What is debt consolidation, and does it hurt your credit?

Are you overwhelmed by paying multiple debts and high interest? Debt consolidation may be your way out. To help you control your finance, in this article, we’ll explore what is debt consolidation, how it works, and how it affects your credit score.

Whether you’re having trouble keeping up with your loans or looking for a better way to handle your finances, debt consolidation can help. From the types of debt consolidation to its pros and cons, find out how debt consolidation can simplify your monthly payments.

Key takeaways

• Debt consolidation rolls up multiple debts into one loan to make your loan payments easier.
• You can consolidate debt through a personal loan, home equity loan, balance transfer credit card, and more.
• Consolidating your debts has numerous potential advantages, like easier payments, lower interest rates, and improved credit.
• Debt consolidation also carries risks, such as additional fees, exposing your collateral, and more debts taken.

What is debt consolidation?

Debt consolidation involves taking out a new loan to pay off your existing debts, like credit cards, medical bills, personal loans, etc. Ideally at a lower interest rate, your new loan allows you to combine several debts into one. In some cases, your lender settles your loans on your behalf while others hand you the funding so you make the payments.

Rather than paying multiple loans with different rates, you just make one monthly payment to simplify your bills. It’s an effective way to easily manage your debts and potentially lower your interest and payments.

How does debt consolidation work?

Let’s say you have two credit cards with different balances and interest rates. For example, one credit card has a $1,450 balance at 20.23% and a monthly payment of $100. Then, the other one’s current balance is $1,735 with an interest of 20.11% and a monthly payment of $125.

This means your total balance is $3,185 with a combined interest of 20.16% and total monthly payments of $225. So, how can you save with debt consolidation? The key is to find a debt consolidation loan with a lower annual percentage rate (APR) than your existing cards.

When you consolidate them, you take out a new loan to pay off the two credit cards — leaving you with one loan to repay. Say you manage to secure a debt consolidation loan with an interest rate of 15% and a loan term of 24 months.

This may lower your monthly payments to about $154. Since the APR is lower than your current combined rate, this may reduce your overall interest payments.

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Types of debt consolidation loans

There are various ways to consolidate your debts. Since debt consolidation is not a one-size-fits-all solution, carefully consider your options to pick the one that best suits your purpose.

Debt consolidation loan

You have the option to take out a personal loan that serves as a debt consolidation loan. You borrow funds from a bank, credit union, or online lender to settle your other outstanding bills. The advantage is that personal loans are typically unsecured, so there’s no need to worry about collateral.

Though personal loans can be used for varying reasons, make sure to still clarify if you can use the funds to consolidate your debts.

Let’s say you have multiple credit card balances. In that case, you can apply for a personal loan to use the borrowed amount to pay off those credit cards. Rather than managing numerous payments a month, you’ll only make one monthly payment toward your new loan.

To make the most of debt consolidation, take into account your new loan’s interest rate and term. Your new loan should ideally have a lower rate compared to your existing debts. Then, remember that you pay more interest over the life of your loan with a longer term.

Balance transfer credit card

Another choice you have is a balance transfer credit card, which allows you to transfer high-interest credit card debts to a new one. This can be an affordable choice because some credit cards offer a 0% introductory interest rate for new customers.

Usually, the promotional period for 0% APR lasts for 12 to 15 months or even more. During the promo period, you can transfer your outstanding credit card balance to a new card that has 0% interest. This, in effect, helps you settle your debt while avoiding interest over the promo period.

But keep in mind that the 0% interest rate is temporary, so try to pay your entire balance before the promo period ends. Once it expires, you accrue interest on your remaining balance.

Though you save money overall, most lenders may charge you a transfer fee. This usually costs you around 3% to 5% of the balance you transfer. So, try to weigh up if this will save you more.

Home equity loan

If you own your property, you may also think about getting a home equity loan. Home equity loans allow you to borrow against the equity in your home. So, this can then help you pay off other debts.

Although home equity loans commonly offer cheaper interest rates than credit cards, they come with risks — one of which is foreclosure. Since your home acts as collateral, you may lose your property if you default on your loan. Typically, they also come with fees, like application fees, underwriting fees, appraisal fees, and more.

Home equity line of credit

Alternatively, you can withdraw funds as you need with a home equity line of credit (HELOC). But note that a HELOC uses your home as collateral as you have a predetermined limit based on the equity you have.

Similar to credit cards, you can replenish your available credit. Meaning you can withdraw as little or as much as long as you have credit at hand. Oftentimes, you can draw funds for 10 years. When you can’t borrow from your credit line anymore, your repayments can stretch up to 20 years.

Since it’s a long-term loan, HELOCs are best for borrowers who need to borrow large sums with longer repayment periods.

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Is debt consolidation a good idea?

Remember, everyone’s situation and needs are unique. Before diving into consolidating your debts, it’s important to weigh the pros and cons.

Pros of debt consolidation

• Easier debt management: Debt consolidation simplifies your debts by combining multiple them into a single loan. This way, it’s easier to keep track of your payments.
• Less overall interest: When you consolidate high-interest debts into a new loan with a lower interest rate, you potentially save on your overall interest payments.
• Lower monthly payments: In line with lower interest, you can also have lower monthly payments. In turn, you can create some breathing room in your budget and improve your cash flow.
• Improved credit: A simpler debt management may make it easier to make timely payments. And since on-time payments can have a positive impact on your credit, this helps you build your credit score and history.

Cons of debt consolidation

• Additional fees: In some cases, you need to pay fees when you consolidate your debts. For example, you may need to pay balance transfer fees when you consolidate your credit card debt. These can increase the overall cost of your loan. So, before you consolidate your debts, make sure the savings outweigh the costs.
• Potential higher interest rates: While you may secure lower rates, it’s still possible to get higher interest. Your creditworthiness influences your debt consolidation loan interest rate. So, if you have poor credit, your loan may have a higher rate.
• Risk of using collateral: Certain debt consolidation options, like home equity loans, require collateral. The biggest risk with this choice is it puts your assets at risk if you default on your loan. Before you put up collateral, make sure you can afford your loan.
• May encourage more debts: Consolidating debts can free up some of your credit. Sometimes, this may tempt you to spend more. This then leads to new debts, so it may defeat the purpose of debt consolidation.

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Do debt consolidation loans hurt your credit?

Debt consolidation affects your credit in two ways. Depending on how you manage your new loan, it can either boost or hurt your credit history.

If you handle your payments the right way, consolidating debt may improve your credit over time. By combining multiple debts into one, you can easily track your loans. Say this helps you make on-time payments, keep your outstanding balances low, or catch up on your past-due accounts. Debt consolidation can then help you lift your credit and avoid risks that may dip your score.

On the flip side, it may hurt your credit score if you miss any payments or default on your new loan. Closing your old accounts also impacts your credit utilization ratio because this reduces your available credit and the length of your credit history.

Final thoughts

Juggling multiple debts is overwhelming, so understanding how a debt consolidation loan works can help you gain control of your finances. Remember, debt consolidation is not for everyone. By considering and assessing your options, you can find the one that aligns with your financial goals.

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Frequently asked questions