Debt Consolidation: Is it in Your Best Interest?
You’re deep in debt with credit cards, medical bills, payday loans. Making the minimum monthly payments is getting you nowhere, and something needs to change.
Does this sound familiar?
Debt consolidation can help you pay off your high-interest debt quicker, and improve your credit score at the same time.
Lower balances typically correlate with a higher credit score.
And let’s be honest, less debt is better than having more debt, right?
Nearly half of all households carry some sort of credit card debt, with an average balance of over $9,000 and a total debt among Americans topping $1 trillion dollars.
The typical American household now carries an average debt of $137,063.
If you are one of the millions of Americans carrying big balances on high-interest credit cards, struggling with your debt, you might be asking yourself “Should I consolidate my debt?”
We’ll answer that question and more as we take a closer look into the advantages and disadvantages of debt consolidation, as well as what option may be best for you.
What is Debt Consolidation?
Debt consolidation rolls multiple debt balances into one single amount and monthly payment.
Successfully consolidating your debt will combine your high-interest bills, such as credit cards, into a single lower-interest payment, reducing the total amount you have to pay back on your debt.
This means you can not only pay less on your debt, but get out of debt faster if you’re consistent in paying your bill.
It can also be a good way to reorganize multiple bills and due dates by rolling them into a single payment, simplifying your finances.
Debt consolidation is not debt elimination. It doesn’t wipe away your debt, but restructures your debt in a way that when properly managed, can set you on the path to being debt free.
When Should I Consider Debt Consolidation?
Debt consolidation makes sense when you’ve gotten in over your head and barely able to make your minimum monthly payments.
Paying just the minimum on your debt can literally take decades before it’s finally paid off and you can breathe a sigh of relief.
Add up the total amount of outstanding debt you want to consolidate. Ideally, you’d want to pay it off in a year, but depending on your situation, this isn’t always possible. If you can’t pay it off in five years, then it might be time to look into more drastic measures, such as speaking with a bankruptcy lawyer.
When you decide to consolidate debt, you need to be willing to make changes to your spending habits. If you don’t change the behavior that got you into this place, you’re bound to end up in the same situation again, or possibly even going deeper into debt.
You should consider debt consolidation when:
- You are ready and committed to pay down your debts and put them behind you for good
- You want a lower monthly payment
- You want to save money on interest
- You want a single payment each month instead of juggling multiple bills
- You have the cash flow to consistently make your monthly payment on time
How Much Money Can I Save by Consolidating Debt?
When you consolidate your debt into a single loan, you’ll be provided an offer for a term length (in months or years) to pay off that loan, and the interest rate of the loan.
To save money, the interest rate of your loan needs to be lower than your current debt interest rate, otherwise, although you may end up with a smaller monthly payment, you are just extending the length of time it will take to pay off your debt.
You should strive for the shortest term length with a monthly payment you can comfortably afford.
The amount of money you can save by consolidating your debt depends on many factors:
- Total debt balance you need to pay off
- Interest rate on your current debt
- Interest rate on your consolidation loan
- Total monthly payment you can make
Below is an example of consolidating $20,000 in credit card debt.
In our example, making only the minimum monthly payment on a credit card will take a massive 34 years to pay off.
Making the minimum monthly payment on a consolidated loan would take 10 years to pay off, and $10,000 in interest savings.
A fixed monthly payment of $500 on a consolidated loan would take less than 4 years to pay off, and save you a whopping $26,000 in interest paid!
You can simulate how much money you can save over time by using our debt calculator here.
Advantages of Debt Consolidation
There are a few advantages when it comes to consolidating your debt.
1. Getting out of debt. Having better terms and lowering your interest rate means that more of your money goes towards paying the principal (balance) instead of just paying on the interest. This means your debts get paid off sooner! If you are consolidating notoriously high-interest debt such as credit cards, the savings can be very significant.
2. Credit Score Boost. Consolidating from revolving credit (credit cards) to an installment loan will lower your overall credit utilization ratio. This is the percentage of your credit that you’re currently using, and makes up 30% of your total credit score, and also the second biggest factor when it comes to your credit score. The credit bureaus will consider your loan as having a lower level of debt, which can raise your score.
3. Simplifying your finances. It can be easier to pay a single bill each month rather than trying to keep track of multiple bills and due dates. A single payment can help you with not missing payments, and not having late fees costing you more. Late fees can also damage your credit score, so having a one-and-done payment can help keep you on track.
4. Avoiding bankruptcy. No matter how buried you are in debt, it’s far better to enter into a manageable debt consolidation loan than it is to file for bankruptcy. Filing for bankruptcy will not only destroy your credit, and ability to make future purchases, but it stays on your report for up to 10 years.
