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Updated on Wednesday, January 23, 2019
Debt consolidation is a way to pay off existing debt with a new loan or line of credit. It could provide relief by turning multiple payments into one, streamlining what you owe and saving you money thanks to a lower interest rate or more time to repay.
Dispelling these 7 debt consolidation myths
In the right circumstances, debt consolidation can help get debt under control. But there are entities that offer the promise of debt consolidation yet don’t deliver — and even charge illegal fees in the process. Understand the following debt consolidation myths, and the pros and cons of the process, before pursuing it.
1. You can consolidate all types of debt together
There are many types of debt consolidation. A debt consolidation loan, for instance, is a personal loan that can be used to pay off multiple kinds of high-interest debt, such as credit cards and payday loans.
But it can’t be used to pay off federal student loans. There’s a separate process for that, called federal student loan consolidation. This option won’t reduce your interest rate, but it can give you more time to pay off your loans or qualify you for additional reduced-payment programs.
You can also consolidate credit card debt on its own using a balance transfer credit card, which moves high-interest debt across multiple cards to a single one. You’ll have as long as 21 months, depending on the card for which you qualify, to pay off the debt interest-free.
2. You need excellent credit to consolidate debt
Like other types of financial products, the higher your credit score, the more favorable terms you’ll get on debt consolidation loans and balance transfer credit cards.
But you can qualify for a debt consolidation loan with good, fair or even poor credit. Visit your local bank or credit union to check the options available there first. You may qualify for a lower interest rate if you have a long-standing relationship with the institution.
You can compare rates on debt consolidation loans through MagnifyMoney’s marketplace.
3. You have to pay to consolidate debt
If you qualify, you could get a balance transfer credit card with no transfer fees and no interest charges during the introductory period. Paying off your debt during that time means consolidating your debt fee-free.
But some cards do come with a balance transfer fee; consolidation loans may also have origination fees. Take these into account when considering whether to consolidate your debt or choose a different option, such as negotiating with your creditors yourself to lower interest rates.
Use caution if you interact with a company that charges to consolidate debt for you. Some companies charge fees to consolidate student loans, for instance, which is free to do directly through the government at studentloans.gov. The Federal Trade Commission (FTC) maintains a list of companies that it has banned from offering debt relief services.
It is illegal to charge a fee by phone before issuing a loan, according to the FTC. Familiarize yourself with the signs of an advance-fee loan scam.
4. Debt consolidation is always a scam
On the other hand, there are legitimate types of debt relief that may cost money.
Though not specifically a type of debt consolidation, debt management plans require working with a nonprofit credit counseling agency to simplify payments and potentially pay less on interest. You’ll make one payment to the credit counseling agency each month, which will then pay your creditors on your behalf. You’ll be charged a monthly fee and potentially an enrollment fee.
But you may find these fees are worthwhile to address your debt with the help of a reputable professional. A debt management plan requires making payments regularly and on time for the full length of the plan, which could take up to five years.
5. Debt consolidation will hurt your credit
Opening new accounts, such as a credit card or loan, may lead to a small drop in your credit score. An inquiry for a new credit card generally takes fewer than five points off a FICO Score, according to FICO. But opening multiple new accounts over a period will more dramatically affect your score.
Research your options in advance so that you apply for a balance transfer card or debt consolidation loan for which you’re likely to qualify. Once you get it, make payments on time, every time. Payment history accounts for the largest share of your credit score — 35%, according to FICO.
6. Consolidating debt is the only way to find relief
You may not have to apply for a new credit card or loan to get out from under your debt. Alternatives to debt consolidation include working directly with your creditors, who may be willing to lower your interest rate, waive late fees or give you a new monthly payment. You could also choose a debt management plan, which doesn’t require you to open a new line of credit.
If you can pay extra toward the debt, you can opt to pay off the smallest loan balance first, then put the equivalent of that monthly payment toward the next-smallest balance. This is the debt snowball method, and can help you gather wins on your way to debt freedom. Or you can pay the highest-interest loan first, called debt avalanche, which will save more money in the long run.
7. Pursuing debt consolidation is a cure-all
While debt consolidation can help you feel less overwhelmed in the short term, ending a reliance on credit cards — and preventing future debt — is a separate, and necessary, process.
Once you’ve chosen a debt consolidation method, audit your expenses and make a spending plan. Cancel subscriptions you no longer use and identify areas that need a closer look, such as how much you spend on meals out. You don’t need a complete overhaul of your budget, but a few key changes — such as cutting back on food delivery or reducing subscription services — can help you avoid creating more debt.
When debt consolidation works
Debt consolidation is a smart move when you qualify for a balance transfer credit card or loan that will lead to interest savings, as well as when you make payments on time for the duration.
Pause making purchases on the accounts you’re paying down. If you get a balance transfer credit card, make sure you fully pay off the debt during the card’s interest-free period. Divide your total debt by the number of months with the 0% interest rate and commit to sending that amount to the card each month.
Choose the right debt consolidation method for you
While debt consolidation myths abound, researching your options and relying on reputable sources of professional guidance will help you land on a strong strategy. Deciding to pay off debt is half the battle. The next step is to choose a debt consolidation method that will give you the best chance of success.