Is Debt Consolidation a Good or Bad Idea?
If you’re carrying a lot of high-interest debt with multiple lenders, it can be difficult to maneuver your money around to accommodate multiple due dates. You may end up with late fees if you make a mistake and miss a payment, or if you can’t afford one of the minimum payments. It can be an anxiety-inducing predicament.
In moments like these, a debt consolidation loan can seem like a great idea. It may well be. Debt consolidation loans may lower your interest rates and can replace your multiple payment due dates with one fixed payment per month that’s easy to remember.
But there are some situations where a debt consolidation loan may be disadvantageous. Let’s examine if a debt consolidation loan is a good idea for you.
Table of contents
Understanding debt consolidation loans
When you’re carrying multiple debts — usually on multiple credit cards — you may consider taking out a debt consolidation loan. The new lender will pay off your multiple creditors. Then you’ll owe the entirety of your debt to the new lender. You’ll pay it off via one monthly payment. Usually, this payment will be fixed and predictable.
There are many ways to take out a debt consolidation loan, and the loans described below generally carry fixed interest rates (meaning your payment amounts should be consistent). The loan that’s right for you will depend on your credit score and if you own any property.
Debt Consolidation Loan Options
Generally, personal loans are unsecured debt, which means there is no collateral at risk should you be unable to repay. The most creditworthy applicants may find personal loan interest rates as low as 3.99%, which is far below the national average credit card interest rate, which was 14.99% in the fourth quarter of 2017, according to the Federal Reserve.
Home equity loans
Home equity loans usually offer lower interest rates than personal loans. They also tend to be easier to qualify for, as your home is the collateral, should you fail to repay your debt.
If you own a home, cash-out refinancing is another option for debt consolidation. Essentially, you’re consolidating your credit card debt and your mortgage in one fell swoop. This only makes sense if the interest rate you get on cash-out refinancing is lower than the interest rate on your current mortgage.
401(k) or 403(b) loans
If you have a 401(k) or 403(b) through your employer, you may be able to borrow money from your account without penalties or fees. Generally, you can borrow $50,000 or half of your savings — whichever is less — and have five years to repay. During this repayment period, the borrowed money will be missing out on stock market gains or interest paid on bonds. You will pay interest on your loan, but this interest will end up back in your retirement account.
If you fail to repay on time — or before you leave the employer depending on the terms of the loan provision — you will be subject to penalties and fees.
When is a debt consolidation loan a good idea?
Debt consolidation loans provide significant benefits, but only in specific situations. Here are some reasons you may want to take out a debt consolidation loan:
You’re committed to getting out of debt
Jen Hemphill, accredited financial counselor (AFC) and host of the “Her Money Matters” podcast, notes that the biggest factor in determining the value of a debt consolidation loan is how well you have addressed the problems that have gotten you into this mess in the first place.
“It all depends on where you are in your financial journey,” she said. “Are you serious about changing your past behavior? Have your circumstances changed? If you can answer ‘yes,’ you’ll have more success, and one monthly payment can make life easier for you.”
You can get a lower interest rate
Perhaps you’ve decided you want to get out of debt in the next three years, and you have the following debts:
- A credit card with a $4,000 balance at 14.99% APR
- An auto loan with a $10,000 balance at 6.99% APR
- A credit card with a $3,000 balance at 25.99% APR
If you paid off all those debts three years from today, you’d end up paying $20,456.02 — $3,456.02 in interest alone. Across the three payments, you’d be spending $568.23 per month. (This calculation assumes interest compounds monthly on each account.)
But if you took out a $17,000 debt consolidation loan at 6.99% APR and paid it off over three years, your total cost would be $18,893.99, $1,893.99 of which would be interest. Your monthly payment would be $524.83. Not only does that lower APR help you save $43.40 per month, it helps you save $1,562.03 on debt payoff.
Calculate how much you’d spend paying off your debts separately, and see if a debt consolidation loan can save you money.
It’s also important to note that those with high credit scores stand to benefit the most from debt consolidation loans. This is because a high score merits lower interest rates. This can be a catch-22, as large amounts of debt can lower your credit score. The large debt that drove you to look for a consolidation loan may be the very thing preventing you from garnering a good interest rate.
You want a lower monthly payment
If you need to save money in the short term, a consolidation loan may allow you to lower your monthly payment. Take the above example, but compare a three-year loan term and a five-year loan term. A $17,000 personal loan with a 6.99% APR paid over five years would result in a monthly payment of $336.54— much lower than the $524.83. The total payment would end up being higher ($20,192.41), but if you need to lower your monthly debt payments, the five-year loan may be a smart choice. Keep in mind that a longer loan term may result in a higher APR, which means even more costs in the long term.
You want the simplicity of a single monthly payment
If your goal is to simplify your finances, paying off multiple debts with a single loan may be a good solution. It’s still important to consider the costs of consolidating — whether you’ll pay more in interest or fees, for example — but taking several payment dates and combining them into one monthly bill can make things much easier to manage.
When is a debt consolidation loan a bad idea?
Consolidating your debt under the wrong circumstances can wreak havoc on your financial life. Here are some examples of when consolidating your debt can hurt more than help:
You can’t afford your loan
You could lose your home if you can’t keep up with payments on a home equity loan or cash-out refinance.
If your a new loan has a higher monthly payment than your current debts combined, you could end up in trouble if your financial situation changes before the end of your loan term.
