Different due dates, loan types, interest rates, fees — sometimes it feels like your debt should come with a manual. And in the confusion of keeping track of too many loans, you might be feeling the pinch of high interest charges or even late fees.
If so, it might be time to consider debt consolidation: taking out a new loan to replace your current debt.
This debt consolidation cheat sheet includes everything you need to know to decide if debt consolidation is right for you.
What is debt consolidation?
A debt consolidation loan is an unsecured personal loan you take out to combine and replace existing debt.
Debt consolidation loans are most often used to pay off and combine credit cards, personal loans, or other debt. Thanks to a debt consolidation loan, you can:
- Simplify your payments
- Avoid high credit card interest rates and save money
- Transition from a years-long payment schedule
- Steer clear of monthly payments you can’t afford
Instead, you’ll have a new loan with a new interest rate, new monthly payment, and new payoff date. But you’ll need to carefully choose the right debt consolidation loan terms to progress toward your debt goals.
3 ways you can use debt consolidation effectively
Still wondering how does debt consolidation work? Here are three of the most common and effective ways you can use a debt consolidation loan to improve your financial situation.
1. Get lower interest rates
One of the biggest pros of consolidating debt is the chance to pay less interest.
For instance, maybe you want to consolidate $10,000 of credit card debt. You pay a 14.00% credit card APR, on par with the average rates reported by the Federal Reserve Bank. Meanwhile, personal loan rates average 10.13%.
If you take out a new $10,000 debt consolidation loan at the 10.13% average rate, you’ll save $3,663 over a five-year term. This screenshot of our credit card consolidation calculator shows how the move could affect your monthly payments as well.
However, to consolidate debt to a lower interest rate, you’ll need good credit.
Getting a lower interest rate on a debt consolidation loan might be simple if you’ve improved your credit score since you took out the original loans. But even a borrower with fair or average credit might be able to save if they can consolidate high-interest debt to a lower amount.
The only way to know for sure is to get personalized rate quotes from a few lenders. That can set you on the path to reducing the cost of your interest payments in the long run.
2. Change monthly payments
Consolidating debt also can be a chance to change your monthly payments. First, it can make your life simpler by replacing multiple debt bills with a single, easy-to-track payment.
Many borrowers also can lower their monthly payments by getting a lower interest rate or choosing a longer repayment plan. When debt is straining your budget, a little wiggle room can make a big difference.
On the other hand, some borrowers might actually pay more each month with a debt consolidation loan. Choosing a loan term of two or three years, for instance, probably will mean you’ll pay more than your previous monthly minimums.
3. Adjust your payoff date
Your monthly payments are tied to your debt consolidation loan term — or how long you and the lender agree you have to repay the debt.
The longer your loan term is, the less you’ll pay each month. The shorter it is, the sooner you’ll be out of debt but the more you’ll pay each month.
Your loan term and payoff date also will affect the total interest you pay (or save) over the life of the loan. A shorter term will have higher monthly payments but will help you avoid years of interest charges.
By comparison, a longer term will stretch out the balance and lower your monthly payments but could raise the total interest you pay. In other words, a consolidated loan could cost you hundreds of dollars more than you would have paid if you’d left the original debt alone.
Make sure you do the math to see if it’s worth extending the payoff date on your loan. You can use our student loan payment calculator to play with different loan terms and see how different repayment terms and interest rates could affect your monthly payments.
3 pitfalls you should avoid with debt consolidation loans
Although consolidating debt often makes sense, it isn’t always the best move. Watch out for these three pitfalls.
1. Beware of debt consolidation services
Debt consolidation services promise to help you consolidate your debt. However, they can be costly, and if you’re not careful, you could end up getting scammed.
Fortunately, you don’t need them. There is nothing a debt consolidation service offers that you couldn’t easily do yourself for less or for free. If you decide a debt consolidation loan is right for you, shop around and apply for the loan yourself.
2. Include origination fees in cost calculations
On top of interest charges, many debt consolidation loans also carry origination fees. These fees can range anywhere from 1 to 6 percent of the total loan amount, which can add to your total loan costs.
Origination fees typically are taken out of the loan funds before the lender disburses them to you. For example, you get only $7,600 of your $8,000 loan thanks to a 5 percent origination fee. Plan to borrow enough that your loan funds both cover the origination fee and pay off the debt you’re consolidating.
Not all lenders charge this fee, so you might want to apply with those that skip it. You also should compare APRs on debt consolidation loan offers. APRs will reflect the total loan costs — including the interest rate and origination fee.
Fun fact: Sometimes a lender might offer a good enough rate to make an origination fee worth paying.
3. Stop borrowing after debt consolidation
Getting a debt consolidation loan is only the first step to financial freedom. It can get the debt you already have under control, but it won’t end the cycle of borrowing — that’s up to you.
Consolidating debt must be followed by a responsible plan of action to avoid taking on additional debt.
Beware of the available lines of credit you might free up once you consolidate credit card debt and pay off your maxed-out balances. You should have a strategy in place to avoid charging new purchases to your credit cards. If not, you’ll quickly max them out and land yourself in twice as much debt.
Responsible spending is also a must. If you don’t think you can resist running up balances again, you might need to go as far as canceling your credit cards. It will have an adverse impact on your credit utilization ratio right now, but that’s ultimately better than ending up in even more debt.
Is debt consolidation right for you?
Lastly, after doing your homework, you might find that debt consolidation isn’t right for you. Maybe you already pay low interest rates, so there’s little potential for savings. Or you could have a rocky payment history that makes it difficult to qualify for debt consolidation with poor credit.
Instead of trying to consolidate debt, you can tackle it head on by taking some of the following steps:
- Make a plan to pay off your debt that breaks this big goal into small, doable steps
- Start with small changes in your money habits and build on your progress as you go
- Pay extra on your debt whenever possible with the debt snowball or debt avalanche method
Ultimately, if you’re struggling with your current payments or are at risk of defaulting and still have several years left on your loans, debt consolidation might be a good idea.
But if you’re managing to make the payments and have only a couple of years left until your payoff date, you might want to consider other options instead.
At the end of the day, is it worth making lower monthly payments in the long run? Or can you pay off your debt using alternative strategies? The choice is yours.
Meredith Simmonds contributed to this article.
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