If you have accumulated a lot of debt and are making multiple payments each month on a number of credit cards or loans, you might consider consolidating. Debt consolidation should be considered whenever you feel overwhelmed with monthly payments because it can get you out of debt faster with less money spent.
Whether you’re struggling to make ends meet or just want to use your money more wisely, debt consolidation may be for you.
Table of Contents
- 1 What is the best way to consolidate your debt?
- 2 Do consolidation loans hurt your credit score?
- 3 What can you do to keep your score from dipping after consolidating?
- 4 Can you get a debt consolidation loan with poor credit?
- 5 When is it a good idea to consolidate debt?
- 6 When is it a bad idea to consolidate debt?
- 7 Debt consolidation programs you should avoid:
- 8 How do you prepare for debt consolidation?
- 9 Is debt consolidation the same as debt management?
- 10 Bottom Line
What is the best way to consolidate your debt?
There are generally two recommended ways to consolidate your debt. The first involves taking out a personal loan, and the other taking a unique type of credit card. Depending on your debt and credit score, one option might be better than the other.
Option 1: Debt consolidation loan
With a debt consolidation loan, you use the money from the loan to pay off all of your existing debt. Because it is a type of personal loan, a debt consolidation loan is paid off in installments over a set period of time. The length of the payoff term determines how much you’ll pay each month and how much interest you’ll pay during the life of the loan.
Shorter loan terms mean higher payments, but less interest paid overall (and depending on the loan amount, the difference could be thousands of dollars). With a longer loan term, your monthly payments are lower and more manageable, but you’ll make payments for longer and will pay more interest over the long run.
Option 2: 0% balance transfer credit card
A balance transfer credit card sounds exactly like what it is. With it, you can transfer all of your debts regardless of what type they are onto the new card, including loans. The trick is to pay it all off within the 0% promotional period.
This way all of your payments go directly towards the principal and none of them are wasted on interest. When every single penny you pay goes towards principal, climbing out of debt is a lot easier and faster.
Do consolidation loans hurt your credit score?
To better understand how moving forward with debt consolidation will likely affect your credit score, let’s do a quick recap.
Your FICO credit score is determined by the following five factors:
- Payment History: 35%
- Amount Owed: 30%
- Length of Credit History: 15%
- New Credit: 10%
- Types of Credit Used: 10%
Borrowers struggling with high debt usually have lower credit scores because of how much they owe. As you can see, the amount owed is the second highest contributor to your credit score at 30%. If all of your credit cards are maxed out, then your score is lower than it could be even if you have been making all of your payments on time.
If you’ve been struggling to keep up with payments, then your payment history has likely also been dinged, too. Each time you don’t make a payment on time, regardless of the reason, your score takes a dip. The longer a bill goes unpaid (30 days, 60 days, 90+ days) the more severe the dip will be.
If you have a lot of debt, you’re probably hoping that if you pay off everything in one big “on time” payment your score is going to jump up overnight.
Unfortunately, it’s not that simple. There are two reasons for this.
Reason 1: Hard Inquiries
In the interest of complete transparency, a hard credit inquiry will only drop your score by about five points. Hard credit inquiries happen after you have been pre-approved and officially move forward with applying for a new line of credit.
In the grand scheme of things, it’s not going to cripple your future borrowing goals or purchase ambitions, but expect the slightest of dips after you’ve applied for debt consolidation with a reputable lender. If you’re shopping around for rates and deals, do it within a few weeks and it will only count as one inquiry.
Reason 2: Credit Utilization
Credit utilization, or amount owed, refers to how much debt you have as opposed to how much credit you have available. When consolidating debt, your amounts owed credit category will go back and forth.
The reason is that credit cards are considered maxed out whenever the balance surpasses 70%. Divide how much you owe by the credit card’s balance to get the card’s percentage balance. Say you take out a credit card to transfer your debt to — that one card will likely be pushed past 70%, which would cause your score to dip.
The good news, though, is that if you keep your other cards open and don’t close the account, you’ll have a lower utilization ratio. Will the cards with paid balances offset the card with a close to maxed out balance? Not really. Your score will essentially stay the same (in the beginning, but more on that below).
If you take out a loan to pay off your debt, it’s more or less the same story. While you’re paying off debt you’re also incurring debt.
In the beginning your score will stay the same, and may possibly even take a dip.
What can you do to keep your score from dipping after consolidating?
Credit scores aren’t fixed overnight, so make the most of consolidating your debt by following these simple rules.
Keep all of your cards open.
One reason for this is because of utilization, and the other is because the length of credit history category. The longer a credit card is open, the more it helps your credit score.
Keep a minimum balance on each credit card.
Cards with balances between 1% and 9% help your credit score more than cards with zero balances on them. It sounds counter intuitive to not keep them at zero, but cards need to be in an active state if you want them to help your score.
Make every payment on time.
When you consolidate, you have fewer payments each month and a lower monthly payment to stay on top of, so there’s no reason to be late. While consolidating takes time to help your credit score, the most effective approach to improve your credit is to consistently make payments on time.
