If you are in debt, you are not alone. American household debt alone totals $14.6 trillion! This is because the average American has over $90,000 in debt. Many people are struggling to manage that debt, especially after the impact the pandemic had on businesses and jobs.
For those who have debt split over multiple credit cards and loans, with differing interest rates, debt consolidation may be a serious consideration. What is debt consideration and is it actually a good idea?
Let’s take a look at what debt consolidation means and its pros and cons.
The concept of debt consolidation is fairly simple. If you have multiple debts that you are paying back, you can consolidate them into one debt. For example, you may use a credit card to pay back all your debts, so that you now only have to pay back this credit card.
There are multiple types of debt consolidation, some of which are DIY and others which are offered by loan companies. Debt consolidation can offer a solution to two main issues:
- It gathers your debt into one manageable place
- It may get you a more manageable interest rate
The types of debt consolidation include:
Balance Transfer Credit Card
This refers to transferring the entire balance of your debt to a credit card with a low or 0% interest rate for the first few months. You may have to pay a transfer fee, but not having to pay interest in the first six to twenty-one months will help you manage your debt.
A personal loan will generally have lower interest rates than a credit card. However, they may have application and origination fees, as well as prepayment penalties.
While a home equity loan will have a low interest rate, it comes with its own set of risks.
Borrowing Against Retirement Savings or Life Insurance
This is a particularly risky way of financing your debt consolidation, and it should be avoided in most cases.
If you’re skeptical about whether debt consolidation can really help, you have reason to be. Simply transferring your debt to a new lender creates its own problems. However, there are some serious benefits to debt consolidation.
The benefits of debt consolidation mainly fall into two categories:
- Debt management: Instead of paying multiple different loans or credit cards, you pay one amount each month. Your debt becomes easier to track and to work with in your budget.
- Reducing interest: If some of your debts are from loans or credit cards with high interest rates and you can get a loan that covers them with a lower average interest rate, you reduce the cost of your debt. You can make smaller monthly payments and clear your debt more quickly.
Based on these benefits, it may seem like a no-brainer to go for debt consolidation, as long as you will be paying lower interest rates. However, there are some concerns to keep in mind, especially when it comes to your credit score.
Debt consolidation could have a positive or negative impact on your credit score. This largely depends on the current state of your credit record and the type of debt consolidation you get.
The positive impact on your credit score comes from the potential to improve your debt-to-credit ratio. This refers to the proportion of the credit available your debt consumes. If you get a new credit card or loan to cover your debt consolidation, you immediately have higher credit available even though your debt stays the same. A lower debt-to-credit ratio improves your credit score.
Your credit score may also improve since you are less likely to miss payments. Since you are paying one lump sum rather than a number of smaller debts, keeping track of your debt is more manageable. Also, if you transfer your debt to a credit card with a 0% interest fee for the first six months or so, you will pay your debt off more quickly.
The negative impact on your credit score mostly comes from the hard inquiries made by the loan or credit card companies on your credit score. These inquiries can temporarily lower your credit, but one inquiry is unlikely to have a significant impact. If you choose to close your other sources of credit, however, you will increase your debt-to-credit ratio which will hurt your credit score. To avoid this, keep your other sources of credit open even though you are no longer using them.
Debt consolidation is a good idea if you are going to get a lower interest rate. Not only will it help you manage your debt, but it will also lower the cost of your debt while improving your credit score. However, do careful research into the new credit card or loan to make sure you are not getting yourself into more trouble than it is worth.