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According to the Federal Reserve Bank of New York, the average American has $51,900 in debt. This includes debts of all kinds, such as student loans, credit cards, mortgages, auto leases, personal loans and more. Unfortunately, carrying significant debt can have a negative impact on your mental health and make you feel trapped in your situation. If it feels like your debt is out of control, debt consolidation or credit consolidation might be the answer for you.
How does debt consolidation work?
As the name suggests, debt consolidation is when you combine all your debt into one payment at a lower interest rate. Let’s say a person has student loan debt, medical bills, credit card debt and an auto loan. The monthly payments for all these debts are due at different times, in various amounts and at different interest rates.
Debt consolidation is the process of finding a lender that will loan you money to pay off all your separate debts so you can focus on paying back just one lender instead. When people feel they don’t have control over their many debts, debt or credit consolidation can feel like having a clear and straightforward plan. It’s also an excellent solution for a person carrying various types of debts at high interest rates.
Some of the benefits of debt consolidation include:
- You no longer have to keep track of various payment dates and amounts. Having one payment reduces the risk that you’ll miss a payment or make a late payment.
- You can often negotiate a lower interest rate with your new lender than the varying interest rates you had with your previous debts.
- As a result of a lower interest rate, you’ll pay less interest overall and finish paying off your debt much faster.
- You have a clearer picture of your overall progress in paying off your debt, as well as a finish date.
Types of debt consolidation
There are different types of debt consolidation, each with their own benefits and negatives. We cover each type down below.
Debt consolidation loans
A debt consolidation loan is a personal loan from a lender that covers all your other debts. If you have a healthy credit score, this option can help you consolidate your debt with a lower interest rate. This lower interest rate can help you save thousands over the life of the loan.
Let’s say you have $8,000 in debt across two credit cards, both of which hold an interest rate of 18 percent. If you’re paying $300 in monthly payments, it will take you approximately 35 months to pay the loan in full. During those 35 months, you’ll pay $2,293 in interest.
Now, if you take those two loans and consolidate them to a new loan with an interest rate of nine percent, you’ll be debt-free five months sooner and pay only $959 in interest.
Unfortunately, if you don’t have a great credit score, you may not qualify for a debt consolidation loan or may receive a high interest rate from the lender. It’s essential to approach several lenders so you can shop around for the best rate.
Home equity loans
If you own your home, you likely have equity in it. You can choose to leverage your home to receive a home equity loan, also called a second mortgage. A home equity loan is a secured loan, meaning you offer up your house as an asset if you fail to meet the terms of the loan.
This approach can be very appealing as home equity loans often offer very low interest rates and flexible terms. Just remember that you’re risking your home.
Balance transfer credit cards
A balance transfer credit card looks to entice people to transfer their debt onto a new credit card with a zero percent APR for a specific period (somewhere from six to 20 months). If you choose this option, you can take advantage of those no-interest months to make a significant dent in your debt’s principal balance. You can use a balance transfer card for credit consolidation and transfer several credit balances onto one card.
It’s important to do your research when it comes to balance transfer credit cards. Some common facts to know include:
- A balance transfer credit card often charges a one-time fee for the transfer.
- You should make sure the limit of the new credit card covers all your debts.
- Typically, the zero percent APR only applies to the transferred debt and not any new charges. So you’ll want to avoid accumulating new debt on this card.
- The number of months with zero percent APR often correlates with your credit score. A high credit score usually means a longer promotional period.
- Sometimes fine print will state that a late or missed payment can trigger exorbitant fees or increase interest.
Savings or retirement accounts
For some people, pulling money out of their savings or retirement accounts may be an option. The interest on your debts is likely higher than the interest you’re earning in a savings or retirement account. However, if you decide to pursue this choice, make sure you understand the rules. For example, taking money out of your 401(k) requires you to pay it back or pay an early-withdrawal fee.
Debt management programs
Nonprofit credit counseling agencies usually offer debt management programs. These firms look to help individuals who are struggling financially and need a plan to get out of debt. Many debt management programs will only work on specific kinds of debt, such as student loans and credit card debts.
Once you go through a consultation and approve the plan, the credit counsel agency will take over. They will call your lenders on your behalf and negotiate new interest rates and payment terms. Next, the agency takes over payments for you while you pay the agency instead. You get to make one monthly payment and know that you have experts helping you get out of debt.
Many of these credit agencies charge a small fee or waive the fee entirely, depending on your situation. Additionally, a credit counsel agency may include a stipulation that you have to close all credit cards and not apply for new ones while they’re working with you.
How does debt consolidation affect your credit?
How debt consolidation affects your credit largely depends on your particular situation and credit history. We discuss below how debt consolidation is likely to impact different factors that contribute to your credit score.
Credit utilization
One of the main factors that make up your credit score is your credit utilization ratio. In general, it’s best to keep the total credit you use at 30 percent of the total credit available to you. Depending on which debt consolidation option you go with, you may or may not improve your credit utilization.
For example, if you open a new balance transfer credit card and keep your old cards open, your credit utilization will likely improve.
However, if you choose a debt consolidation option like a debt management program that makes you close all your credit cards, your utilization will worsen (initially).
New inquiries
If you’re choosing the type of debt consolidation plan that requires a hard credit check, such as a balance transfer credit card or a personal loan, you may see a small decline in your credit score at first. Having multiple hard inquiries on your credit report in a relatively short period negatively impacts your credit score.
Risk
Note that with debt consolidation, not only do you risk affecting your credit, but you also risk your home and your retirement savings, depending on the kind of loan you choose—and these are pretty big things to have on the line.
When should you consider debt consolidation?
Debt consolidation is the right choice for many people. Typically, if you have a good credit score, have high-interest debt and know you can stick to a repayment plan, you’re the right candidate.
You should not consider debt consolidation if you don’t have a significant amount of debt. If this is your situation, simply make a plan and pay off your debt quickly and on your own.
Additionally, debt consolidation won’t work if you won’t make your payments—no matter how reduced they are.
Use a debt consolidation calculator to determine if your savings will be worth the risk and effort involved.
What are alternatives to debt consolidation?
If you feel confident you can tackle your debt yourself, make a repayment plan and stick to it. Consider using either the snowball method (smallest debts first) or the avalanche method (highest interest first).
If you explore debt consolidation options and realize you can’t afford to pay for food, shelter and debt, it might be time to consider debt relief. There are plenty of resources out there that can help you get rid of debt. Explore all of your options before committing to a solution. And if you’re worried about your credit, consider working with the advisors at CreditRepair.com.
