single loan may streamline your finances, but the strategy likely won’t fix underlying financial challenges. For that reason, it’s important to understand the pros and cons of debt consolidation before committing to a new loan.
To help you decide whether debt consolidation is the right way to pay off your loans, we’ll walk you through the advantages and disadvantages of this popular strategy.
What Is Debt Consolidation?
Debt consolidation is the process of paying off multiple debts with a new loan or balance transfer credit card—often at a lower interest rate.
The process of consolidating debt with a personal loan involves using the proceeds to pay off each individual loan. While some lenders offer specialized debt consolidation loans, you can use most standard personal loans for debt consolidation. Likewise, some lenders pay off loans on behalf of the borrower, while others disburse the proceeds so the borrower can make the payments themselves.
With a balance transfer credit card, qualified borrowers typically get access to a 0% introductory APR for a period between six months and two years. The borrower can identify the balances they want to transfer when opening the card or transfer the balances after the provider issues the card.
Is Debt Consolidation a Good Idea? Debt consolidation is usually a good idea for borrowers who have several high-interest loans. However, it may only be feasible if your credit score has improved since applying for the original loans. If your credit score isn’t high enough to qualify for a lower interest rate, it may not make sense to consolidate your debts.
You may also want to think twice about debt consolidation if you haven’t addressed the underlying problems that led to your current debts, like overspending. Paying off multiple credit cards with a debt consolidation loan is not an excuse to run up the balances again, and it can lead to more substantial financial issues down the line.
Pros of Debt Consolidation
Consolidating your debt can have a number of advantages, including faster, more streamlined payoff and lower interest payments.
1. Streamlines Finances
Combining multiple outstanding debts into a single loan reduces the number of payments and interest rates you have to worry about. Consolidation can also improve your credit by reducing the chances of making a late payment—or missing a payment entirely. And, if you’re working toward a debt-free lifestyle, you’ll have a better idea of when all of your debt will be paid off.
2. May Expedite Payoff
If your debt consolidation loan is accruing less interest than the individual loans would, consider making extra payments with the money you save each month. This can help you pay off the debt earlier, thereby saving even more on interest in the long run. Keep in mind, however, that debt consolidation typically leads to more extended loan terms—so you’ll have to make a point of paying your debt off early to take advantage of this benefit.
3. Could Lower Interest Rate
If your credit score has improved since applying for other loans, you may be able to decrease your overall interest rate by consolidating debts—even if you have mostly low-interest loans. Doing so can save you money over the life of the loan, especially if you don’t consolidate with a long loan term. To ensure you get the most competitive rate possible, shop around and focus on lenders that offer a personal loan prequalification process.
Remember, though, that some types of debt come with higher interest rates than others. For example, credit cards generally have higher rates than student loans. Consolidating multiple debts with a single personal loan can result in a rate that is lower than some of your debts but higher than others. In this case, focus on what you’re saving as a whole.
4. May Reduce Monthly Payment
When consolidating debt, your overall monthly payment is likely to decrease because future payments are spread out over a new and, perhaps extended, loan term. While this can be advantageous from a monthly budgeting standpoint, it means that you could pay more over the life of the loan, even with a lower interest rate.
5. Can Improve Credit Score
Applying for a new loan may result in a temporary dip in your credit score because of the hard credit inquiry. However, debt consolidation can also improve your score in a number of ways. For example, paying off revolving lines of credit, like credit cards, can reduce the credit utilization rate reflected in your credit report. Ideally, your utilization rate should be under 30%, and consolidating debt responsibly can help you accomplish that. Making consistent, on-time payments—and, ultimately, paying off the loan—can also improve your score over time.
Cons of Debt Consolidation
A debt consolidation loan or balance transfer credit card may seem like a good way to streamline debt payoff. That said, there are some risks and disadvantages associated with this strategy.
1. May Come With Added Costs
Taking out a debt consolidation loan may involve additional fees like origination fees, balance transfer fees, closing costs and annual fees. When shopping for a lender, make sure you understand the true cost of each debt consolidation loan before signing on the dotted line.
2. Could Raise Your Interest Rate
If you qualify for a lower interest rate, debt consolidation can be a smart decision. However, if your credit score isn’t high enough to access the most competitive rates, you may be stuck with a rate that’s higher than on your current debts. This may mean paying origination fees, plus more in interest over the life of the loan.
3. You May Pay More In Interest Over Time
Even if your interest rate goes down when consolidating, you could still pay more in interest over the life of the new loan. When you consolidate debt, the repayment timeline starts from day one and may extend as long as seven years. Your overall monthly payment may be lower than you’re used to, but interest will accrue for a longer period of time.
To sidestep this issue, budget for monthly payments that exceed the minimum loan payment. This way, you can take advantage of the benefits of a debt consolidation loan while avoiding the added interest.
4. You Risk Missing Payments
Missing payments on a debt consolidation loan—or any loan—can cause major damage to your credit score; it may also subject you to added fees. To avoid this, review your budget to ensure you can comfortably cover the new payment. Once you consolidate your debts, take advantage of autopay or any other tools that can help you avoid missed payments. And, if you think you may miss an upcoming payment, communicate that to your lender as soon as possible.
5. Doesn’t Solve Underlying Financial Issues
Consolidating debt can simplify payments but it doesn’t address any underlying financial habits that led to those debts in the first place. In fact, many borrowers who take advantage of debt consolidation find themselves in deeper debt because they didn’t curb their spending and continued to build debt. So, if you’re considering debt consolidation to pay off multiple maxed-out credit cards, first take time to develop healthy financial habits.
6. May Encourage Increased Spending
Similarly, paying off credit cards and other lines of credit with a debt consolidation loan may create the illusion of having more money than you actually have. It’s easy for borrowers to fall into the trap of paying off debts, only to find their balances have climbed once again.
Make a budget to reduce spending and stay on top of payments so you don’t end up racking up more debt than you started with.
When You Should Consolidate Your Debt
Debt consolidation can be a wise financial decision under the right circumstances—but it’s not always your best bet. Consider consolidating your debt if you have:
A large amount of debt. If you have a small amount of debt you can pay off in a year or less, debt consolidation is likely not worth the fees and credit check associated with a new loan.
Additional plans to improve your finances. While you can’t avoid some debts—like medical loans—others are the result of overspending or other financially dangerous behavior. Before consolidating your debt, evaluate your habits and come up with a plan to get your finances under control. Otherwise, you may end up with even more debt than you had before consolidating.
A credit score high enough to qualify for a lower interest rate. If your credit score has increased since taking out your other loans, you’re more likely to qualify for a debt consolidation rate that’s lower than your current rates. This can help you save on interest over the life of the loan.
Cash flow that comfortably covers monthly debt service. Only consolidate your debt if you have enough income to cover the new monthly payment. While your overall monthly payment may go down, consolidation is not a good option if you’re currently unable to cover your monthly debt service.