Pros And Cons Of Debt Consolidation

Between credit cards, student loans, and auto loans, it can be difficult to keep track of payments and balances on outstanding loans. Consolidating these debts into a single loan may streamline your finances, but this strategy probably won't fix the underlying financial challenges. For this reason, it is important to understand the advantages and disadvantages of debt consolidation before taking out a new loan.

To help you decide whether debt consolidation is the right way to pay off your debt, 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 personal loans 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. Similarly, some lenders make loan payments on behalf of the borrower, while others distribute the proceeds so that the borrower can make the payments himself.

With a balance transfer credit card, eligible borrowers get access to a 0% introductory APR for terms typically between six months and two years. The borrower can identify the balance they want to transfer while opening the card or can transfer the balance after the card is issued by the provider.

How does debt consolidation work?

Debt consolidation works by merging all of your debts into one loan. Depending on the terms of your new loan, it could help you get a lower monthly payment, pay off your loan sooner, raise your credit score, or simplify your financial life.

Debt consolidation is a three-step process:

1. take a new loan
2. Use the new loan to pay off your old loans
3. pay off new loan

For example, let's say you have $20,000 in credit card debt divided among three different cards, each with an interest rate greater than 20%. If you take out a $20,000 personal loan with an interest rate of 10% and a term of five years, you can pay off that loan faster and save money on interest.

Is Debt Consolidation a good idea?

Debt consolidation is usually a good idea for borrowers who have several high-interest loans. However, this can only be possible if your credit score has improved since you applied for the original loan. If your credit score is not high enough to qualify for a lower interest rate, there would be no point in consolidating your loans.

If you haven't addressed the underlying problems that led to your current debt, such as overspending, you may want to think twice about debt consolidation. Paying off multiple credit cards with a debt consolidation loan is no excuse for racking up balances, and it can lead to more significant financial problems in the future.

Benefits of Debt Consolidation

Consolidating your debt can have many benefits, including faster, more streamlined payments and lower interest payments.

1. Streamlines Finances

Consolidating multiple outstanding loans into a single loan reduces the number of payments and interest rates you have to worry about. Consolidation can also improve your credit by making you less likely to make late payments or miss payments altogether. And, if you're working towards a debt-free lifestyle, you'll have a better idea of when all your debt will be paid off.

2. Can get paid quickly

If your debt consolidation loan is earning less interest than personal loans, consider making additional payments with the money saved each month. This can help you pay off the loan earlier, thereby saving even more on interest in the long run. Keep in mind, however, that debt consolidation typically leads to longer loan terms – so you'll need to make sure you pay off your loan early to take advantage of this advantage.

3. Interest rate may come down

If your credit score has improved since applying for other loans, you may be able to lower your overall interest rate by consolidating loans -- even if you have mostly low-interest loans. Doing so can save you money over the entire term of the loan, especially if you don't consolidate loans with a longer loan term. To make sure you get the most competitive rate, shop around and focus on lenders that offer a personal loan pre-qualification process.

Remember, however, that some types of loans come with higher interest rates than others. For example, credit cards usually have higher rates than student loans. Consolidating multiple loans into a single personal loan can result in a rate that is lower than some of your loans but higher than others. In this case, focus on what you're saving.

4. Monthly payment can be lower

When consolidating loans, your overall monthly payment is likely to decrease because future payments are spread over a new, and perhaps extended, loan term. While this can be beneficial from a monthly budget perspective, it also means you may end up paying more over the life of the loan, even with a lower interest rate.

5. Can Improve Credit Score

Hard credit inquiries may result in a temporary drop in your credit score when you apply for a new loan. However, debt consolidation can also improve your score in a number of ways. For example, paying off revolving credit lines like credit cards can lower your credit utilization rate as reflected in your credit report. Ideally, your utilization rate should be less than 30%, and consolidating debt responsibly can help you accomplish this. Making consistent, on-time payments—and, eventually, paying off the loan—can also improve your score over time.

Cons of Debt Consolidation

A debt consolidation loan or balance transfer may seem like a good way to streamline credit card debt payments. That said, there are some risks and disadvantages associated with this strategy.

