How Does Debt Consolidation Work? (Pros and Cons)
If you have debt, you’re not alone. As of May 2020, American consumer debt was $14.3 trillion. That figure includes mortgages, auto loans, card cards, and other outstanding payments.
One solution is debt consolidation using personal loans. Consolidating debt with a personal loan can simplify your payment schedule and — in some cases — reduce how much interest you pay. But it won’t solve all your problems. Let’s look at the pros and cons of personal loans as a debt consolidation tool and see if this approach might be right for you.
What is debt consolidation?
Debt consolidation is the process of paying off multiple debts with a new loan or line of credit. As a result, you’ll have one monthly payment instead of many. Debt consolidation is a form of debt refinancing that makes it easier to repay outstanding obligations. Debt consolidation is ideal if you have a manageable amount of debt and a good credit score.
To understand why debt consolidation may be attractive, consider the alternative. You likely have multiple existing loans, which may include a mortgage, one or more car payments, student loans, and credit cards. Each month, you have to pay different amounts on different days to different lenders.
If that’s not complicated enough, each loan has a different interest rate. If your goal is to pay off all your debt, it might not be readily apparent whether you should first repay a $1,000 loan with a 20% APR or a $2,000 loan with a 10% APR. Fortunately, debt consolidation allows you to reorganize and simplify these obligations into a single payment.
Types of debt consolidation loans
It’s possible to consolidate debt using a variety of methods, including home equity loans and lines of credit (HELOCs), credit card balance transfers, credit counseling programs, and other types of loans. Here, we are focusing on debt consolidation using personal loans.
You can secure a personal loan from various financial institutions, including banks and credit unions, and direct-to-consumer online lenders. Like other forms of credit, lenders require a good credit score and proof of stable employment for personal loan approval.
Personal loans are not the only way to consolidate your debts. For instance, you could tap into your home equity to pay existing obligations. Home equity loans and lines of credit offer the lowest interest rates, and you can borrow up to the amount of equity in your home. But they require you to use your house as collateral. If you default on your payments, your lender can claim your property.
Other methods include balance-transfer credit cards and 401(k) “loans.” Balance transfer credit cards often offer a 0% introductory APR for a year or two. That’s attractive, but you can typically only use balance transfers to consolidate other credit card debts. With a balance transfer, you are also limited by the card’s credit limit. You may not be able to consolidate all your debt with a single balance transfer.
A 401(k) “loan,” while not technically a loan, enables you to borrow money from your 401(k) at a low interest rate. You could use that money to pay off existing debts. This may seem like a good idea because you are borrowing money from (and paying interest to) yourself rather than a bank. But 401(k) loans rob you of returns your money could be earning for your future. We recommend that you consider 401(k) loans as a last resort.
Benefits of debt consolidation
The benefits of debt consolidation include a fixed repayment schedule, faster repayment, and, sometimes, savings on interest and an improved credit score.
Faster repayment
Debt consolidation allows you to repay your debts faster than you would have without assistance. The process alleviates financial strain by lowering your interest rate and monthly dues. A well-structured consolidation can put you on a fast track to a debt-free future.
Lower interest rate
According to CreditCards.com, the average credit interest rate is 16.04%, as of November 2020. Personal loans come with lower interest rates, making them an attractive way to reduce your debts. The average APR is 10.07% for personal loans, though the exact rate will vary based on your credit score, terms, and amount owed.
Fixed repayment schedule
Debt consolidation makes it as easy as possible to make monthly payments. Instead of paying bills at different times, you make one uniform payment each month. You also get the benefit of knowing when you’ll make your last payment.
Improved credit score
Debt consolidation will hurt your credit score in the short-term. As long as you make on-time payments, though, you can anticipate an overall credit boost. According to FICO, 35% of your creditworthiness depends on whether you make your monthly payments on time.
If your debts involve credit cards, you should leave them open. You will receive no penalty for having open cards that you don’t use. In fact, it can help you. A diverse array of credit lines will bolster your credit utilization ratio and extend your credit history, which counts for 10% and 15% of your FICO score, respectively.
Drawbacks of debt consolidation
The drawbacks of debt consolidation include applying for more credit (and thus being tempted to use it) and, in some cases, higher fees or interest rates.
Underlying problems
Debt consolidation doesn’t mean debt elimination. You have no guarantee that, even after you consolidate your obligations, you won’t get into debt again. In some cases, debt consolidation using personal loans may be a financial Band-Aid when what you actually need is a trip to the ER.
Debt consolidation will not help you if you consistently live beyond your means.
Instead, you likely need to make lifestyle and spending changes. Part of that involves cultivating discipline and creating a realistic budget. (More of this in a minute.) You should also develop an emergency fund in case of unexpected expenses, such as a car malfunction or job loss.
Increased costs
Depending on which consolidation method you choose, you may incur fees.
One way to consolidate debt is by using a for-profit debt consolidation or “credit “counseling company. (These are different from non-profit credit counseling agencies that provide actual counseling, not debt consolidation).
One way these companies make money is by charging fees. Many lenders charge you a percentage of your total debt, which can range from 15% to 25%. For example, if you owe $10,000 in credit card bills, the company may charge you $2,000 as a baseline fee.
