What Is Debt Consolidation?
Point of Interest
Debt consolidation can be a great option if you want to lump all of your monthly payments into one. But it is important you understand the way it works in order to avoid accumulating more debt in the long run.
In the United States, finances regularly top the list of stressors. Between 2007 and 2015, money was the No. 1 reason for stress to Americans, according to a study from the American Psychological Association. One reason for all that stress is the amount of debt in people’s lives.
Debt consolidation can be a useful tool to manage both your money and your stress levels. If this is keeping you up at night, consolidating your debt might help you sleep easier.
What is debt consolidation?
Debt consolidation combines debt from multiple sources into one monthly payment. If you have a balance on three high-interest credit cards and three student loans, you could use debt consolidation to roll them together and make one monthly payment instead of six different payments each month.
Debt consolidation might mean a lower interest rate for your debt as well. This is not a guarantee, though, and will depend on factors like your credit score and debt-to-income ratio.
How does debt consolidation work?
The big picture view of debt consolidation is that you combine several debts into one, and thus have only one monthly payment. There are some more nuances to this process that will depend on which route you go. You have two options:
- A debt consolidation loan
- A 0% interest credit card balance transfer
A debt consolidation loan from a bank or a private company takes all your debts and rolls them into one. You may qualify for a new and lower interest rate. Generally, a debt consolidation loan extends the life of your debt. In exchange for lower monthly payments, the length of the loan is extended. You don’t owe less money; you simply have more time to pay the same amount.
For example, say you have $40,000 in debt:
- $10,000 on a credit card at 18% interest
- $5,000 on student loan 1 at 7% interest
- $5,0000 on student loan 2 at 7% interest
- $20,000 on an auto loan at 9% interest
These are all relatively high-interest rates. Debt consolidation takes these separate loans and payments and combines them into one payment for you. You don’t have to pay for each company separately anymore. You instead make your payment to the company that consolidated the loan for you. Let’s say with a good credit score, consistent income and a decent debt-to-income ratio, you qualify for a lower interest rate of 8% on your new loan. Now you have one payment, at a lower interest rate, each month.
You can use this calculator to figure out how debt consolidation might help lower your monthly payments.
A credit card balance transfer is another type of debt consolidation. You transfer the balances from one or more cards with high-interest rates onto a card with a low or zero percent interest rate. This gives you some interest relief. However, a major thing to take note of is if your new lower interest rate is permanent or only for a certain amount of time. Most credit card companies will offer a 0% interest rate for a set timeframe; something like 12 months. After that, a new interest rate will come into play.
If you can pay off your debt in the zero-interest timeframe, a credit card transfer can be a smart and powerful money move. If you can’t pay off your debt in that time though, you’ll be in the same place you were before.
If you’re thinking this is a perfect solution for your debt, it might be. But before you sign any paperwork, consider that consolidation might extend the life of your debt. If you opt for a plan that lowers your minimum monthly payments, it could mean it takes you longer to pay it off.
Remember also that a lower rate isn’t a guarantee when you consolidate your debt. Nor is debt consolidation debt elimination. You are still responsible for paying the entirety of your debt. Make sure to research and compare personal loans thoroughly.
When to consolidate debt
A good time to consolidate debt is if you’re having a hard making your monthly payments because of the amount you pay each month. Consolidating can offer some relief by making it easier to pay via the one payment, and by offering a lower monthly payment amount.
You can also consider consolidation if your total debt is between 30 to 40% of your total income. Credit bureaus generally like to see a credit utilization rate of 30% or less, so it stands to reason that they’d like to see a debt load in the same range. This shows you still have enough income coming in to make your debt payments and not rely on a loan or credit card to pay your bills.
When not to consolidate debt
Skip consolidating your debt if you are in the home stretch of your debt payoff, meaning five months or less. The time, work and literal cost of consolidating isn’t worth it.
You shouldn’t consolidate debt if you have trouble maintaining a steady income. It will be hard to get approved for a debt consolidation loan. This applies especially to credit card transfers because those 0% interest rates are for a limited time only. If you know you won’t be able to pay the debt off by the end of the limited terms, you might find yourself with an even higher interest rate. The 0% interest time might be helpful, but your focus should be on increasing and maintaining your income.
Debt consolidation alternatives
The biggest alternative to consolidating debt is getting serious about eliminating it. Paying off your debt is a permanent solution, as long as you have a plan and a system to stay out of debt.
You can follow the debt snowball method to pay off debt. Make the minimum payments on every debt you have except for your lowest balance debt. Any extra cash on hand should go toward that lowest balance until it’s paid off. Then, you roll your extra payments and the minimum payment you were making onto your next lowest balance debt.
The final word
Debt consolidation is a great tactic to help you get out of debt faster, but it’s important to understand when is the right time to do so. You shouldn’t consolidate debt in order to continue other lavish spending or to payoff debt that you’re almost done with, but you should consider it if you’re struggling to keep up with regular monthly payments. Always remember to lay out all the options before making any big financial decisions.