1. May come with additional cost

There may be additional charges involved in taking a debt consolidation loan such as origination fee, balance transfer fee, closing costs and annual fee. When shopping around for a lender, be sure you understand the true cost of each debt consolidation loan before signing on the dotted line.

2. Your interest rate may go up

Debt consolidation can be a smart decision if you qualify for a lower interest rate. However, if your credit score isn't high enough to access the most competitive rates, you may be stuck with a higher rate than your current loans. This could mean paying the principal fee, as well as paying more interest over the term of the loan.

3. You may end up paying more in interest over time

Even if your interest rate goes down during consolidation, you may end up paying more interest during the term of the new loan. When you consolidate loans, the repayment timeline starts from day one and can extend up to seven years. Your total monthly payment may be lower than you're used to, but the interest will continue to accrue over a longer period.

To circumvent this issue, budget a monthly payment higher than the minimum loan payment. This way, you can avail the benefits of a debt consolidation loan while avoiding additional interest.

4. You run the risk of missing a payment

Missing a payment on a debt consolidation loan—or any loan at all—can do major damage to your credit score; You may also have to pay additional charges for this. To avoid this, review your budget to make sure you can comfortably cover the new payment. Once you consolidate your loans, take advantage of autopay or any other tool that can help you avoid missed payments. And, if you think you might miss an upcoming payment, let your lender know as soon as possible.

5. Doesn't address underlying financial problems

Consolidating debt may make payments simpler, but it does not 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 rack up debt. So, if you're considering debt consolidation to pay off multiple maxed-out credit cards, take the time to develop healthy financial habits first.

6. May encourage increased spending

Similarly, paying off credit cards and other lines of credit with a debt consolidation loan can create the illusion of having more money than you actually have. It's easy for borrowers to fall into the trap of paying down the loan, only to find that their balance has piled up yet again.

Create a budget to cut expenses and stay on top of payments so you don't end up with more debt to begin with.

When should I consolidate my loan?

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:

• Large amount of debt. If you have a small amount of debt that you can pay off in a year or less, debt consolidation isn't worth the fees and credit checks associated with new debt.
• Additional plans to improve your finances. Although you can't avoid some debt – like medical debt – other debts are the result of overspending or other financially risky behavior. Before consolidating your debt, evaluate your habits and create a plan to get your finances under control. Otherwise, you could end up in even more debt than you were before you consolidated.
• High enough credit score to qualify for a lower interest rate. If your credit score has gone up since you took out other loans, you are more likely to qualify for a loan consolidation rate that is lower than your current rates. This can help you save on interest over the entire tenure of the loan.
• Cash flow that comfortably covers the monthly loan service. Consolidate your loans only if you have enough income to cover the new monthly payments. Although your overall monthly payment may be lower, consolidation is not a good option if you are currently unable to cover your monthly loan service.

How To Get Debt Consolidation Loan

Qualifying for a personal loan for debt consolidation can be simple and straightforward, especially if you have a good income and a solid credit history. Here's how to do it:

• Check your credit. Check your credit score and reports from all three major bureaus. Correct any errors that may negatively affect your credit score, and use your credit score to help inform which loans you may qualify for.
• Gather your loan application documents. This can speed up your loan application process as most lenders require the same documents. You'll need your most recent pay stubs, W-2s, bank statements and tax returns, etc.
• Get payment estimates from your current lenders. For any debt you're consolidating, you'll typically need a current loan payment statement that includes your balance, as well as any interest accrued since your last payment.
• Shop around for rates. Look for the best rates available to you online and in person. If possible, pre-qualify to see what rates you can get without affecting your credit score.
• submit your application. Choose the best option and complete your loan application. Respond promptly if the lender needs any additional information.
• Receive loan amount. Upon approval, your lender will contact you with details on how your loan amount is disbursed. Some lenders pay off your old creditors for you while others require that you do it yourself.

How long does debt consolidation stay on your credit report?

It depends on the type of information reported to the credit bureaus. If you miss a payment on your debt consolidation loan, that information will remain on your credit report for seven years before being automatically removed. However, positive information like loans you've repaid in good standing will stay on your credit report for a very long time – up to 10 years.