Some other fees you may encounter include:
- Annual fees for loans and credit cards
- Balance-transfer fees
- Closing costs on home equity loans
- Loan-origination fees on personal loans
Higher costs
Here’s the dirty little secret about debt consolidation: It might cost you more over the long-term. How is that possible? The longer it takes for you to repay a debt, the more interest you have to pay. If the repayment period is long enough, you may pay more to resolve your debts than you would have without debt consolidation.
Consider this example from financial guru Dave Ramsey. You have $30,000 in medical bills. These unsecured debts include a two-year loan for $10,000 with 12% interest and a four-year one for $20,000 at 10% interest.
You need to make $1,100 in monthly payments to pay the balances within 41 months. Because of interest, your final total will be $34,821. You talk with your lenders and decide you want to pursue debt consolidation using personal loans.
After negotiating the terms, you settle on a $640 monthly payment with a 9% interest rate. Both figures are lower than you were paying previously. Sounds good, right?
The problem is that this loan would take 58 months to pay in full. The more extensive terms mean that you would pay more interest over the next five years. You’d pay $37,103 in total, which is $2,282 more than you would have if you had left your debts as is.
While paying more money to consolidate your debts is far from ideal, it’s not the end of the world. The longer time frame would allow you to make manageable payments each month that don’t strain your bank account. While you would end up paying roughly $2,000 extra overall, debt consolidation may be worthwhile if it means successfully eliminating your outstanding obligations.
When to consolidate debts
Debt consolidation can be a smart move if you have a moderate amount of debt, and you can still afford the monthly payments. If you are already struggling to keep up with your debt payments, it may be too late for debt counseling to save you. You may be better off filing for Chapter 7 or Chapter 13 bankruptcy (see more on this below).
As a rule of thumb, you should have the financial wherewithal to repay your obligations within one to five years. Anything over that is excessive. Anything under that and the savings probably aren’t enough to merit consideration.
This Goldilocks status requires a good credit score so that you can qualify for low interest rates. You’ll also secure more favorable terms when you negotiate the personal loan. You can expect single-digit interest rates if you have a FICO score above 760. The lower your credit score, the higher the interest rates on a debt consolidation personal loan.
Debt consolidation is a viable option if you plan to pay off your debts. However, if you recently opened a business, you’ll likely have more obligations in the future. While you should try to limit outstanding payments, debt consolidation may not be the best move in this scenario.
Here are a couple of tips to see if debt consolidation using personal loans is right for you:
- Your debts, not including mortgage, shouldn’t exceed 40% of your total income
- You have a high enough credit score to qualify for low-interest debt consolidation
- Your cash flow allows you to make consistent payments on your debt
- You plan to reduce your debt over the upcoming years
Let’s say you have five credit cards. Each of them has a different interest rate, ranging from 17% to 25%. You always make on-time payments but find it increasingly difficult to do. You may benefit from personal loans that can lower your interest rate to 7% through debt consolidation.
When not to consolidate debts
Debt consolidation treats the symptoms of debt, not the underlying problems. If you make consistently frivolous or exorbitant purchases, debt consolidation becomes merely a temporary solution. You may reduce your outstanding obligations in the short-term but will have little chance of paying them off in full.
Lenders offer debt consolidation to people with good credit. However, if you can’t secure low-interest rates or favorable terms, you’re better off looking at alternatives. The same is true if you have an excessive amount of debt.
Chapter 7 bankruptcy is available for anyone with limited income who cannot pay all or some of their debts. Eligibility varies based on your state’s median income level and the ability to pass the “means test.” While the process enables debtors to discharge most of their debt, trustees have the power to foreclosure or repossession property.
You can qualify for Chapter 13 bankruptcy if you have 1) a regular income, 2) less than $394,725 in unsecured debts, and 3) less than $1,184,200 in secured debts. Chapter 13 helps debtors resolve debts without giving up their home, car, or other essential possessions. Debtors must make monthly payments for the following three to five years and pay back some of their unsecured obligations.
However, before considering bankruptcy, be aware that “bankruptcy is one of the worst things you can do for your credit,” according to Ben Luthi, writing for the Experian credit agency. “A Chapter 7 bankruptcy will remain on your credit reports and affect your credit scores for ten years from the filing date; a Chapter 13 bankruptcy will affect your credit reports and scores for seven years.” Declaring bankruptcy will likely prevent lenders from considering you for any loans for the coming decade.
Getting a loan and consolidating debts – How does it work?
When consolidating debt with a loan, the first step involves listing all the debts you want to consolidate, along with each debt’s total amount owed, interest rate, and monthly payment due. Next, calculate the total amount you owe to determine the size of your debt consolidation loan you need.
Compare rates at the websites of banks, credit unions, and other lending sources covering the total amount you owe. After applying for a loan, the lender will do a credit check and perhaps verify your employment, ensuring you earn a steady income.
Upon approval, make sure you agree with the fees and interest rate charge of your loan offer. You should also compare the monthly loan consolidation payment with the amount you currently pay. After agreeing to the loan, you will receive the funds in your bank to pay off your debts.
The bottom line
Done correctly, using a personal loan to consolidate credit card balances can save you hundreds or thousands of dollars in interest and make it repaying your debt easier. But in order for a personal loan to be helpful, you must: 1) Have good enough credit to qualify for an interest rate lower than your credit cards’ rate, 2) Be able to afford the loan’s fixed monthly payment and 3) Cancel or stop using your credit cards after paying off the balance(s) the the loan.
