Debt consolidation is generally touted as a smart financial move because it can boost your credit score and save you money.
But a few mistakes could actually hurt your credit or cost you more money in the long run. Here’s what to keep in mind when deciding to consolidate your debt and how to choose the best way to do it.
How does debt consolidation work?
Debt consolidation generally consists of taking out a loan to pay off existing debts, most often credit card debt.
These are technically personal loans which lenders often market as “debt consolidation loans”, which is not incorrect. It’s just their way of letting you know how they can help you.
You will take out the loan, receive the funds and use them to pay off your credit card balance. Then you will repay the loan over time like any other loan.
You can also consolidate with a balance transfer credit card or another type of loan, such as a retirement account loan Where home equity loan. However, personal loans generally have the advantage of having lower interest rates and no collateral requirements.
People with a lot of high-interest debt tend to turn to consolidation because it simplifies repayment and could lower the cost of debt through lower monthly payments, a lower interest rate, or both.
Advantages and disadvantages of debt consolidation loans
Although debt consolidation generally improves your credit score, there are pros and cons to consider before consolidating credit card debt or other high interest loans.
- Fewer monthly payments
- Lower interest rate
- Lower monthly payment
- Increases credit score
- Costs more over time
- Could hurt your credit score
- A larger monthly payment
- Potential charges up front or over time
5 alternatives to debt consolidation
You might come across companies offering one of many ways to settle your debt. They will each have a different effect on your credit score and apply to different situations:
Consolidation refers to the “bundling” of several debts into one. A single loan or credit card pays off the balance of several others, so you are left with just one line of debt. Consolidate your debts when you want to streamline the repayment of multiple debts.
2. Debt refinancing
Refinancing works like consolidation, but the term generally refers to paying off a single debt. You pay off a loan balance with a new loan that offers you a better interest rate and better repayment terms. Refinance your debt if your credit and finances have improved since your first loan.
3. Debt relief
Debt relief is an umbrella term that includes consolidation and refinancing, and it often includes some debt forgiveness. The term is often used by companies that facilitate debt consolidation or a “debt management plan” – you’re usually better off doing a bit of research and managing the debt yourself.
4. Debt Settlement
Settlement is when you agree with a creditor on a reduced repayment amount which they will consider full payment. This will show up on your credit report and could have a negative impact for several years, but will help you pay off the debt faster.
5. Debt restructuring
Restructuring is more common for companies than for individuals and usually occurs in difficult situations. The effect is similar to refinancing, but it reorganizes existing debt rather than replacing it with new one.
Do you need good credit to consolidate your debts?
You don’t necessarily need a high credit score to take out a debt consolidation loan, but better credit gives you a better chance at a low interest rate and favorable terms.
Beware of predatory lenders if you have a low credit score. Some unscrupulous companies are ready to give you a loan that you cannot afford with a very high interest rate. A loan you can’t afford to repay could put you worse off than you are with credit card debt.
How can debt consolidation help your credit score?
Debt consolidation could improve your credit score in two main ways:
- Lower your use of credit: The amount of available credit you use weighs heavily on your score. A bunch of credit cards maxed out looks bad. Consolidation pays off these balances and reduces your usage.
- A positive line on your credit file: The loan is a way to demonstrate your creditworthiness as long as you stay up to date with payments.
Consolidation itself does not leave a negative mark on your credit report like debt settlement does. But the loan (or credit card) appears as a new line of credit, which could temporarily lower your score.
How could debt consolidation hurt your credit score?
A few common debt consolidation mistakes could hurt your credit score or cost you money. Here are some tips for making the right decision about whether a debt consolidation loan could hurt your credit score and how to save money in your situation.
Do not close paid accounts
After paying off your credit cards, do not close all accounts. Having them on your credit report affects these the factors that make up your credit score:
- Age of credit history: Creditors want to see that you’ve been around the block with credit. When you close old cards, your average credit history goes down.
- Composition of credit: It’s about the variety of debt types you have – installment loan vs credit card vs mortgage, for example. This has a small but significant effect on your credit score.
- Use: More open cards means more available credit. Cut your cards to avoid increasing that balance again, and that unused credit will keep your utilization rate low.
Your credit card consolidation loan or balance transfer credit card is still in debt with monthly payments that you need to keep up with.
Budget before taking out the loan so you know you can afford the monthly payment. Staying on top of payments should improve your credit score over time, but falling behind will hurt you.
If you opt for a balance transfer card – which usually comes with an introductory APR of 0% for about a year – plan to pay off debt during the introductory period. Any longer, and you’ll have to pay interest and likely face high interest and annual fees.
Compare Consolidation Options
Shop the best debt consolidation loans before you commit.
Consider what type of consolidation — personal loan, balance transfer card, or secured loan — which suits you best based on your budget, existing debt and creditworthiness.
Online lending markets can help you quickly see and compare personal loan offers from lenders side by side.
To evaluate a debt consolidation loan, consider:
- Interest rate: Aim for an interest rate lower than the combined rate of your existing debt. A loan with a higher rate might still relieve you of a lower monthly payment and fewer creditors, but it will cost you more money.
- Monthly payment: Rearranging your debt to get a smaller monthly payment could outweigh the long-term savings you’d get with a shorter repayment term or lower interest. A smaller bill could mean the difference between paying on time or not, which has a major impact on your credit score.
- Costs: Read the fine print to understand the total cost of consolidation. A personal loan may have an origination fee and a balance transfer card may charge an annual fee after the first year.
- Repayment period : The more time you have to pay off the debt, the smaller your monthly payment will likely be — and the longer the balance will have to accrue compound interest, costing you more money over time.
Refinance again in the future
Perhaps your best option now is to take out a loan with a high interest rate and a long repayment term. If this puts you on the right track with paying off your debts, this could be just what you need to boost your credit score.
Don’t stick to these bad terms long term.
As your score increases and you get a handle on your monthly budget, consider refinancing the loan for better terms in the future.
Debt Consolidation Frequently Asked Questions (FAQ)
What do you need to qualify for debt consolidation?
Eligibility for a debt consolidation loan has many of the same requirements as eligibility for any loan. You will need to be at least 18 years old, provide proof of citizenship, and submit documents showing your current income and ability to make monthly payments on your debts at prevailing interest rates. You will also need to meet the lender’s minimum credit score requirement, which is usually in the 600 range for this type of loan.
Is debt consolidation a good reason to get a personal loan?
Many lenders specifically offer debt consolidation loans, but you don’t have to consolidate that way. Instead of working with debt consolidation loan companies, you can choose to consolidate your debts through personal lenders with lower interest rates. It can be a smart financial decision if you have multiple high-interest credit card bills or multiple debts, but your credit score must be 650 or higher to qualify for unsecured personal loans from most lenders.
How long will it take for debt consolidation to improve my credit rating?
How long it takes for debt consolidation to affect your credit score depends on how you consolidated the debt. In the case of a simple debt consolidation loan, you should see it improve your credit score within 6 to 24 months. If you are trying to qualify for another loan, such as a home equity loan, you will want to start the consolidation process up to a year before applying.
Kaz Weida is an editor for The Penny Hoarder. Dana Miranda contributed.