If you have multiple credit cards, auto loans, or student loans, it can be challenging to keep track of all of them. Chances are, they all have different payment due dates and high interest rates. And you may not be able to keep up with or afford every monthly payment that’s asked of you. This can result in missed payments and subsequent hits to your credit score.
A debt consolidation loan is one way to combine these loans into one and help you keep track of everything you owe. Keep reading for more information about a debt consolidation loan and why you may (or may not) want one.
What is a Debt Consolidation Loan?
The idea of “debt consolidation” means rolling multiple loans or debts into one payment. Usually, debt consolidation takes a handful of different high-interest loans (credit cards, for example) and consolidates them into one larger loan with a lower interest rate (if you qualify).
By reducing and reorganizing your total debt into one consolidated loan, the hope is that you will be able to keep track of your payments better. Additionally, you’ll generally have a lower monthly payment. And you might be able to pay off your debt faster than you would have otherwise. However, there are pros and cons to taking out a debt consolidation loan, so be sure to consider both before you do so.
Why Would I Want to Consolidate Debt?
In the following sections, we will discuss the pros of debt consolidation or why you would want to consolidate your debt into one large loan. There are many reasons someone might want to do this, but the most prevalent are to help streamline your finances and payments, expedite the payoff of debts, and boost your credit score.
Streamline Your Finances/Payments
One of the primary reasons people want to consolidate their debt into a larger loan is to streamline their finances and payment process. When you have multiple credit cards, student loans, or auto loans, it can be tough to keep track of all the payment dates and late fees. When you take out a debt consolidation loan, all of those payments are transferred into one larger loan with one due date instead of multiple dates. This helps keep things organized and prevents you from missing future payments and dealing with pesky late fees.
Can Help Expedite Payoff
Taking out a debt consolidation loan can also help expedite the payoff process and allow you to become debt-free much faster. Since debt consolidation loans often have lower interest rates than the individual high-interest loans you have accrued, you could consider making additional or larger payments with the money you save through interest every month. This will help you pay off the loan even quicker and prevent you from holding onto your debt for any longer than you need to.
Debt consolidation loans typically lead to longer, extended loan terms, so taking advantage of the money you save to make larger payments can help you take advantage of all the benefits of consolidating your debt.
Can Improve Credit Score
Consolidating your debt into a singular loan will likely cause your credit score to take a slight dip initially due to the hard credit inquiry required for approval. However, there are a few ways that debt consolidation can actually improve your credit score.
One of those ways is that it can lower your total credit utilization percentage.
When you free up your credit card lines using debt consolidation and bring your balances back to zero, your credit utilization rate will be lower, which is a factor that has a massive impact on your credit score. Ideally, this should be under 30 percent, but sometimes debt, holidays, personal issues, and more cause this number to be driven up.
Cons to Consolidating Debt
Now that you’ve heard all the positives of debt consolidation, you might be ready to sign a loan agreement right away. However, while all of the above pros might sound great, you need to also be aware of the potential negatives that come alongside a debt consolidation loan. In the following section, we will discuss some of the problems that can come with taking out a debt consolidation loan.
Can Have Added or Hidden Costs
While debt consolidation loans might save you money in the long run, they can have some upfront fees and costs that might be difficult to manage. Things like origination fees, balance transfer fees, closing costs, annual fees, and more may prove difficult if you are already struggling to cover your current debt payments. This shouldn’t necessarily be a dealbreaker, but make sure you set those fees aside before you decide to take out a debt consolidation loan.
Missing Payments is a Big Deal
Missing payments might not be a huge deal right now. But if you miss a debt consolidation loan payment, it can be a much bigger problem. Not only will you be subjected to added fees if you miss payments with a debt consolidation loan, but you will also significantly damage your credit score when you neglect to cover your required payments on time. To avoid this, make sure to evaluate your budget each month and set aside a payment amount that meets or exceeds the minimum monthly payment.
You Might Pay More in Interest
Many debt consolidation loans sound very appealing, as the interest rate for the loan is lower than the rates you currently pay for your individual loans or credit cards. However, since the length of debt consolidation loans is typically much longer than other loans, you may end up actually paying more in interest throughout the life of the loan, even though the interest rate is lower. Therefore, while your monthly payment might be lower, interest will accrue for a much more extended period with a debt consolidation loan.
Doesn’t Solve Your Debt Issues
Consolidating your debt into one larger loan may sound like a fresh start to all your debt issues. However, consolidating your debt will not solve your underlying problems with money, nor will it cause all of your debt to go away. If you have high balances on credit cards, for example, consolidating that debt will not eliminate the bad habits that caused that debt to accrue originally. Instead, as we’ll discuss in the next tip, it may even worsen them.
Can Create the Illusion of More Money
When you consolidate your debt and free up all your credit lines, your credit card balances will go back down to zero. While this might initially be a relief, it can quickly make it seem like you have more money and can continue using your credit cards. This is the complete opposite of the point of a debt consolidation loan, and it can send you into a financial tailspin very quickly.
So, Should I Take Out a Debt Consolidation Loan?
Whether or not you should take out a debt consolidation loan really depends on the type of person you are. Suppose you have good money habits and are only having a bit of trouble managing your current individual loan payments. In that case, you could benefit from longer loan terms, a lower monthly payment, and lower interest rates. However, if your budgeting skills are mediocre and you lack self-discipline, definitely be aware of all the pros and cons before you take out this type of loan.