Can you get a debt consolidation loan with poor credit?
Yes, it is possible to get a debt consolidation loan with poor credit, but it is possible you’ll be denied. If you get approved, you’ll likely pay higher interest than other people with good credit. Luckily, there are many lenders who work exclusively with people with poor credit and offer decent interest rates. Shop around to find the best possible loan conditions for your credit profile.
When is it a good idea to consolidate debt?
There are a few factors to determine if you should consolidate your debt. The biggest factor is if your debt does not exceed 50% of your income. If it does, then you may want to consider other strategies. If you’re able to make payments and keep an acceptable standard of living, then consolidation could be a good idea.
An important thing to keep in mind is that you still need to devote your cash flow to your debt. Debt consolidation doesn’t remove this factor. Though you could save money each month, if you want to get out of debt, a good portion of your paycheck still needs to go to paying off your debts.
You should also have decent credit if you want to find a good deal. This is unfortunate, yet true. The best consolidation loans or credit cards are only available to people with good credit. There are options for people with poor credit, but they may have higher interest rates.
Let’s look at a quick example.
If you have two credit cards with rates at about 19% and 25%, but you qualify to get a personal loan with an interest rate at 8%, then consolidating your debt is a smart move. You’ll save money and get out of debt faster.
When is it a bad idea to consolidate debt?
There are a few situations where consolidating debt is probably not a good idea and could actually hurt you both in the short term and long term.
If you return to viewing and handling money the same way.
If you don’t change how you manage your monthly spending habits, consolidating your debt will only help you for a short while. Creditors know that when people pay off a credit card, psychologically they view it as acceptable to use them again because the balances are so low.
Even if they worked really hard to pay everything off, they’ll go back into debt in relatively short amount of time. In many ways, truly getting out of debt is more of a mindshift than it is anything else. To be financially responsible, you must view money as something to protect rather than spend.
When the interest rate is greater than what you already have.
If you have poor credit, it’s possible a lending institution won’t give you a better rate than what you already have. In some cases, it can be more than what you have now. If this happens, don’t take the loan or credit card offer.
Yes, it’s nice to all of your debts centered in one place, but it’s not worth it if you’ll actually have to spend more to get out of debt in the long run. Of course your monthly obligations may be lowered by taking on a longer loan term, but in the end you’re spending more money than you should, and that’s rarely a good idea.
When you won’t be able to pay it all off during the introductory period.
If the rate is set to jump after a trial period, will you be able to have it all paid off before the rates jump up? If not, what will the rates jump up to? Take the time and do the math.
Calculate how much you’ll be able to pay off during the trial period, what your payments will look like once rates jump up, and what it will cost in the long run to get it all paid off. If the numbers are greater than what they were before, it’s probably best to keep things status quo.
Debt consolidation programs you should avoid:
Some people turn to alternative ways to pay off their debt. The most popular ones are getting a home equity loan or a 401(k) loan. However, these are not recommended.
A home equity loan involves taking out a loan that is secured by whatever equity you have in your home. The problem with doing this is that you are putting yourself at more risk. Here’s an abbreviated list of all the cons associated with a home equity loan:
- You could lose your home
- It might take ten years or more to pay off your debt
- It can’t be discharged via a bankruptcy the same as credit card debt can
- If the value of your home drops, it’s possible you could end up paying more than it’s worth
The problems with a 401(K) loan involve:
- Losing a significant portion of your retirement savings
- There could be tax consequences and penalties involved
- It’s not as easy to discharge through a bankruptcy
Neither option is very appealing when you get down to it. Though both could get you out of debt as fast and efficiently as a personal loan or 0% credit card, the potential cons far outweigh the benefits.
How do you prepare for debt consolidation?
If you decide to move forward with a personal loan or debt transfer credit card, there are a few things you should do to prepare.
- First, make a list of all of your monthly debts. These should include all of your credit cards and loans.
- Find your most recent billing statements and make note of what the balance is for each.
- Add up all of your debts to figure out how much you need to consolidate everything.
- Determine what your credit score is. If it’s low, you may want to take steps to improve it before applying for a loan or credit card. Get a credit report from each of the credit bureaus (Experian, Equifax, and TransUnion), and make sure that the information on each report is accurate. For many Americans, there are negative entries on their report that are not true. If this is the case for you, you’ll need to begin the dispute process.
- Five, shop around for the best company working with borrowers with your credit profile. Compare interest rates, loan terms, fees, and any requirements needed to submit an application.
Is debt consolidation the same as debt management?
No, there is a difference. With debt management, you still keep all of your accounts separate. Debt management companies negotiate on your behalf to reduce monthly payments and interest rates where they can. No new accounts are opened, but the monthly toll is reduced whenever and wherever possible. It may be a good option for people whose credit scores are too low to qualify for a personal loan or credit card.
Review your options and see what you qualify for. If your credit score can support a 0% transfer credit card or low interest personal loan, then debt consolidation may be just the answer you’ve been looking for.