The Advantages and Disadvantages of Debt Consolidation | Personal finance
If you have multiple streams of debt, like high-interest credit cards, medical bills, or personal loans, debt consolidation can combine them into one fixed monthly payment.
Getting a debt consolidation loan or using a balance transfer credit card can make sense if it lowers your annual percentage rate. But refinancing debt has pros and cons, even at a lower rate.
Advantages of debt consolidation
You may receive a lower rate
The biggest benefit of debt consolidation is paying off your debt at a lower interest rate, which saves money and could eliminate debt faster.
For example, if you have total debt of $9,000 with a combined APR of 25% and a combined monthly payment of $500, you will pay $2,500 in interest over approximately two years.
But if you were to pull out a debt consolidation loan with an APR of 17% and a repayment term of two years, the new monthly payment would be $445 and you would save $820 in interest. The money you save on the lower monthly payment could also be used to pay off the loan sooner.
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If you qualify for a balance transfer card, you would pay no interest during the promotional period, which can last up to 18 months. You will also likely have to pay a 3-5% balance transfer fee.
Use a debt consolidation calculator to see your total balance, your total monthly payment, and the combined interest rate on all debts.
You will only have one monthly payment
Instead of tracking multiple monthly payments and interest rates, consolidation lets you combine debt into one payment with a fixed interest rate that won’t change for the life of the loan (or during the promotional period, in the case a transfer card balance).
But it’s not just about simplifying your repayments. Consolidation can give you a clear and motivating finish line to be debt free, especially if you don’t have a debt repayment plan in place.
You could build your credit
Applying for a new form of credit requires a thorough credit investigation, which can temporarily lower your score by a few points.
However, if you make your monthly payments on time and in full, the overall net effect should be positive, especially if you are consolidating credit card debt.
Paying off credit card balances lowers your credit utilization rate, which is one of the main factors that determines your score.
Disadvantages of debt consolidation
You cannot benefit from a reduced rate
Balance transfer cards can be difficult to obtain and generally require good to excellent credit (690 or higher on the FICO scale).
Debt consolidation loans are more accessible and there are loans suitable for applicants with bad credit (629 or less on the FICO scale). But borrowers with the highest scores generally receive the lowest rates.
Unless the lender can offer you a lower rate than your current debts, debt consolidation is generally not a good idea. In this case, consider another debt repayment strategy, such as debt avalanche or debt snowball methods.
Borrowers looking to consolidate with a loan can pre-qualified with some lenders to see potential rates without affecting their credit scores.
You could fall behind on your payments
Missing payments for new debt means you could end up worse off than when you started.
For example, if you fail to repay your balance transfer card during the interest-free promotional period, you will be forced to pay it at a higher APR, potentially higher than the original debt.
If you fall behind on a consolidation loan, you could rack up late fees and missed payments would be reported to the credit bureaus, putting your credit scores at risk.
Before consolidating, make sure the new monthly payment fits comfortably into your budget for the entire repayment period.
You have not solved the root problem
While consolidation is a useful tool, it’s not a surefire solution for recurring debt, and it doesn’t address the behaviors that led to debt in the first place.
If you’re struggling with overspending, consolidating could be a risky choice. By taking out a loan to pay off credit cards, for example, those cards will again have a zero balance. You might be tempted to use them before the new debt is paid off, plunging you into an even deeper hole.
If you have too much debt, it may be better to consult a credit counselor from a reputable non-profit organization who can help you put a debt management plan in place, rather than trying to take care of it yourself.