Debt consolidation allows consumers to combine multiple loans or liabilities, usually by taking out another loan in order to pay off existing debts. In general, consolidating accounts makes it possible for borrowers to put more of their payment toward reducing the principal, rather than spending so much money paying accrued interest.
Consider a person with $5,000 in credit card debt at 16% interest, $10,000 in student loans at 6% interest, and another credit card at $2,500 and 11% interest. If she pays $300, $600, and $200 respectively to each loan, a significant chunk of each payment goes to paying interest before being applied to the principal balance. This means that it takes longer to pay off all the debts than if they were rolled into a single loan at a lower rate.
Another good reason to consolidate loans is to make payments less confusing. If you are working to pay off more than a few loans, it can be hard to keep track of due dates and statements that come in the mail. Working through all of this information can take a lot of time and most people are not so hyper-organized, which means that there may be missed payments and resulting fees to deal with. Through consolidation, borrowers can aggregate all of their loans into one, with one statement and one monthly due date.
By consolidating loans, many people are able to lower their payments as well as their interest rates. However, it is important to sit down and calculate the savings (or costs) of consolidation before committing to it. If you choose to consolidate, make sure it will actually result in savings. A loan calculator can show you how long it takes to pay off a consolidation loan and the total interest charged. Don’t sign on for a consolidation loan without running the numbers, and be wary of variable rate loans (loans that start out with a low rate, but jump up after a certain period of time).
Debt consolidation is for people who are serious about paying down debt right now. If you are ready to make major headway in paying off debt and you have found a consolidation loan with a good rate, then consolidation is the way to go. If you can’t limit future spending, now is not a good time to consolidate. Debt consolidation really only works if one is willing to limit other expenditures and pay off the total debt faster; otherwise, the interest accrues very quickly and the consolidation is no longer useful.
This post was written by Angie Picardo, a writer for the personal finance website NerdWallet, where you can find advice on a range of topics from managing credit debt to saving money with Atlanta airport parking.