Pros and Cons of Debt Consolidation

Get out of debt
•••  Getty

If you’re having trouble making ends meet each month, and you’re looking for answers, debt consolidation can work for you if you’re disciplined, understand what consolidation can and cannot do, and follow a few simple guidelines.

What Is a Debt Consolidation?

Debt consolidation is the process of gathering your debts into one account with just one monthly payment. The idea behind a consolidation is to reduce the number of payments you have to make, and if possible reduce the interest rate and total amount you’re out of pocket each month, making it easier to pay off the balance.

Things to Remember

While debt consolidation can be an effective way to get control of your debt, there are a couple of things to remember.

  • Debt consolidation generally will not include your secured loans like your car loan. It will apply on to unsecured debt like credit card, personal bank loans, lines of credit, and other debts like medical bills.
  • Debt consolidation will not work unless you stop using your credit cards.and other accounts that you include in the consolidation. The best course is to close the accounts and cut up the credit cards. Some debt consolidation lenders may require that you do this as a condition of the loan.

    Types of Debt Consolidation

    There are a number of ways to go about consolidating your debt. Here are some to consider.

    Consolidation Loan: Many financial institutions offer some form of consolidation loan, including banks, credit unions, and finance companies. If you already have a relationship with one of those institutions, it will be a great place to start, and you may even get a break on the interest rate.

    With a personal bank loan, you’ll make the same payment every month for a set duration, typically three to five years. It’s very much like a car loan. In fact, some banks offer loan consolidations for which you can put up a savings account or CD as collateral. This will usually get you a better rate, but it only makes sense if you’re getting a decent rate on your savings. Otherwise, you’ll probably be better off using the savings to pay the debts.

    Because a personal loan has a set duration, it's easy to watch your progress and know when you’ll finally be free of debt.

    Consolidation Credit Card: If your credit is already pretty good, you might qualify for a credit card to which you can transfer balances. People often do this when they receive an offer with an attractive rate for balance transfers.

    Be aware that this can affect your credit score. FICO scores take into account your credit utilization (how much credit you’re using compared to what’s available to you.) and the overall amount you owe, among other factors. As you pay off accounts, your credit utilization goes down (which can be good for your credit score), but you’ll have one account with a large balance (which can negatively impact your score). Presumably, though, if you have a lower interest rate, you’ll be able to pay the account down faster.

    Home Equity Loan: If you have equity in your home, you may be able to use the proceeds of a home equity loan to pay off your high-balance high-interest accounts.

    Because a home equity loan is secured by your real property you’ll probably be offered a rate that’s much better than what you’re paying on your credit card accounts. But that’s a double-edged sword. If you run into trouble later and can’t make your loan payments, you’re putting your property at risk because your lender will have the right to foreclose on your loan.

    401k Loan: Similar cautions apply to 401k loans. If may seem attractive to use that nice balance you have in your retirement account to pay off that debt, but you need to be careful. If you have trouble paying back that loan, it will be converted into a withdrawal. You could be slapped with early withdrawal penalties of up to 10%, and have to pay the taxes that you didn’t pay when you deposited the money. If you change jobs, your 401k loan may have to be repaid within 60 days or be considered a distribution (with penalties and taxes due).

      

    Consolidation vs. a Debt Management Plan

    Conduct an online search for “debt management plan” and you’ll come up with dozens if not hundreds of companies offering to help you get control of your finances. These companies, many of which claim to be non-profit, secure an agreement from your creditors that will allow you to pay off your debts by making one payment each month to the agency, which distributes your payment among your creditors.

    In some cases, the agency is able to secure agreements to forgo interest and late charges, but that concession is voluntary and some creditors refuse to make it easier for you. Ideally, the payment plan is for a set duration that will pay off your accounts in full.

    Your best bet is to work with an affiliate of the National Foundation for Credit Counseling. You can find affiliated agencies in your area by using the agency search button on the website.

    Consolidation vs. Bankruptcy: If you’re just not going to be able to make a meaningful dent in your outstanding debt on your own, you might want to consider filing bankruptcy. It’s not the end of the world, and it has some advantages over other types of consolidation and debt management. You may be able to choose between Chapter 7, straight bankruptcy, and Chapter 13, a three to five year repayment plan. You can learn more about those advantages at When to Consider Filing Under Chapter 13 Instead of Chapter 7.