Getting out of debt is usually much harder than getting into it, especially if you’re dealing with a large balance and high interest rates. For many people, it can feel like it will take forever to pay off this debt. As a result, some people turn to debt consolidation loans to help them manage their balances faster and more effectively.
While debt consolidation can be a useful tool, there are important pros and cons to know before deciding if you should consolidate your debt.
What Is Debt Consolidation?
Debt consolidation involves taking out a new loan to pay off multiple smaller debts. Rather than making several payments to different creditors, you’ll have just one monthly payment to manage. This strategy is often used for high-interest debts such as credit card balances, medical bills, or personal loans.
Typically, the goal is to secure a loan with a lower interest rate than what you’re currently paying, which can save you money over time and make repayment more manageable.
The Advantages of Debt Consolidation
- Lower Interest Rates: One of the primary benefits of debt consolidation is the potential for securing a lower interest rate than what you’re currently paying on multiple debts, particularly if you have high-interest credit card debt. By locking in a lower rate, you can save significantly on interest payments over time. This is especially helpful if you’re dealing with high-interest loans or credit cards, as the savings can be redirected toward paying down the principal balance more quickly.
- Simplified Payments: Juggling multiple payments to different creditors each month can be overwhelming. Debt consolidation rolls your debts into one, so you only have to keep track of a single monthly payment. This not only reduces the mental burden of managing numerous bills but also decreases the likelihood of errors, late fees, or credit score damage from missed payments.
- Faster Debt Payoff: By consolidating your debts at a lower interest rate, more of your monthly payment goes toward the principal balance rather than just covering interest. This can help you pay off your debts more quickly. Additionally, having a set loan term (unlike credit cards, which allow you to carry a balance indefinitely) provides a clear timeline for when you’ll be debt-free, creating a sense of motivation and progress.
- Improved Credit Score: If your consolidation loan allows you to pay off your high-interest revolving debts, like credit cards, this could positively impact your credit score. Credit card debt contributes significantly to your credit utilization ratio, a key factor in determining your score. Reducing or eliminating this revolving debt can lower your utilization, which can boost your score. Over time, consistently making on-time payments on the new loan will further improve your credit.
The Drawbacks of Debt Consolidation
- Upfront Costs: While debt consolidation can save you money in the long run, some loans come with upfront costs such as origination fees, application fees, or even prepayment penalties. These costs can add up, and if they’re high enough, they may negate the benefits of consolidating your debt. Before committing, make sure you understand all the fees involved and calculate whether the savings in interest will outweigh these costs.
- Risk of Higher Total Costs: If you extend the repayment term of your consolidation loan to lower your monthly payment, you could end up paying more in total interest over the life of the loan. While the lower monthly payment may be more manageable in the short term, stretching the loan out over a longer period means you’ll accumulate more interest. It’s essential to find a balance between a comfortable monthly payment and minimizing your overall costs.
- Temptation to Accumulate More Debt: After consolidating their debts, some people feel a sense of financial relief and may be tempted to use credit cards or take on new loans again, leading to the accumulation of more debt. Without addressing the underlying habits that led to debt in the first place, such as overspending, debt consolidation can provide only temporary relief, and you may find yourself in an even deeper hole. It’s crucial to develop a disciplined approach to spending after consolidation to avoid falling into the same pattern.
- Credit Impact: While debt consolidation can eventually improve your credit score, the process of taking out a new loan can cause a temporary dip in your score. The lender will perform a hard inquiry on your credit report, which may lower your score by a few points. Additionally, the average age of your credit accounts could decrease if the consolidation loan is your most recent account, which can also affect your score. However, as long as you make timely payments on the new loan and avoid accumulating new debt, your score should recover and improve over time.
Should You Consolidate Debt?
Debt consolidation can be a powerful tool, but it’s important to assess whether it aligns with your financial situation and goals. Here are some additional factors to consider before making a decision:
Can you qualify for a lower interest rate?
Debt consolidation is most beneficial when you can secure a loan with a lower interest rate than what you’re currently paying on your existing debts. To qualify for these favorable terms, you generally need a good credit score. If your credit score is low, you may only qualify for a loan with similar or even higher rates, which may not improve your situation.
Are you committed to changing your financial habits?
Consolidating your debt doesn’t address the root causes of your financial struggles. If overspending or poor budgeting led to your debt, it’s crucial to commit to changing these habits. Without a plan to control spending and manage your money responsibly, debt consolidation could provide temporary relief, but you might find yourself back in debt in a few years. Consider developing a realistic budget and practicing better money management alongside your debt consolidation plan.
What are your other debt repayment options?
Before opting for consolidation, it’s worth exploring other debt repayment strategies like the debt snowball or debt avalanche methods. The debt snowball focuses on paying off your smallest debts first to build momentum, while the debt avalanche targets high-interest debts to save on interest costs. Both approaches can help you reduce your debt without taking on a new loan, and depending on your situation, they might offer faster or cheaper alternatives to consolidation.
Do you need help managing your debt?
If your debt feels overwhelming or you’re unsure which path is best, consider seeking professional help. A financial advisor or credit counselor can guide you through your options, including debt consolidation, and help you create a personalized plan for getting out of debt. This can provide valuable insights into how to manage your finances going forward, ensuring you don’t fall back into old habits.
Get Control of Your Debt With AZCCU
Debt consolidation can be an effective way to simplify your finances and reduce the stress of managing multiple debts. However, it’s not a one-size-fits-all solution. Understanding the pros and cons and being realistic about your financial habits can help you determine if this approach is the best fit for your situation.
Arizona Central Credit Union offers debt consolidation and debt payment calculators to help you understand your personal loan needs to pay off your debt. If you have any questions, contact us online or call (866) 264-6421.
