Debt Consolidation 101
If you are one of the 39% of Americans with unpaid credit card balances, you may be wondering if debt consolidation could provide a way out of debt without paying those high credit card rates. Or perhaps you’ve become aware of the dangers of your mounting debt and are curious about your options.
Debt consolidation is a great tool for paying down multiple unsecured debts. But like any tool, you can hurt yourself if you don’t use it correctly. In this article, we will discuss what debt consolidation is, why it’s beneficial under some circumstances, and why you should avoid it under others.
Debt consolidation, boiled down
Debt.org describes debt consolidation as combining several unsecured debts, such as credit cards, personal loans, and medical bills into one bill. The goal is to simplify the debt by combining the accounts into one payment, secure a reduced interest rate, and end up with a payment lower than the sum of the original minimum payments.
If that sounds good to you, there’s a simple reason for that. That description is over-simplified. There are many nuances and side-effects to be explored. We’ll start with the monthly payments.
Debt consolidation monthly payments
Will you pay less per month? Yes, most likely. If you have a limited income and reducing your payments on debt is vital to your finances, this is an enormous benefit of debt consolidation. The money freed up that was previously spent on debt will hopefully go toward your living expenses and keep you out of further trouble.
Reduced overall expenditure on monthly payments on debt is definitely the greatest benefit of debt consolidation. But will you only pay the minimum monthly payment on the new loan?
Think carefully about your answer, because if you stick with minimum payments, you will technically be doing less to pay down your debt than you were before consolidation.
Again, if your situation requires lower monthly payments, debt consolidation might be a win. If your goal is to get out of debt as soon as possible, debt consolidation could become an obstacle, depending on your repayment plan. Here is a fantastic debt consolidation calculator to help you out.
Does debt consolidation save you money?
By bundling multiple loans into a consolidated loan at a lower rate, you are not necessarily reducing your debt at all. The debt has simply passed from multiple creditors to one. The lower rate may sound good, but in all likelihood the debt consolidation extended the repayment period, leading to more overall payments.
Dave Ramsey, the famed businessman, show host, and author best known for his berating attitude toward irresponsible spenders, expresses some strong feelings against debt consolidation. He shows his math to illustrate how consolidating debt, even at a lower interest rate, can actually increase your debt.
We can keep this section short. There’s an obvious “convenience” factor in paying one creditor vs. paying several. Dealing with multiple creditors takes time, and time is money, right?
Just keep in mind that convenience can come with its own price as well. You might have had the chance to negotiate interest rates with multiple creditors, but by consolidating, you only get one entity to negotiate with, going forward.
Lower interest rates?
We mentioned earlier that part of the mission of a debt consolidation loan is to secure a lower interest rate. For example, the national average interest rate on credit cards is around 15%. Moving that debt to a loan with an interest rate closer to 9% seems reasonable.
But what if you are consolidating multiple loans with varying interest rates? Would it make sense to include a 6% interest loan into the same 9% loan, along with the credit card debt? It really depends on how badly you need that single payment. Most likely, you’re better off not rolling low interest loan into a higher interest loan.
What about your credit score?
According to Bankrate.com, taking out a debt consolidation loan can cause a dip in your credit score. Since your debt has simply “moved,” your credit score won’t completely tank, but because a loan means a new inquiry on your credit.
One might think consolidating credit card debt to a low interest loan would increase a credit score, since you now have a lower debt-to-credit ratio. As Bankrate.com points out, however, this also means you’ve put yourself in a situation where you could potentially max those credit cards out all over again.
Debt consolidation: decision time
Climbing out of debt is never easy. It takes not only knowledge of your options, but the discipline to change the habits that got you into debt in the first place. Debt consolidation, we know, can reduce your monthly payments and possibly reduce your interest rates. But we also know it doesn’t “fix” the debt problem.
If you decide you have the need to consolidate, avoid the temptation to use any zero balance credit cards from now on. Turn a new leaf. And if possible, pay more than the minimum payment to quickly put debt in the rear view mirror.