If you feel overwhelmed by loans, you may be looking for a way to simultaneously simplify and reduce your expenses. Debt consolidation is one of the most common ways to achieve this, and it’s important to properly understand how it works and what it involves.
What is debt consolidation?
Simply put, debt consolidation combines multiple high-interest debts into a single, lower-interest payment. This reorganization makes your debt easier to manage and repay and can even reduce your total debt. “If you’re dealing with a manageable amount of debt and just want to reorganize multiple bills with different interest rates, payments and due dates, debt consolidation is a sound approach you can tackle on your own,” Amrita Jayakumar recommends in an article for NerdWallet.
Different types of debt consolidation
There are four major types of debt consolidation. The most common is a fixed-rate consolidation loan, which many financial institutions offer. You can use the money from the loan to pay off your debts, then pay back the loan — usually on a monthly basis — over a set term.
If you have good credit, you can consolidate debt using a consolidation credit card, which allows you to transfer all of your debt onto a single account. The best time to take this approach is during a promotional period. “People often do this when they receive an offer with an attractive rate for balance transfers,” Carron Armstrong of TheBalance remarks. For example, you could transfer all of your debt onto a credit card with a zero percent interest rate and pay the balance in full.
Two less-commonly used forms of debt consolidation involve taking out a 401(k) loan or a home equity loan, but these involve risks to your retirement or home and thus should not be taken lightly. It’s important to completely understand the risks of these options before opting for them.
Three benefits of consolidating debt
Debt consolidation can be a fantastic tool when used in the right situations. The primary advantage it offers is the potential for a lower overall interest rate on your loans. If you are able to bundle multiple forms of high-interest debt into a single consolidation loan with a low interest rate, you can save a significant amount of money and take years off your debt repayment. “You just need to ensure the APR on your new loan is lower than the APR on your existing debt,” advises Nick Clements in a Forbes article.
Another benefit of consolidating debt is added convenience. If your debt is spread out across multiple accounts, managing it can be time-consuming, confusing and potentially problematic. With a consolidation loan, you only have one payment and one deadline to worry about.
Consolidating debt can increase your credit score. If your credit cards are fully utilized, they have a significantly negative impact on your credit score. By paying them off with a loan, you’ll be reducing that utilization. Clements cites a study by Lending Club showing that “people who used a loan to pay off credit cards saw an average score increase of 21 points within three months of the loan.”
Limitations of consolidating debt
Some people mistakenly feel as though consolidating debt is synonymous with removing it. Jayakumar warns that “consolidation isn’t a silver bullet for debt problems. It doesn’t address excessive spending habits that create debt in the first place.” If you are so overwhelmed with debt that you will not be able to pay off even a consolidated loan with reduced payment, consolidation is not likely to be an effective tool. If this is the case or if your debt exceeds more than half of your income, seek debt relief instead.
Consolidating debt isn’t a catch-all solution to debt problems, but it can be an effective tool for reducing manageable debt and may be a viable strategy for you.