If you’re one of millions of Americans trying to get rid of consumer debt, you’ll do almost anything to pay it off quickly: work long hours, take on a part-time job, sell your belongings in a yard sale.
When you’re feeling helpless about your debt, consolidating your loans might seem like the best option, especially if you have multiple types of loans weighing you down.
Why is debt consolidation so popular? Consolidation involves either taking multiple loans and converting them into one loan, or transferring one loan with one lender to another one, locking in more favorable terms along the way. Most of the time, people consolidate because they get a better interest rate they want to take advantage of. After all, a lower interest rate could help people pay off the debt faster and save money at the same time.
Other consumers like to consolidate if they have multiple loan payments that are proving difficult to juggle. Consolidating can simplify their finances and ensure that they’re not missing any payments.
However, consolidating your debt isn’t risk-free. Indeed, it’s a strategy with many potential repercussions, not the least of which are the impacts to your credit score and your financial future in general. Many people sign up for debt consolidation thinking it’ll change their lives, without realizing what they’ve actually agreed to.
Risks to consider before consolidation
You may pay more interest over time. One of the biggest risks when consolidating a loan is that you could end up paying more than you did before. If your consolidation loan has a longer loan term (that’s how much time the lender gives you to pay back the loan), you might pay more in interest overall than if you had kept your other loan(s) as is.
When some people consolidate their loans, they find that their monthly payments are now less than in the past. Some vow to keep paying the same amount anyway, to take advantage of lower interest rates and take bigger chunks out of the principal in the process. This is ideal. If you simply keep paying your new reduced monthly payment, it could take longer to pay off the loan and you could face higher interest charges in the long run.
Your credit might take a temporary hit. You might decide that paying down debt is worth the risk of a temporary ding to your credit, but it’s still a risk worth noting. If you are taking out a new credit card, a home equity loan or any other type of loan to consolidate debt, the lender will have to pull your credit report.
Every time you open a new form of credit, it has two impacts on your credit score. First, it counts as a hard inquiry and can erode your score. New credit inquiries will also stay on your credit report for a year, according to Experian, complicating attempts to take out another loan.
Secondly, a new debt on your report decreases the average age of your credit. The lower your credit age, the lower your overall score.
Which doesn’t mean you should avoid debt consolidation. It just means you should consider the pros and cons. Indeed, the benefits of debt consolidation can certainly outweigh this risk.
Debt relief fees. Some consolidation companies that promise to service your debt also end up charging high fees for something you can do yourself. Before consolidating, read reviews of banks and lenders to see which one will have the fewest fees and best rates you can get.
You may not solve the underlying issue. When you take out a new loan to repay other debts, you may not be fixing whatever foundational problem dragged you into debt in the first place. It’s one thing to face an unexpected medical emergency that resulted in bills you can’t afford to cover out of pocket. But if your debt is the result of overspending or a lack of budgeting, then you may only be treating the symptoms of a bigger condition. Because you are trading in one set of loans for another, you may still struggle to pay down the debt if you don’t change your spending habits.
Next up: We’re going to cover several ways to consolidate your debt and explain the pros and cons of each.
4 ways to consolidate your debt — and the risks involved
How they work. A balance transfer is when you take a credit card balance and move it to a different card, usually one that you have just opened. Most consumers use a balance transfer because they’re relatively easy to do and because they find a credit card offering a lower interest rate than the one they aim to replace.
Many credit card companies have special promotions in which you can get a 0 percent introductory APR on balance transfers for a certain length of time, sometimes as long as 24 months. Because credit card interest can be in the double digits, transferring a balance to a card with no interest lets borrowers pay off their total debt much faster.
For example, if you have a $5,000 balance on a credit card with 15% APR and you apply for a credit card with 0% intro APR for 24 months, you could transfer the balance and save $639.73 if you pay off the balance before the offer ends (making $250-a-month payments to accomplish that goal).
However, there might be a fee you have to pay with a balance transfer, often set at 3-5 percent of the total balance. Do the math before you apply for a balance transfer offer. The money you will save on interest charges might outweigh the cost of the balance transfer fee.
Risks. One of the risks of a balance transfer is that you might not actually pay off the balance before the balance transfer offer ends. This is dangerous because then you could end up paying high interest fees on top of the balance transfer fee you already paid to start the ball rolling.
Also, opening up a new credit card will usually ding your credit score and drag down the average age of your credit accounts (also a ding). If you’re applying for a mortgage or other significant loan, a new credit inquiry could hurt your chances of getting the best rate.
Credit card companies can be ruthless when it comes to 0 percent balance transfer offers. If you miss a payment or are late, your special offer could end, and you could be switched to the regular, substantially higher APR. If you go through with a balance transfer, set up autopay, or check every month to make sure your payment has gone through on or before the due date.
How they work. A personal loan can be applied in a number of ways, such as paying off medical bills, funding a wedding or consolidating debt. It’s a fixed amount of money borrowed for a fixed amount of time. If you have a high credit score and a solid income, you may be able to qualify for a loan with a decent rate, which can make this a more affordable borrowing tool than, say, a high-interest credit card. On the other hand, people with poor credit may still qualify for a personal loan, but are likely to have to contend with much higher interest rates.
