Debt consolidation is one of those topics that you often see on late-night infomercials. Companies promise to decrease your payments and save you money on your debt, while simplifying the process.
But what does debt consolidation actually mean and can it really save you money? Read below to see the ins and outs and to see if debt consolidation makes sense for you.
Compare the Fees
Debt consolidation involves creating a new loan that merges several loans. People consolidate for many reasons, sometimes to save money, other times to simplify the payoff process.
Repaying multiple loans involves keeping track of several due dates, interest rates and payment processes. If you consolidate your loans, you will only have to make one payment a month, instead of many.
Like refinancing a loan, consolidating a loan involves going through a detailed process and will often result in extra fees. When deciding if consolidation will save you money, make sure to count the fees you will owe and if the math makes sense.
Typical fees include:
Origination fees: These can cost between 1-5% of the total loan amount. So if you owe $30,000 total, your origination fee can be between $300 to $1,500.
Balance transfer fees: If you decide to transfer your debt onto a new credit card, you will a balance transfer fee, between 3-5% of the loan.
Compare APRs, But Do the Math
The best scenario to use debt consolidation is when you're able to get a lower interest rate than your current loan. For example, let's say you have three credit cards that have balances and APRs of 19%, 23% and 25%.
If you are able to transfer those balances onto one new card with an APR of 0% for 12 months, then you may be able to save money while consolidating your debt.
But APRs aren't the only thing you need to compare. Many debt consolidation programs extend your payment plans, so even with a lower rate, you could still end up paying more over the long haul. Make sure to compare the total cost of interest that you will pay over the entire term of your current loan compared to the new loan. This will ensure you make a decision that will save you money, instead of spend more of it.
A Word of Warning
While consolidating your debt can make it easier to keep track of your debt, it may not necessarily save you money. Some consolidation programs don't decrease your total loan or interest – they only extend your payments. This means that you will pay more interest over the long run, while delaying when you will pay off your debt.
Some people use debt consolidation to lower their payments while they set up a retirement account or emergency fund. Others use to create some breathing room in their budget.
Some also claim that debt consolidation is like signing up for Weight Watchers when you're overweight. The program will work while you're on it, but it might not help you learn to manage your debt and live within your means.