Disadvantages of Debt Consolidation
If consolidation loans were the perfect solution, everyone would be using them. So what are some reasons consolidating your debt may not be the best choice for you?
1. Your Spending Habits. Be honest with yourself. If you transfer your credit card debt to a consolidation loan, are you just going to charge them back up again? If so, then consolidation could be a huge financial mistake. The purpose of a consolidation loan is to reduce and get out of debt, not to accrue more. It does no good if you continue with the excessive spending habits that created your debt in the first place.
2. Associated fees. Depending on the type of loan or the bank you apply at, there may be hidden fees such as an origination fee, processing fee, or an early repayment fee. Banks expect to make money off you from the interest you pay over a period of time. Paying off your loan early will deny them that interest, so they may hit you with an extra charge. You should be aware and ask about any associated fees when applying for your loan.
3. Current credit score. Some banks will make a hard inquiry check when you apply for a loan, which can temporarily lower your credit score a few points. Your credit score can also determine how favorable the rate will be on your loan. If your credit score is already damaged, it may not be worth it to take out a new loan if the rates are no better than what you currently have.
4. Collateral. If you already have low or bad credit, the bank may also require you to put up something for collateral in order to consider your approval. Collateral is putting up something of value that if you fail to make your loan payment on time, the bank will seize it. Ask yourself if you’re willing to lose whatever it is you need to put up for collateral in the event you may be unable to make your payment.
What Are My Consolidation Options?
The best way to consolidate debt depends on how much debt you currently have, your credit score and credit history, and whether you have home equity or investment accounts.
Here are the most effective ways you can consolidate your debt:
1. Consolidation Loan
Consolidation loans provide competitive interest rates, and can be used to consolidate credit cards or any other type of debt. You’ll have a fixed interest rate and monthly payment that won’t change.
They can be harder to get a lower rate for those with bad credit, but typically the maximum interest rate is still lower than most credit cards, so they can help you pay your debt off faster.
We recommend applying with SuperMoney Loans, who will find your best loan offer up to $100,000 with rates as low as 4.99%. Plus, checking your rate won’t affect your credit score. Get your personalized loan offer in seconds!
2. Home Equity Loan or Line of Credit
If you’re a homeowner, you may be able to take out a line of credit (HELOC) from the equity acquired in your home.
To be eligible, you’ll need a home appraisal. If what you owe on your mortgage is less than the appraised amount of your house, you can use the difference for a HELOC.
Example: Your house is appraised with a value of $250,000. You owe $200,000 on your mortgage. You could be eligible for a HELOC of up to $50,000.
A HELOC typically has the lowest interest rate of any loan since it is a secured loan, using your house as collateral. However, this also means that if you fail to make your monthly payment, you could lose your house.
A HELOC also has a long repayment period (up to 20 years), so while they can offer a lower monthly payment, you’ll remain in debt a long time if you don’t make additional payments on top of the minimum.
3. 401(k) Loan
If you contribute to an employer-sponsored retirement account like a 401(k) plan, you can take out a loan against the balance of your account.
The benefits of a 401(k) loan are that they don’t show up on your credit score, and they have a low interest rate. They typically have a repayment period of five years.
However, taking a loan out of your 401(k) plan can significantly reduce your retirement. If you can’t repay your loan, there are also penalties and taxes on the unpaid balance. And if you lose or quit your job, then you must pay the loan off within 60 days.
A 401(k) loan is only advisable when all other options are off the table.
4. Debt Settlement Plan
A debt settlement plan provides a fixed monthly payment at a reduced interest rate. If you can’t qualify for other options, or have a low credit score, then it may be best to look into debt settlement.
You’ll be connected with a debt relief consultant who will go over your personal situation and come up with a suitable relief strategy and program.
You will need to have a regular income, and a debt settlement plan will typically last for 3 to 5 years.
Access Debt Relief offers a number of debt strategies that have helped millions of people, and their providers are open and available any day of the week, 24 hours a day.
Alternatives to Debt Consolidation
Credit Card Balance Transfer
If you have good to excellent credit, you may qualify for a balance transfer credit card.
Yes it may sound counter-intuitive to get out of credit card debt by opening a new credit card, but a balance transfer card typically offers a promotional period of 12 to 18 months that charges no interest.
Most balance transfer cards have an initial 3 to 5% transfer fee, so it’s best to calculate if the interest you save over time will negate the cost of the transfer itself (a 5% fee on a $10,000 balance transfer would be $500). And once the promotional period ends, you’ll start being charged the standard interest fees.
For this to be most effective, you’ll need make a solid plan to pay off the entire debt before the promotional period is over, otherwise you’ll find yourself back in the same debt cycle again.