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What Is Debt Consolidation and Is It Worth It?

What Is Debt Consolidation and Is It Worth It?

Jenius Bank Team5/14/2024
Woman researching on a tablet computer.

Debt consolidation could help you pay off debt faster.

The average American has roughly $21,800 in personal debt, not including mortgages.1 Most of that debt is split between loans and credit cards, all of which require monthly payments. If you’re carrying a hefty balance, paying off what you owe may feel overwhelming, especially if you’re balancing payments toward multiple creditors.

Debt consolidation could help. Let’s take a look at how this works.

Key Takeaways

  • Debt consolidation lets you combine separate debts into one, so you end up with a single payment each month, ideally at a lower rate.

  • Consolidation could be a good option for borrowers with already high credit scores and those who are confident that they won’t go back into debt later on.

  • Debt consolidation does not reduce what you owe your lenders. If you’re looking to reduce what you owe, debt settlement may be a better option.

How Does Debt Consolidation Work?

Debt consolidation is a strategy to help manage high-rate debt. It allows you to use a new debt, typically a loan, to pay off current balances. In doing so, you’re rolling multiple liabilities into a new one with a single payment monthly.

Debt consolidation may also help you lower your rate, expressed as Annual Percentage Rate (APR), and save money in the long run.

Debt Consolidation Options

There are a few ways that borrowers may consolidate their debt. The best method for you depends on your financial situation. Here are a few options to consider.

Personal Loans

Debt consolidation is commonly done with personal loans: you start by taking out the new personal loan and paying off existing debt; then you shift to making payments on that new personal loan.2

Often, these types of debt consolidation loans have lower rates than credit cards and other forms of debt, so they are done with the intention of saving you money. Rates are typically fixed, meaning your payment on the debt consolidation loan would be consistent each month.

With these loans, you usually receive money upfront and apply it towards paying off your creditors. However, with most debt consolidation loans, there is no mandate for which liabilities you pay off and how much. So, the follow through is up to you.

Credit Card Balance Transfers

Another frequent method for consolidating debt is using a balance transfer offer on a credit card. When using this method, which only works with other credit cards, you use the credit limit on one card to pay off the balance of other cards.

Many credit cards offer low or even 0% promotional APR on balance transfers for a set period. But, if you don’t pay off the transferred balance by the deadline, you pay the card’s normal, non-promotional APR on the remaining balance—these rates tend to be quite high!3

To take advantage of a promotional offer, you may do a balance transfer using a current credit card or a new one, depending on the best deal you find. Just remember, any time you open a new credit account, the lender is going to do a hard inquiry on your credit report, which may cause your credit score to drop.

Other Debt Consolidation Options

Here are some alternatives to personal loans and credit card balance transfers.

  • Home equity loans (HELs) and home equity lines of credit (HELOCs): These loans and lines allow you to tap into your home’s equity and use the money to pay off what you owe on other debts. These debt types are secured by your home, so lenders typically charge lower rates. Of course, they are only available to homeowners and the qualifying amount usually depends on the equity available in the home.4

  • 401(k) loans: These loans let you borrow against your 401(k). There are no restrictions for how you use the funds, but if you fail to repay your loan on time, you may end up having to pay an early withdrawal penalty.5 If you’re considering 401(k) loans, bear in mind that the funds you use could miss out on compounding growth opportunities within your 401(k) and could impact the performance of your retirement savings long term.

Think about your finances, your total debts, and how much you want to consolidate as you consider these possibilities. Remember, a professional financial advisor may be able to help you make the decision that benefits your finances most in the long run.

Debt Consolidation vs Debt Settlement

Though debt consolidation and debt settlement are often used interchangeably, they’re two different approaches.

As we’ve covered, debt consolidation is the process of combining one or more debts into a new loan or line of credit with a single payment monthly. Debt settlement is the process of negotiating your debts with your creditors and trying to reduce what you owe overall.

Debt settlement may be harder to achieve and often people must work with attorneys or experienced debt settlement professionals to negotiate with their creditors. Debt consolidation may be simpler and, while you still must repay what you owe in full, you typically don’t need assistance to apply.6

Pros and Cons of Debt Consolidation

Let’s summarize a few pros and cons to consider before shopping for consolidation loans.7

The Pros of Consolidating Your Debt

Potential benefits with debt consolidation:

  • Faster debt pay off if you stick to your payments

  • Lower rates and potential savings on interest over time

  • An opportunity to simplify budget management with a single payment monthly—even more so if that payment is fixed

  • A chance to improve your credit score (paying down credit balances increases available credit)

The Cons of Consolidating Your Debt

There may be some downsides too:

  • A potential drop in credit score from originating a new debt

  • Origination fees for new loans or balance transfer fees on cards

Note, debt consolidation works best when it’s part of an overall commitment to shape up your finances—when you’re consolidating high-rate debts to pay them off for good and not run up balances again.

Is Debt Consolidation Right for Me?

Debt consolidation isn’t the perfect fit for everyone trying to pay off debt, but it could be a great choice for certain borrowers, especially those who want to streamline payments or have high-rate balances. It could also be a good option if you have a high credit score and may more easily qualify for low rates on new loans and credit cards.

Debt consolidation may not be for those who already have a high debt-to-income ratio (DTI). In that case, lenders may not be willing to approve a new debt to do the consolidation. And, if you got into debt because you overspent in the first place, consolidating may encourage you to repeat the pattern.8 So it’s important to be honest with yourself about your intentions before starting the process.

Final Thoughts

Debt consolidation may be a helpful tool if you’re trying to pay down high-rate debts. Do your due diligence and choose a lender that offers you a competitive rate.

Of course, consolidating debt isn’t the only option you have at your disposal. You may decide that it’s best to pay off what you owe without taking on new debt. Using methods like the debt avalanche repayment method may help you do just that. Take time to research your options and to help you decide what’s the right option for your budget.

Borrowing & CreditMoney Management