Is Debt Consolidation a Good Idea?
You’ve racked up multiple forms of debt over the years, and now you’re ready to pay off your debt once and for all. Perhaps you’re wondering, is debt consolidation a good idea?
Debt consolidation is a way to combine all your debt and pay it off more easily in one monthly bill. It may be a good idea if you find a decent interest rate and stick to a repayment plan, but it can also come with fees and might not get you out of debt more quickly.
If you’re considering debt consolidation, read up on what to expect.
What is debt consolidation?
Debt consolidation is a way to repay debt. Typically with debt consolidation, you will take out a new loan or line of credit and use it to pay off your existing debt. This allows you to combine multiple kinds of debt — like credit cards, medical bills and personal loans — and repay it on a more manageable payment plan. Instead of juggling three or four payments (or more), you will have a single bill every month.
Common ways to consolidate debt include:
- Debt consolidation loans : Such a loan is a personal loan you use to pay off debt. Debt consolidation loans typically come with a fixed interest rate and a fixed loan term. They can be secured or unsecured loans. (A secured loan is backed by collateral like your car; an unsecured loan isn’t.)
- Balance transfer credit cards: You may be able to move existing debt onto a balance transfer credit card, which typically offers a low- or no-interest promotional APR for a set period of time. As long as you pay off the balance before the promotion expires, your debt will stay relatively interest-free.
- Other types of loans: It’s possible to consolidate your debt and pay it off with other types of loans, like 401(k) loans, home equity loans and home equity lines of credit (HELOCs). These loans are all backed by collateral, like a home or retirement savings.
- Debt management plan: A nonprofit credit counselor can set up a straightforward debt repayment plan for you and also teach you about healthy financial habits. You may be asked to close credit card accounts, but if you’ve struggled with unmanageable debt for years, this type of program can provide the support you need.
With debt consolidation, no single approach will work for everyone. The best solution for you will depend on the scope of your debt, your financial history and also your priorities.
Debt consolidation might be a good idea if …
It makes repayment cheaper or easier to manage
Debt consolidation can either shorten or extend your repayment timeline, and both possibilities may help you in the end.
Let’s take debt consolidation loans, which typically come with 12- to 60-month terms or longer.
- A short-term loan could make debt repayment faster and cheaper. You might be able to repay your overall debt considerably faster than you could with your existing repayment options, especially if you also qualify for a lower interest rate. Your monthly payments may be higher, however.
- A long-term loan could extend how long you are in debt but lower your overall monthly costs. This is the major benefit to a longer term, though you’re likely to pay more in interest over time.
It doesn’t come with excessive fees
With any debt consolidation method, make sure potential fees don’t vanquish whatever savings you might generate. Personal loans, for example, can come with an origination fee that typically ranges from 1% to 8% of the total loan amount. If your loan is $5,000, this means you could spend up to $400 on this one fee alone.
Balance transfer credit cards typically have a balance transfer fee between 3% and 5% of the transferred amount. So even though you might benefit from a low or no promotional APR, the balance transfer fee can increase your debt load. Keep in mind, too, that if you fail to repay your balance before the promotional period ends, you could be charged deferred interest.
Credit counseling agencies can come with a startup fee as well as a monthly fee between $25 and $50. However, these agencies sometimes reduce or waive fees for debt management plans, especially if a borrower is struggling financially.
How to find a debt consolidation loan
- Determine what you want in a loan: The first step is to pin down your financial goals. Do you want a manageable monthly payment? The lowest interest rate or fees possible? Depending on your income and credit history, this type of loan can come with a lower interest rate than what you might pay for a debt like a credit card. For that reason, it might help you to consolidate multiple debts that carry high interest rates.
- Research lenders: It’s possible to find debt consolidation loans at brick-and-mortar banks and credit unions as well as with online lenders like LightStream and Upstart. Visit our personal loan marketplace to explore lenders and compare offers.
- Prequalify: Try to prequalify with at least three lenders to see what kinds of loan terms might be open to you. You’ll need to provide basic information about your income, employment status and any other debts you have. To check your credit history, your lender will do a soft credit check, which will not affect your score.
