Table of Contents
- Debt consolidation loans allow you to pay off several existing credit cards and other debts with one new loan
- This process can help you reduce your overall interest rate and simplify debt management with one monthly payment
- Initially, debt consolidation may hurt your credit scores, but it will help if you keep up with payments
- Keeping your old accounts open may also help your credit recover more quickly
- You should always weigh several choices to decide on your best option for paying off debt quickly and at the lowest cost possible
U.S. consumer debt is rising rapidly. According to data from the Federal Reserve Bank of New York, credit card balances rose by 15.7% year over year in the second quarter of 2023, landing at an all-time high of $1.03 trillion.
Credit cards represent just one type of rising consumer debt, which is increasingly suffocating American households. Roughly 8% of credit card and other types of personal debt balances were more than 90 days delinquent as of Q2 2023, leaving many consumers in over their heads.
In the face of rising inflation and growing debt burdens, debt consolidation is an enticing option. This process, which replaces multiple high-interest loans or credit cards with a single loan at a lower rate, can help you reduce the costs of carrying debt and pay it off faster.
As appealing as debt consolidation may be, it’s important to understand how it works and how it will affect your credit score before you jump in. In the short run, debt consolidation may hurt your credit, but there’s more to the story. Here’s how it works.
Debt Consolidation Methods
The goal of debt consolidation is to eliminate the stress of managing several high-interest balances and monthly payments so you can focus on paying off a single, manageable loan more quickly. Essentially, you take out a new loan and use it to pay off the balances of the loans or credit cards you want to consolidate.
In practice, this can take many forms. Personal loans are the most popular and straightforward method, as they allow you to consolidate unsecured debt with another type of unsecured loan. If you have a good credit score, a personal loan may have a much lower interest rate than credit cards. Some personal loans can offer rates as low as 6% or 7%, while credit cards range between 16% and 30%.
Because qualifying for a low-interest personal loan requires good credit, it’s not always the best option. That’s why many consumers look to secured loans, such as a home equity loan or line of credit. These loans use your home as collateral and offer low rates of 7% to 10% with less stringent credit requirements. Keep in mind, however, that your lender can seize your home if you default on payments.
What Debt Consolidation Does To Your Credit Scores
Regardless of which method you choose, debt consolidation will likely hurt your credit score in the short term. That’s because any new loan application will result in new hard inquiries on your credit report, which can cause your credit scores to dip by a few points. Opening new accounts — and potentially closing old ones after you consolidate — also reduces the average age of your credit, and that will typically ding your scores a bit, too.
Ultimately, however, debt consolidation can boost your credit scores. On-time payments and credit utilization ratio — the percentage of your revolving credit limits that you’re using — have a much greater impact on your credit scores, and consolidation can help you improve in both areas.
For instance, if you pay off several credit cards with a single personal loan and keep those cards open, your credit utilization will drop significantly. Personal loans also fall under a different type of credit, so the new loan may improve your credit mix, according to lenders. Combined with on-time payments, this can result in substantial credit score improvements over time.
Why Consider Debt Consolidation
Of course, consolidating debts isn’t the only way to improve your credit. Overall, consolidation serves three primary purposes:
- Reduce interest rates: Credit cards carry some of the highest interest rates of any consumer debt. If you fall behind or just make minimum payments, this interest can add up quickly. Consolidation offers a chance to combine these high-interest debts into one lower-interest loan.
- Simplify monthly payments: It’s much easier to keep track of one monthly payment than several different due dates, minimum payment amounts, and interest rates.
- Streamline debt management: While other methods like the debt snowball or avalanche may allow you to pay off multiple debts more quickly, debt consolidation takes the stress of managing that process off your plate. With one payment and one rate to worry about, you can set your payoff goal and forget about it.
So, how do you decide if debt consolidation is the right option for you? If high interest rates are pushing you deeper into debt and you’re struggling to manage several credit cards or personal loans, consolidation may be worth it. Your current credit scores and home equity are important considerations, as well, as they’ll determine whether you have good debt consolidation options.
Debt Consolidation Alternatives
As you explore your options for debt consolidation, it’s a good idea to weigh your alternatives. Here are a few other possibilities you can explore.
