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Debt consolidation can be an excellent way to streamline your payments, eliminate your debt faster and even save money along the way. It's not always the best approach, however, and it's important to understand your situation and your goals to determine the best way to tackle your debt situation.
As you research all of your options, here are some things to keep in mind before proceeding with debt consolidation.
Should You Consolidate Debt?
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 out for lenders that don't charge this upfront fee.
Balance Transfer Credit Card
Balance transfer credit 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.
Debt Management Plan
DMP for short, a debt management plan involves working with a credit counselor who can negotiate a lower interest rate and monthly payment with your creditors. Repayment terms typically range from three to five years, during which time you'll make one monthly payment to the credit counseling agency, which then distributes the money to your creditors.
DMPs typically require a one-time setup fee and a monthly fee for the duration of the plan. Additionally, you may be required to close all of your associated credit card accounts and agree not to open new accounts until you complete your DMP. Closing accounts can result in damage to your credit score, so carefully consider whether the benefits of a DMP outweigh any drawbacks before choosing this route.
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
As long as you make your payments on time after consolidating, you can use the process to build your credit score over time. If you miss a payment by 30 days or more, your credit score can take a significant hit.
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. Additionally, you can use Experian's card comparison tool to get matched with personal loans and balance transfer credit cards 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.