Pros and Cons of Debt Consolidation

Debt consolidation is the process of rolling multiple debts into one loan, ideally at a lower interest rate. It can lower the cost of monthly payments, speed up the repayment process, and even improve your credit score. But it’s not right for everyone. Consider the pros and cons of debt consolidation before taking out a  loan to make sure it's the right move.

Pros of debt consolidation

There are many potential positive outcomes from consolidating debt:

• Lower interest rates: One of the best reasons to consolidate your debt is exchanging high-interest debt for low-interest debt. Credit cards on average have higher interest rates than personal loans, according to the Federal Reserve. So rolling credit card debt into a personal loan with a lower interest rate can save you money over time.
• Simplified payments: Keeping track of just one payment is easier than managing several. You’ll have one set payment that won’t change rather than multiple payments that can vary from month to month.
• Can pay off debt faster: Lower interest rates can help you pay off your debt faster. If you have a high balance on a credit card with a high interest rate, you'll likely be charged hundreds of dollars in interest each month, cutting into your ability to repay it quickly.
• Improved credit score: Many credit score models take into account how much credit you’re using out of the credit you have available to you — for example, the FICO score model uses your credit utilization ratio to determine 30% of your score. Consolidating your debt can bring down that ratio and boost your score. It can also improve your credit mix, which makes up 10% of a FICO score.

Learn More: How To Build Credit

Cons of debt consolidation

Here are four downsides to consider before you make any moves:

• Potential for higher overall costs: If you have a low credit score, you may not be able to qualify for a lower interest rate that would justify consolidation. Carefully review the interest rates and fees of debt consolidation loans to insure that you can save money. 
• Risk of taking on more debt: If you have multiple maxed out credit cards and take out a personal loan to consolidate that debt, don’t run the balances on your credit cards back up again. You could end up with a large monthly payment on a personal loan, plus multiple credit card bills, and be worse off than when you started.
• Negative impact on credit score: While there’s a chance your credit score could go up with debt consolidation, it could also go down. Adding on more debt could be a negative with some credit scoring models and the “hard” credit inquiry necessary to obtain a new loan will ping your credit score.

Ways to consolidate debt

There are multiple ways to consolidate debt — here are the most common:

• Use a personal loan: Personal loans are a great way to consolidate debt. Available at banks, credit unions, and from online lenders, these loans have relatively short repayment terms (usually 1 to 7 years) and have consistent monthly payments. They have lower interest rates on average than credit cards, so you can save money and pay off your debt faster.
• Tap into home equity: If you have equity in your home, you could get a home equity loan or a home equity line of credit (HELOC) and use it to consolidate your debt. Since these loans are secured by your home, you may be able to get a low interest rate. But if you’re unable to make your payments, you could lose your home.
• Transfer balances to a credit card: Some credit cards offer a 0% interest rate for a period of time if you transfer your debt onto the card. There is usually a fee associated — generally a percentage of the amount you're transferring — but if you can pay off your balance before the 0% rate falls off, you can save a good deal of money. Once the promotional rate ends, however, the interest rate will resume at the standard rate, so time your payments with that in mind.
• Borrow against your 401(k): Some 401(k) plans will allow you to borrow against your balance. Whether you can borrow, how much you can borrow, and other factors will depend on your 401(k) provider, but interest rates are generally low. However, these loans sap your 401(k) balance and reduce your retirement investments. You also may have to pay back the loan very quickly if you leave your job, and you could owe tax penalties if you default on the loan.

How to apply for a debt consolidation loan

While the steps will vary depending on the type of consolidation loan you decide on and each lender’s own processes, here are the basic steps you can expect:

• Check your credit score: Before you apply for any loans, pull your credit reports and review them. If your score is low, you might be better off waiting until you can boost it to apply for loans. If there are any errors dragging your score down, contest them and get them removed before you apply.
• Prequalify: Many types of loans will allow you to prequalify by entering your basic information. These prequalifications will give you an idea of the annual percentage rates (APRs) and monthly payments you may qualify for. But keep in mind that your final rate may differ, as prequalification is not an offer of credit.
• Compare options: Once you’ve prequalified for a variety of loans with different lenders, compare the loans to see which is best for you. Generally speaking, you’re looking for the loan that will cost you the least over its life, such as one with a low APR and fees and manageable monthly payments.
• Complete your application: Once you’ve identified the best loan for you, go back and finish your application. You can expect to provide proof of income, a government ID, and other supporting documentation. If you’re getting a secured loan, which is secured by collateral, the process will be longer and more involved. It is at this stage that your lender will conduct a hard credit pull, which can damage your score by a few points.
• Plan for repayment: Set up automatic payments if you can, or find another way to ensure you make your payments on time.

Alternatives to debt consolidation

If a debt consolidation loan isn’t an option for you, you may consider these alternatives. However, these should only be pursued if you’re sure that you can’t manage your debt via other methods.

• Debt management plans: When you work with a credit counseling service, they may be able to help you negotiate with your creditors to make repayment more manageable, often by lowering your payments or removing late fees. While these plans won’t directly affect your credit score, creditors may note it in your credit report, which may make future borrowing more difficult. 
• Debt settlement: Unlike debt management organizations, debt settlement companies are usually for-profit and will charge you fees. They negotiate with your creditors on your behalf, often making an offer for a lump sum payment that’s lower than the amount you owe. These companies usually require that you stop making payments, which can tank your credit score and bring lawsuits. If your debt is forgiven, there may be tax consequences.
• Bankruptcy: You may consider bankruptcy if your debt is overwhelming. If you have regular income and want to keep a home you own, you will most likely file for Chapter 13 bankruptcy. In this process, you typically present a 3- to 5-year repayment plan in court. At the end of the plan, if you have successfully followed the repayment plan, your debt is discharged. When filing for a Chapter 7 bankruptcy, your unsecured debt is liquidated. But you can keep most of your assets. Bankruptcy is obviously a last resort: The process itself is not free, and a Chapter 13 bankruptcy will remain on your credit report for up to 7 years, and a Chapter 7 for up to 10 years. Bankruptcies will likely make it extremely difficult for you to borrow money for years to come.

Should I consolidate my debt?

If you’re able to qualify for a loan with a much lower interest rate than your current debt carries, and you’re confident you’ll be able to make the monthly payments for the term of the loan, debt consolidation is probably a good option for you. 

Also, if you can transfer your debt to a balance transfer card and know you can repay it before the 0% interest rate ends, that could be a wise choice — just ensure any fees associated with the card will cost less in total than the interest and fees associated with your current debt.

Carefully review your options before taking on any new debt.