What does it Meant to Consolidate? How it Works
Debt consolidation is the strategy of combining multiple loans into a single loan. It is similar to refinancing – you get a brand new loan and use it to pay off existing debt.
When you consolidate, you don’t really pay off any debt. Instead, you shift your debt to a different loan. You’ll still owe just as much as you did before consolidation, but you might get certain benefits from combining those loans and moving them elsewhere.
Example: assume you are borrowing with two credit cards. Each card charges 18% APR, and you owe $1,500 on each card. To consolidate debt, you could get a $3,000 loan to pay off those cards (ideally, your new loan would have a much lower interest rate).
Simply shifting money around doesn’t accomplish anything. But there are ways to consolidate debt and come out ahead.
Save money: the best reason to consolidate loans is to save money, and the easiest way to do that is to borrow at a lower interest rate. Credit cards, for example, often charge relatively high interest rates, making it difficult to pay off your debt. If you consolidate into a lower-interest-rate loan, you’ll save on interest costs. That means more of every dollar you put toward your debt will go toward reducing your loan balance (and less of it will evaporate in interest expenses). Ultimately, this should help you pay off debts faster.
Simplify: consolidating multiple loans for a single payment can also make it easier to stay on top of your payments. You won’t save any money just by switching to a single payment, but if it helps you avoid missed payments and late fees, go for it. In fact, your required monthly payment might actually be higher after you consolidate – and that’s a good thing.
A larger payment (combined with lower interest charges each month) means you’ll pay off your debts faster. You won’t get anywhere if you just make minimum payments on your credit cards.
Is it a Good Idea to Consolidate Debt?
If you can save money and avoid creating additional problems, consolidating debt is a great idea. The key is to find a loan that truly lowers your interest costs. Run the numbers to make sure you’ll come out ahead, and don’t ignore any fees:
- For your consolidation loan, try a basic loan amortization calculator
- See how to find interest costs on credit cards
Consolidation, like everything in life, comes with pros and cons. Watch out for unintended consequences.
Increasing costs: if consolidating makes you take longer to pay off your debt (because you want to keep monthly payments low, for example), you might end up paying more in interest over the life of your loan. It’s hard to go wrong with a loan term of 3 years or less – that’s probably much faster than you’d pay off credit cards if you stick to the minimum.
Risking collateral: if you get a loan secured with collateral, you risk losing that property if you can’t repay the loan as agreed. For example, if you use a second mortgage or HELOC, your lender can take your house in foreclosure if you stop making payments.
Likewise, your car could get repossessed if you pledge it as collateral. Especially when you’re already using an unsecured loan (like a credit card or personal loan), it’s risky to put your house or car on the line.
Losing federal student loan benefits: student loans from government programs have certain features that can help when times get tough. For example, you might defer payments during unemployment or have interest costs subsidized. However, if you consolidate with a private lender, those features go away and you can’t get them back.
Doubling down: after you consolidate, it can feel like you’ve paid off debt (because your credit card statements will show a zero balance). Again, you’ve only moved your debt, but those cards will tempt you. If you “re-fill” those cards, you’ll owe twice as much as you currently owe – so it’s essential not to go back to those cards after consolidation.
Consolidation and your Credit
Consolidating debt should not have a major impact on your credit. However, it can lead to some movement in your credit scores.
When you apply for a loan, your lender will check your credit, resulting in an “inquiry” hitting your credit reports. Those inquiries can lower your credit scores slightly, but you can minimize the damage by submitting all of your applications at the same time (or within about 30 days).
Over time, there’s a chance that you’ll actually see your credit scores improve – assuming you don’t rack up debt again. You’ll switch from (possibly maxed out) revolving credit card debt to installment debt, and regular payments on those loans can improve your credit.
How Debt Consolidation Works
To consolidate debt, you’ll need to apply for a new loan and use the proceeds of that loan to pay off existing debts. Shop among various lenders, and various types of lenders, including:
- Banks (small local banks are your best bet)
- Credit unions (learn how credit unions work)
- Online non-bank lenders
- Peer to peer lenders
Consolidating with good credit: if you’ve got good credit, you’ve got a lot of options for consolidation. Any of the lenders above will offer you a competitive loan. Look for plain-old loans – you don’t need to hunt for “debt consolidation” loans. Definitely shop around, because some lenders will be better than others.
Consolidating with bad credit: if you have less-than-perfect credit, you’ll have fewer options, and you need to be careful. It’s harder to get approved, and the debt consolidation world is notorious for scams. Start with the types of lenders listed above. Some will require that you pledge collateral or use a cosigner, and you’ll have to evaluate the pros and cons of those strategies. You might also run across companies advertising debt consolidation programs. What they really offer is a form of debt management or debt counseling – which isn’t always a bad thing. Look closely at what they promise, see if you can do it yourself, and avoid paying steep fees if you’re not going to get value for your money.