Applying for a personal loan is easy. You can reach out to a local bank or credit union or apply online. Most lenders will give out personal loans up to $35,000 and will ask that they be repaid within three to five years. If you get approved for a personal loan, the bank will usually wire you the funds, and then you can use them for any purpose.
Risks. A personal loan is often set up as a short-term loan. While this might help people pay off their debt expeditiously, the pitfall of a compressed timeline is the difficulty of staying on track. There’s no point in getting a personal loan to consolidate your debt if you end up unable to repay your loans.
How they work. A home equity loan is when you borrow money from the equity you’ve built up in your property. You can use this money to start a business, remodel your house or, yes, pay off debt. There are two ways you can borrow this money, either with a home equity line of credit (HELOC) or a home equity loan.
A HELOC is a line of credit you have access to for a certain period of time. You can withdraw money for a certain length of time and then enter a final repayment period, whereas a home equity loan means the bank gives you a lump sum that you then repay every month. The amount you can receive depends on how much the home is appraised for and how much you still owe.
Many people prefer to take out a home equity loan or HELOC for debt consolidation purposes because interest rates are usually far lower than they would be on a different kind of loan. Unlike a personal loan or credit card balance transfer offer, a HELOC is backed by a piece of property that the bank can resell if you stop making your payments. For that reason, lenders are willing to give you a better deal than if you take out a loan that’s not secured by such collateral.
Also, when you repay a home equity loan, you can usually deduct the interest on those payments. This gives you an advantage in taxes when it comes to consolidating.
Risks. A home equity loan and a HELOC are, as we noted, backed by the home as collateral. If you fail to repay the home equity loan or HELOC, then the lender can seize the residence. In such circumstances, not only does your credit history take a hit, you also may have lost your biggest financial asset.
If you lose your home due to foreclosure, your credit score will also likely tank, making it harder to purchase another house. These issues are all a huge reason why consumers should be careful about these particular options.
Student loan consolidation (private and federal)
How it works. If you have student loans through the federal government, you can either consolidate/refinance them through the Direct Consolidation Loan program or through a private lender. You won’t save any money on interest with the Direct Consolidation program, however, as the program determines your new interest rate by averaging the rates on your existing loans. But it can be helpful for borrowers juggling multiple student loan payments.
If you’re looking to save on interest, then you may choose to refinance your loans with a private lender instead. To get the best refi offers, you’ll have to have great credit and a solid income. Check out MagnifyMoney’s list of the best student loan refinance companies out there. Like other forms of consolidation, refinancing your student loans will streamline your payments and make it easier to stay on top of what you owe. If you’re apt to forget payments, then consolidating several loans into one, with one payment, might help you avoid racking up late-payment fees.
The risks. If you decide to consolidate your federal loans with a private lender, you will lose all the protections and benefits that come with federal loans, including deferment, forbearance and income-based repayment plans. Forgiveness options such as the Public Service Loan Forgiveness Program are also off the table if you consolidate your federal loans with private loans, even through federally guaranteed banks.
Income-based plans are useful if you work in a low-paying field or have an unstable job. Most private loan servicers don’t provide these types of options, which makes it even more important to keep your federal loans where they are.
Often, consolidating your student loans can mean that your monthly payment decreases as your payment term increases. Unless you’re actively paying more than the minimum every month, you’ll end up paying more in interest overall.
If you are wanting to know more to about the methods listed above as a way to consolidate debt, you can visit MagnifyMoney’s parent company LendingTree here.
Alternatives to debt consolidation
If you’re having trouble managing your debt, refinancing your loans could be one solution. When you refinance, your hope is to secure a loan with more favorable terms, ideally a lower APR, but you may also refinance in order to get a loan with lower monthly payments.
The simplest way to take hold of your debt is to go over your expenses and compare them to your income. Are there any changes you can make to spend less money every month? Could you try to eat out less or take the bus to work? All those small substitutions will add up quickly and you can put the difference toward your loans.
If you want to pay off your debt quickly and are afraid of consolidating, consider using the debt snowball approach, popularized by Dave Ramsey. This strategy recommends paying off the smallest balance first. Then, when that loan is extinguished, you’ll apply the monthly payment to the next-smallest balance, and so on, until all your debts are repaid. The snowball method can help you feel empowered, and not overwhelmed, in tackling your loans.
If you’re truly having difficulty with your loans, you should consider talking to a bankruptcy attorney. That expert should be able to tell you if your situation is truly dire and if you should consider filing for Chapter 7 or 13.
The bottom line
Consolidating debt can make sense for the right person. If you’re already trying to pay off your debt quickly and want to minimize your interest fees, then consolidation could save you even more money and time.
Before you sign up, however, look at the total amount of interest you’ll pay with your current loan terms compared with the terms of consolidation. Will you save money? Or will you just trade in smaller payments in exchange for more breathing room?
If you see consolidating as one more way to extend your payments, then doing so won’t lead to debt payoff. Consider the pros and cons before you decide on debt consolidation — and be aware that it’s not a magic cure.