Is It a Good Idea to Consolidate Debt?

How Debt Consolidation Works

Debt consolidation works by combining multiple debts into one streamlined payment, often using a debt consolidation loan or balance transfer credit card (more on these options below). Ideally, the new loan or credit card should have a lower interest rate than you're currently paying on your debts. That way, you may be able to save money on interest while also making your payments more manageable.

Pros and Cons of Debt Consolidation

While debt consolidation can be a helpful strategy for paying off debt, consider the pros and cons to help you decide if it's right for you.

Learn more: Does Debt Consolidation Hurt Your Credit?

Is Debt Consolidation a Good Idea?

Consolidating debt isn't a one-size-fits-all solution, so it's important to evaluate your circumstances and goals to determine whether it's the right move for you. To help you get started, here are some situations where it might make sense, as well as some where it might not.

When to Consider Debt Consolidation

• You have good credit and can qualify for better terms on a loan or credit card.
• Your budget can handle the new monthly payment without sacrificing essential expenses and other debt obligations.
• You have a sizable amount of high-interest debt.
• You have several monthly payments and want to combine them into one.
• You want to lower your monthly payments.
• You have debt with variable interest rates and want to switch to a fixed rate.
• You're committed to changing your spending habits to avoid taking on more debt.

When to Think Twice About Debt Consolidation

• Your credit score is low, and you can't qualify for better terms than what you currently have.
• The new monthly payment is higher than your total current payments.
• You can pay off your debt within a year without consolidating it.
• Your income and employment situation is uncertain or unpredictable.
• You want to avoid opening a new credit account.
• Your debt situation is dire enough that even reduced monthly payments would be unaffordable.
• You're concerned about potential fees related to personal loans, balance transfer credit cards or debt management plans.

How to Consolidate Debt

There are a few different ways to consolidate your debt, including a personal loan, balance transfer credit card or debt management plan. Here's how each option works.

Personal Loan

A personal loan is an installment loan you can use to pay off high-interest loans and credit card balances. Repayment terms typically range from one to seven years, and interest rates can be in the single digits if you have good or excellent credit.

That said, some lenders charge an origination fee that can be as much as 12% of the loan amount in some cases and is deducted from your loan disbursement. If your credit is in great shape, look for lenders that don't charge this upfront fee.

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Balance Transfer Credit Card

Balance transfer cards offer introductory 0% APR promotions, typically between 12 and 21 months, during which you can pay down a balance transferred from another credit card—and, in some cases, a loan—interest-free.

Balance transfer credit cards typically charge a fee ranging from 3% to 5% of the transferred amount, which will be added to your new balance. Also, note that you may be limited on how much you can transfer based on the new card's credit limit.

Learn more: Balance Transfer vs. Debt Consolidation Loan: Which Is Best?

How Debt Consolidation Affects Your Credit Score

Depending on the type of consolidation you choose, the process can impact your credit score in different ways:

Hard Credit Inquiry

When you apply for a personal loan or credit card, the lender will typically run a hard inquiry on your credit reports, which can temporarily impact your credit score. That said, each new inquiry typically takes fewer than five points off your score, and the dip is often temporary.

New Account

If you open a new loan account or credit card, it can negatively impact your length of credit history, particularly by lowering the average age of your accounts. But again, the impact is typically temporary in nature.

Credit Utilization

Your credit utilization rate is the percentage of the available credit on your credit cards that you're using at a given time. If you pay off credit card balances with a personal loan, it'll reduce your utilization rate on those accounts to zero, which can help increase your credit score.

If you use a balance transfer credit card, the impact on your credit will depend on how your utilization rate changes on both the new and old accounts.

Finally, closing credit card accounts with a DMP can cause your utilization rate to spike, which can hurt your credit until you pay down the balances.

Payment History

Your payment history is the single most important factor in calculating your credit scores, so making on-time payments is key. Consolidating your debt could help you improve your payment history as long as you make your payments on time after consolidating. That can improve your score over time.

Consolidation may decrease the number of payments you have to make each month by combining your balances. It may lower the total amount due each month to keep your debt current. If it makes your payments more manageable, consolidation could help you avoid making late payments.

On the other hand, if you miss a payment by 30 days or more, your credit score can take a significant hit.

Credit Mix

Credit mix is a credit scoring factor that takes into account the different types of credit you have. The two main types of credit to know about are revolving credit and installment credit.

• Revolving credit refers to credit that allows you to borrow up to a set limit, then repay your balance and continue to borrow over time, as long as you continue to meet the lender's terms. Credit cards are a common example of revolving credit.
• Installment credit refers to loans that provide you with a lump sum of money. Then, you repay the loan over time in set installments, often with a fixed monthly rate. Personal loans and auto loans are common examples.

So, how does debt consolidation affect your credit mix? If all of your debts are exclusively either installment or revolving balances, then consolidation could diversify your credit mix if you consolidate using the other type of credit. In other words, if you currently have credit card debt, consolidating with a debt consolidation loan could diversify your credit mix. Or, on the other hand, if you have debt in the form of high-interest loans, consolidating with a balance transfer card could also improve your credit mix.

Learn more: What Affects Your Credit Scores?

Alternatives to Debt Consolidation

While consolidating can be a smart strategy for getting out of debt and improving your financial situation overall, it isn't the only way to get out of debt. In some cases, one of these alternatives may be a better fit.

• Debt avalanche method: The debt avalanche strategy is a DIY approach to getting out of debt. It works by eliminating your debts in order from highest interest rate to lowest. That can help you pay off your most expensive debts first, which may save you the most money over time.
• Debt snowball method: Like the avalanche method, the debt snowball strategy is a way of prioritizing and aggressively paying off debts. With the snowball strategy, you'll start by paying off your smallest balance first. Then, you'll move on to the next smallest and so on. Watching the number of balances you carry dwindle in number faster can motivate you to keep going.
• Credit counseling: Credit counseling is a service that can help if you're feeling overwhelmed with debt. When you meet with a credit counselor, they'll go over your finances with you. Together, you'll take inventory of your debts alongside your income and budget, then chart a potential course out of debt. To be sure you're getting good advice, look for a nonprofit credit counselor accredited through the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of American (FCAA).
• Debt management plan (DMP): In some cases, a credit counselor may suggest a debt management plan as a strategy to get out of debt. When you enroll in a DMP, your counselor negotiates with your lenders for you to attempt to lower your rates. Then, you'll make one monthly payment directly to your credit counselor, who'll disperse the funds to pay down your debt. Repayment under a DMP typically takes around three to five years.

Learn more: How to Get Out of Debt

Check Your Credit Before Consolidating Debt

If you believe debt consolidation can help you tackle your debt, check your credit score before you get started to gauge your creditworthiness and potential options. Then, review personal loans and balance transfer credit cards that you're likely to qualify for based on your credit profile.

As you execute your debt payoff strategy, continue to monitor your credit to understand how your actions impact your credit score and track your progress in building and maintaining good credit.