Your new loan costs more than your existing debt
This is especially hazardous for those with lower credit scores because a low credit score means you may not be able to qualify for a rate low enough to save money.
Say you have the debts listed above and want to consolidate with a $17,000 personal loan with a three-year term. You compare loan offers, and the best APR you qualify for is 12.99%. In that scenario, it will be cheaper to make a three-year plan to pay off the debts individually at their current rates, because the total cost of the consolidation loan would be $20,617.75.
You keep adding to your debt
Hemphill cautions that these disadvantages are more likely to crop up if you haven’t changed your financial habits or circumstances.
“Debt consolidation can be a Band-Aid to the situation if you don’t understand the root of the problem,” she said. “If nothing has changed, you’re just going to dig yourself into more debt.”
Qualifying for debt consolidation loans
To qualify for a debt consolidation loan, you will need to prove you have sufficient income to repay the loan. You will also need to meet the lender’s minimum credit score requirements. The minimum score will vary by lender and product. For example, you may qualify for a personal loan with a score as low as 500 with NetCredit, but Discover requires a credit score of 600+ for the same product.
Meeting the minimum credit score requirement does not mean you will qualify for the lowest advertised interest rate. If your score is on the lower end, you are likely to be offered a higher interest rate. There are also other factors that will affect your loan terms, like your debt-to-income ratio. If your goal is to save money, it’s important to make sure the debt consolidation loan has a lower APR than the debt you’re consolidating. If it doesn’t, there’s no financial justification for consolidating.
- With products like home equity loans and cash-out refinancing, you will be required to have sufficient equity in your home to finance the consolidation. You’re likely to incur closing costs, which will add to the overall cost of the loan.
- Whichever product you use, make sure you understand application, origination and any other fees associated with the loan. If these fees are too large, it may not make sense to consolidate your debt.
- Another thing to watch out for is prepayment penalties. These penalties ding you with a fee if you pay off your debt early. Paying off your debt as quickly as possible lowers the amount of overall interest you pay over the life of your loan.
Alternatives to a debt consolidation loan
Debt consolidation loans are not the only way to fix your financial situation. There are several different options you can explore if a debt consolidation loan is not right for you.
Keep in mind that some debt consolidation products have variable interest rates, meaning the low rate you get initially may not last for the duration of the loan term and the amount you save on interest may change.
Hemphill encourages self-starters to dig themselves out of debt without the use of additional financial products. She points to sites that help you evaluate your spending and calculate future debt payments. The free tools offered can help you create a personalized plan to get out of debt quicker.
She also notes that consumers can call credit card companies directly to negotiate lower interest rates. After you’ve done that, the main advantage a debt consolidation loan has over the DIY route is reducing the number of monthly payments you must make.
Debt settlement is another option, though it’s typically not a desirable one. Debt settlement companies ask you to stop paying your creditors in an attempt to get them to reduce the total amount of debt owed. While you are not making payments, you will still be charged interest and late fees. Extended nonpayment can also leave a deep scar on your credit report.
If the debt settlement company is successful in reducing your debt, you may have to pay taxes on any amount forgiven. Credit card companies are not obligated to work with debt settlement companies, though, so your debt may not be reduced — leaving you with only the negative consequences.
Debt management plans
Working with a credit counselor accredited by the National Foundation for Credit Counseling can be a positive alternative to debt consolidation loans. Instead of making several monthly payments, you make one payment per month to your counselor. They will then pay your debts for you. They may also negotiate fees and interest rates on your behalf.
Debt management plans do come with a fee, though in some cases this fee is nominal. For this reason, Hemphill recommends self-motivated debtors use free tools to create their own debt management plan, though she acknowledges counseling can have value for those who need more hands-on help getting their money in order.
Get free financial coaching
If you need outside help to get your money on track but are reticent to pay fees, Hemphill points out that the Consumer Financial Protection Bureau offers free financial coaching at sites across the country. She notes that the financial coaches are all AFCs.
While the program has an intense focus on veterans, it is open to anyone who is experiencing a rough time in their personal economy.
Current military members and dependents can also get free services from AFCs through Military OneSource.
Balance transfer credit cards
Credit card companies sometimes extend 0% APR introductory offers on balance transfers. When you move your balance from your current card, you won’t have to pay any interest on the balance for a set amount of months, as long as you make on-time minimum payments each and every month.
Be sure you know when the introductory 0% APR offer expires, and aim to have your debt paid off by that date. After that date, the interest rate is likely to skyrocket.
Even though you’re not paying interest on your debt, you may have a pay a balance transfer fee. Do the math to make sure the cost of the fee doesn’t exceed what you’d be paying in interest on your current credit cards.
A second stream of income
No matter which method you use, having more money to throw at your debt every month will help you pay it off faster. Try to develop a second stream of income, whether it be through a part-time job or a side hustle like dog walking.
Debt consolidation loans are only as good as your financial discipline
A debt consolidation loan can be a useful tool to rid yourself of debt. They are especially useful if you’re having trouble keeping track of various monthly payments and can help some consumers lower the amount of interest they’re paying.
But without financial discipline, these loans are not going to solve your money woes. If you keep spending on your credit cards after consolidating, you could end up owing more money than ever before. If you don’t have the income to pay for monthly necessities without a credit card, that’s not going to change after you consolidate your debt.