Debt Consolidation Pros and Cons

Benefits of debt consolidation

Debt consolidation can be a good choice for those with high-interest debt who want lower monthly payments. Here are a few other benefits to consider:

• Lower payments: When you consolidate your debts, you may be able to lower your monthly payments. You can choose a loan term and payment that fits your budget better, and if you get a lower interest rate, it could reduce your monthly payment even further.
• Lower interest rates: One of the biggest advantages of a debt consolidation loan is the potential for lower interest rates. If you have high-interest debts (like credit cards), getting your interest rate down to 10% or lower could drastically reduce the interest you pay over the life of your debts.
• Delinquent accounts paid off: If you have delinquent accounts with multiple missed payments, getting a debt consolidation loan could help you pay off those debts (including late fees) and bring the accounts current. This could improve your credit score and stop late payments and penalties from adding up.
• Fewer monthly payments: When you consolidate multiple debts into one, you can eliminate paying multiple creditors and have just one simple monthly payment. This can make it easier to manage your finances and avoid missed payments.
• Faster debt payoff: A lower interest rate allows you to put more money toward the principal, helping you pay off your debt faster.
• Improved credit score: You might be able to improve your credit score when you consolidate your debts. Paying off delinquent accounts and establishing a history of on-time payments can help improve your score over time.

Drawbacks of debt consolidation

Debt consolidation can help you pay off debt faster, but it has a few downsides. Here’s what to consider before getting a debt consolidation loan:

• High loan fees: Since debt consolidation is usually done with an unsecured personal loan, you may pay high fees. Some lenders charge up to 10% of the total loan balance as a fee, which can get expensive.
• Hard to qualify with bad credit: Debt consolidation loans require a solid credit score to get the best rates. If you’re struggling with debts and have a poor credit score, you might only qualify for a very high interest rate, which can make the loan not worth it. In some cases, you might not qualify for a loan at all.
• Potential credit score drop: Consolidating your debts can improve your credit, but it might also hurt your score. Hard credit inquiries used to get the loan can lower your score, and closing other accounts after consolidation can also hurt your score.
• Risk of more debt: Debt consolidation may seem like a win, but if you can’t pay off your consolidation loan and don’t change your spending habits, you could easily rack up more debt instead of getting ahead.

If you don’t meet borrowing requirements for an unsecured debt consolidation loan, you may find it easier to qualify for home equity loans, cash-out refinances, or other secured options. Additional alternatives include a balance transfer credit card or debt management plan.

Impact on credit score

Consolidating your debt can impact your credit score, but it’s not all bad. Here are a few ways a debt consolidation loan affects your score:

• Payments: Making on-time payments has the largest impact on your credit score. When you consolidate your debt into a loan, make sure to continue paying your creditors until you pay the debts off completely. And once your debt consolidation loan is in place, it’s a good idea to set up automatic payments. Missing payments on your new loan can negatively impact your score.
• Credit inquiry: Applying for a debt consolidation loan results in a hard inquiry on your credit profile. This type of inquiry can cause a temporary dip in your score, but most people see it recover within a month or two. If you’re applying for multiple loans at the same time, keep all your applications within a 14- to 45-day window. Credit scoring models flag this as rate shopping and will typically count it as a single inquiry, which helps minimize the damage.
• Account mix: Credit scores also factor in the variety of accounts you have, like credit cards, loans and lines of credit. Adding a debt consolidation loan could help diversify your credit mix, but your score may drop if older accounts are closed.
• Credit utilization: This measures how much debt you have compared to your available credit. Closing credit cards after consolidating can shrink your total credit limit, which may increase your utilization ratio and lower your score — especially if you still carry balances elsewhere.

Alternatives to debt consolidation

Debt consolidation can lower your monthly payments and save you interest, but it’s not the only way to tackle your debt. Debt relief companies may provide alternatives like debt settlement or debt management plans. These options may be more helpful if you’re behind on payments or don’t qualify for a loan.

Here are some alternatives to consider:

• Adjusting your budget: You may be able to pay off your debt by putting together a budget that cuts out extra spending and puts more money toward your debts each month.
• Debt settlement: Debt settlement companies negotiate with creditors on your behalf to settle debts for less than the full amount owed. This strategy can help you settle debt quickly, but it can also hurt your credit, and forgiven debts may count as taxable income.
• Debt management: These plans use a third party to structure a payoff schedule, typically with one monthly payment sent to a debt relief company. The process can involve hidden fees, so it’s best to work with a reputable provider or nonprofit credit counselor.

» FIND OUT: What’s the difference between debt settlement and consolidation?

FAQ

Is debt consolidation worth it?

Debt consolidation can be worth it if you need lower monthly payments and have high-interest debt. But it only works if you have a steady income and can make payments on time. Without that, you might end up in even more debt.