Money Research Collective’s editorial team solely created this content. Opinions are their own, but compensation and in-depth research determine where and how companies may appear. Many featured companies advertise with us. How we make money.
7 Things to Know About Debt Consolidation
By Mallika Mitra MONEY RESEARCH COLLECTIVE
There’s plenty to keep track of in our financial lives — budgeting, saving, investing and taxes, just to name a few. Paying down debt can be one of the most stressful, especially when you’re dealing with multiple lenders, payment plans and deadlines.
Debt consolidation, which entails replacing your various loans with a single new one, can make handling this financial task a bit more manageable. The trick is to look for a new loan with a lower interest rate than your current debts, which can help you save money and (ideally) pay your debt off faster.
While debt consolidation can be advantageous, it doesn’t make sense for everyone. Here are seven things to know before you consolidate your debt.
1. Consolidation won’t decrease your debt
Consolidating your debt can offer some nice benefits, like having fewer bills to manage, lowering your monthly payments, potentially building your credit and even the possibility of saving money on interest. But one thing consolidation definitely won’t do is forgive or lower your overall debt.
When you consolidate, you’re left with one loan. But that one loan will be the size of all the loans you bundled together, and you still have to pay the whole thing off. If you do your research when shopping around for a new loan, you may save yourself money on interest which could help you pay off the debt faster. Or you may be able to reduce how much you’re spending on debt bills each month by opting for a loan that mixes a lower interest rate with a longer repayment term. But no matter what, you won’t be reducing the balance you owe.
2. You typically need at least a fair credit score
Lenders who offer debt consolidation want to have confidence that you’re going to make good on the new, consolidated loan. One way they do this is by checking your credit score.
The requirements for minimum credit scores can vary widely between different products and lenders, which means there’s no way to nail down exactly what you’ll need your score to be without doing your research. But most lenders won’t approve loans for borrowers with scores that are considered less than “fair” — 580 to 669 if you’re using the FICO score, which is the most commonly used. A “good” score is between 670 and 739, which is near or slightly above the national average credit score.
The higher your credit score, the more likely you are to get a lower interest rate. So while you may be able to get a debt consolidation loan with a poor credit score, you’ll probably be offered a high interest rate. If that’s the case, consolidating your debt could do more harm than good.
3. There are multiple loan options to consolidate your debt
The best consolidation option for one person may not make sense for the next, so considering all your options carefully is key.
There are three main debt consolidation options. The first is a home equity line of credit (HELOC) or home equity loan, which allows homeowners to borrow against their home, which can help them get a lower interest rate than they would with unsecured loans. These loans can come in the form of a lump sum of cash in the case of a home equity loan or as a revolving line of credit via a HELOC. Home equity loans typically have fixed rates, while HELOCs often come with variable rates, though some lenders offer fixed-rate options designed for debt consolidation. This strategy typically makes the most sense for homeowners who have at least 15% to 20% equity in their home and are willing to put their home on the line.
The second debt consolidation option is a balance transfer credit card, which allows people with credit card debt to swap the typically high annual percentage rates (APR) — often 20% or higher — for a rate as low as 0% for a certain period of time. If you have a small enough balance that you will be able to pay it off before the APR jumps and the discipline to avoid charging additional debt onto the new card, opening this type of credit card could make sense.
Finally, there are personal loans issued by banks, credit unions and online lenders. These loans tend to have higher rates than those with collateral, like home equity loans, but if you’ve got a solid credit score you may be able to score a lower rate than you’re currently paying. This move usually makes most sense for people who can’t or don’t want to tap their home equity and have at least a fair credit score.
4. Terms vary
Not all debt consolidation offers come with the same terms. In fact, the terms can vary a lot — and it’s important to fully understand what they mean for you before you commit.
Take credit card balance transfers. If you’re offered an APR even as low as 0%, it won’t last forever. If that APR jumps to 25% after the first year and you still owe the lender money, the terms may make that a bad option for you.
Be sure to read your agreement carefully so you understand how long you have to pay the loan back, and what happens if you choose to pay it back earlier.
5. There can be risks
Consolidating your debt could be the smart move, but it’s not always risk-free. If you receive a home equity loan or HELOC, for instance, you’re using your home as collateral. That means that if you’re not able to make all your payments and you default on the loan, your house could go into foreclosure.
Another risk is that if you don’t have a good credit score, you could receive an offer with an interest rate that’s not lower than what you currently pay. When you factor in the added expenses of consolidating your debt, taking out a new loan may put you in a worse position than paying off the debt you have.
Debt consolidation also doesn’t solve any of the issues that may be at the crux of the debt — and it could even exacerbate it if you now have more credit available. In other words, if you tend to overspend, debt consolidation won’t keep you from racking up debt again. If that’s the case, you may want to focus on budgeting and limiting your spending as you pay down your existing debt. If, on the other hand, you’re struggling to make your minimum payments due to a financial hardship (like a job loss, divorce or medical emergency), you may want to consider other options, like negotiating with your creditors or working with a debt relief company.
6. You’ll have to pay fees
When you’re considering debt consolidation, make sure you factor in the cost of fees. These fees will vary by lender and the type of loan.
Balance transfer credit cards will often charge an initial fee of between 3% and 5%. Meanwhile, closing costs on home equity loans can range from 2% to 5% while origination fees for a new debt consolidation loan can be as high as 10% of the loan.
Check for prepayment, late and annual fees as well. Regardless of which option you choose, the best debt consolidation companies will have very transparent fees so you don’t have any surprise charges.
7. Debt consolidation can impact your credit
Debt consolidation can impact your credit score — for better and for worse. The strategy involves taking out a new loan, which requires potential lenders to take a close look at your credit report. This review is known as a hard inquiry, and it can lower your credit score by a few points. It will also decrease the average age of your overall accounts, which can negatively impact your score.
But in the long run, debt consolidation could help your score, too. That’s especially the case if you’ve struggled to make your monthly payments and debt consolidation will help you turn that around, since missing payments can weigh significantly on your score. Consolidation could also lower what’s called your credit utilization ratio, which is the amount of the credit you’re using compared to what’s available to you. Replacing multiple debts with one new one could lower your credit utilization ratio, which makes you less risky to lenders.