Debt Management Plans
Debt management plans are offered by nonprofit credit counseling agencies. Instead of consolidating debts with a new loan, the agency will negotiate a payment plan with your creditors. You’ll pay a set monthly amount (including a fee), and the agency will pay off your debts on your behalf.
If your creditors are open to it, you may be able to reduce your debts significantly and pay less overall, even with fees included. However, debt management plans can take up to five years to complete, and not all debts are eligible.
Credit Card Balance Transfers
Many credit cards allow you to transfer existing balances from one or more other cards. Technically, this is a form of loan consolidation and can work as a way to eliminate multiple payments and interest rates.
However, balance transfers are only a good idea if you can legitimately reduce your overall interest rate and save. Your best bet is to take advantage of a promotional APR, many of which allow you to transfer balances and pay no interest for 12–18 months. You’ll still pay a fee — usually between 3% and 5% of each balance transfer — but you’ll save more in interest if you pay off your balance within the promotional period.
Overhauling Your Budget
Often, your best option may be to simply review and revise your budget. Many credit counseling agencies offer free services to help you do just that. You may be surprised to find a few expenses you can cut in favor of larger loan payments.
At the least, this is always a good place to start. If you find that some budget adjustments will help you pay off those loans within a year, then consolidation may not be necessary. If the process takes longer, it’s still a good idea to see if you can bring everything together under one loan with a new, lower rate to save on interest.
If you have a 401(k), this is an option of last resort for debt consolidation. Many employers allow you to borrow as much as $50,000 from your 401(k), and these loans usually come with low interest rates. Typically, you’ll need to pay it back within five years, and any interest you pay goes back into your account rather than to a lender.
However, the risk of borrowing from your 401(k) may outweigh the potential rewards. Any money you take out will stop earning interest, and any interest you pay back may fall short of what you could have earned by keeping your money invested. Additionally, if you leave your job, you may have to pay back the loan immediately. Fail to pay back your loan in time, and you’ll owe a 10% penalty, plus taxes on the balance, if you’re under age 59 ½.
Tips for Smart Debt Consolidation
If you do decide that debt consolidation is the right choice, be sure not to rush through the process. The following steps will help ensure you choose the correct option:
- List your current loans and credit cards. Note your interest rates, due dates, minimum payments, and any other pertinent information, so you can weigh it against any potential new loan terms.
- Compare offers from multiple lenders. Don’t jump at the first offer you have. Try to get at least three offers so you can compare rates and payment terms to decide on the best one.
- Use tools to make informed decisions. Simple tools like a debt consolidation calculator can help you compare loan terms to see how much interest you’ll pay over time, how much you’ll save, and more.
Is Debt Consolidation Worth It?
In the short term, debt consolidation will probably hurt your credit. However, staying in debt and falling further behind on payments will do far more damage. Eventually, debt consolidation can help you get out of debt faster, save money, and even improve your credit scores.
That said, it’s not the right option for every situation. It’s important to compare all your loan options, explore what types of rates you qualify for, and weigh these against other ways to pay off your debts. Regardless of which option you choose, the sooner you act, the more quickly you can get on the path toward financial wellness.
Frequently Asked Questions (FAQs)
Will Banks Help With Debt Consolidation?
Many banks and credit unions offer personal loans for debt consolidation. Be sure to compare several options and read the terms carefully to watch out for any possible rate changes that may take effect in the future.
Are There Any Disadvantages To Consolidating Debt?
Debt consolidation may not be the right option in all circumstances. Many loans come with origination fees or only offer a low rate for an introductory period. If your credit score is too low, you may not qualify for a low enough rate to make it worth it. Compare the total cost of paying off your loans individually vs. using a debt consolidation loan.
How Long Does A Debt Consolidation Stay On Your Credit?
Since a new loan isn’t a negative mark on your credit, it will stay on your report as long as the loan remains open. If you fall behind on payments or your new loan becomes delinquent, this negative information will stay on your report for up to seven years.
What Credit Score Do You Need For A Consolidation Loan?
Eligibility requirements vary by lender. However, most debt consolidation loans require a minimum score between 580 and 680.