- Compare loan offers: Once you’ve prequalified, compare interest rates, repayment terms, credit score requirements and fees for each prospective loan. Pay special attention to rates. They typically range from 5% to more than 30% for those with poor credit.
- Formally apply: After you’ve identified the loan that’s right for you, send in a formal application. Your lender will ask for more detailed personal and financial information, as well as documents to prove your income, assets and debts. You can also expect a hard credit check, which may cause a temporary drop in your credit score.
- Wait for a loan decision: Banks and credit unions take anywhere from a couple of days to a couple of weeks to approve personal loans. Most online lenders, however, offer decisions in as little as one or two business days.
- If approved, wait for loan disbursement and pay off your debt: In most cases, lenders will deposit funds from a personal loan into a bank account electronically. This is the time to work your new debt repayment plan into a monthly budget to ensure you never miss a payment and don’t rack up late fees.
Can you get a debt consolidation loan with bad credit?
The answer is yes, but the best interest rates typically go to borrowers with stellar credit. For borrowers whose credit score is excellent (760 or more), the best average APR offer is about 11%, according to August 2020 LendingTree data. For fair credit scores (640 to 679), it’s closer to 24%. With an extremely low credit score, you might not even qualify for a loan at all.
If you have less-than-optimal credit, you might want to explore other debt consolidation options. For example, if you have significant equity in your home, a home equity loan may be able to provide you a lump sum of money, but at a generally lower interest rate, and with a longer loan term, five to 30 years.
If you have significant retirement savings, a loan against your 401(k) or home equity could be your most affordable options. With a 401(k) loan, though, you’ll sacrifice future earnings. With a home equity loan, your home is used as collateral, meaning you risk losing your property if you fall behind on payments.
How to consolidate debt with a balance transfer credit card
- Try to determine whether a quick payoff is realistic: To make good use of a balance transfer credit card, you’ll need to pay off your card balance by the time the promotional period ends, usually within 18 months. If you can’t make that goal, you’ll pay deferred interest and your new APR will likely be much higher than with a standard credit card, as high as 25% even for borrowers with good-to-excellent credit.
- Research balance transfer credit cards: Compare several cards to make sure they offer you the debt-shaving terms you need. For example, cards usually set a maximum for how much card debt can be transferred, so a balance transfer card with a $5,000 credit limit might not work if your card debt is $10,000. You can compare balance transfer options here.
- Apply for the card with the best terms for your situation: Identify the card that has the lowest APR, longest introductory time frame or lowest balance transfer fee — whichever quality you deem to be most important. Keep in mind that borrowers with the best credit scores qualify for the best terms.
- Transfer your balance: Once you’ve been approved, transfer your current card balances onto your new card, and work on paying off the debt quickly. A balance transfer credit card usually works best for borrowers who have a smaller amount of debt that they anticipate paying off in about a year.
How to consolidate debt with a debt management plan
- Find an agency: Locate a nonprofit credit counseling agency in your area through the online database offered by the National Foundation for Credit Counseling (NFCC). Most likely, you’ll be speaking with your counselor by phone, but some agencies may also let you do it online.
- Get your financial information in order: Before speaking with your counselor for the first time, pull together key financial information. This should include a list of current expenses (like what you pay regularly for housing, utilities and debts), as well as pay stubs and credit card statements.
- Be prepared to close open accounts: If you sign up for a debt management plan, be prepared to close any open credit accounts while you’re enrolled. This means you’ll see a drop in the total amount of credit available to you, so you may see a temporary dip in your credit score. While on a plan, you’ll make a monthly payment to your credit counselor, who will then distribute the amount to your creditors on your behalf. They will also negotiate with creditors to potentially have interest rates and fees reduced.
- Stick to the plan: Most debt management plans take between three and five years to complete. Make sure you’re fully on board, or else your finances could suffer even more.
Still wondering if debt consolidation is a good idea? It can be, as long as you find the method that’s right for your finances and stick with it. Check this debt consolidation calculator to see if there’s an option that makes sense for you.