Having a lot of debt, whether it's balances on your credit cards or payments due on personal loans, makes it tough to track what you owe and pay it off in a timely fashion. Not to mention how dangerous debt is to your credit score. If you owe more than 30% of your available credit limit – or too many debts lead to you miss or be late making payments – your FICO score could suffer.
For people who can handle the situation well, consolidating a variety of debts into one debt consolidation loan and monthly payment may ease the stress and provide a little relief to the wallet. Debt consolidation loans allow people to roll their debt balances into one loan, presumably with a lower interest rate, says Gail Cunningham, spokeswoman for the National Foundation for Credit Counseling. “This is convenient because you just have one bill to pay, and it should save you money through the lower interest rate.”
How Consolidation Loans Work
Debt consolidation loans combine several unsecured debts (those without collateral such as a car, house, boat, etc.) into a single loan that may result in a lower interest rate, lower monthly payment or both. That can make it easier to pay off debts faster than without a debt consolidation loan.
These types of loans don’t erase the debt; they simply transfer your debt to a different lender or type of loan.
“Typically, the loan has to be paid off in 3 to 5 years,” says Harrine Freeman, CEO and owner of H.E. Freeman Enterprises, a credit repair and counseling service in Bethesda, Md., and author of “How to Get Out of Debt.”
Freeman says they’re most helpful for those who have multiple debts, owe $10,000 or more, are receiving frequent calls or letters from collection agencies, have accounts with high interest rates or monthly payments, are having difficulty making payments or are unable to negotiate lower interest rates on loans.
A consolidation loan may also be kind to your credit score down the road. “If the principal is paid down faster [than it would have been without the loan], the balance is paid off sooner, which helps to boost your credit score,” says Freeman.
Although debt consolidation loans can offer some relief, they have some downsides.
Freeman says one of the biggest is interest rates, starting with a higher rate. “You may have to pay high interest rates and fees if you have bad credit.”
Even if the rate is reasonable, having a lower monthly payment will likely mean that you'll be paying back what you owe over a longer period of time than if you hadn't taken out a consolidation loan. “That will result in paying more interest over the life of the loan,” says Freeman.
That’s why doing your homework is important. Call your credit card issuer(s) to find out how long it would take to pay off the debt on each of your cards at its current interest rate. Then compare that to the length and cost of the consolidation loan you're considering.
There could be steep penalties and fees if you miss a payment. “Your interest rate could also be raised in this instance,” says Freeman.
What's more, debt consolidation loans aren’t necessarily a credit score’s best friend right off the bat. Freeman says that if the loan is reported on your credit report it will temporarily lower your credit score. That is to say, lenders interpret having a debt consolidation loan as a sign that you have debt you’re unable to manage without one – a situation not viewed favorably by potential lenders.
And, of course, just as with any other type of credit account, a missed payment on a debt consolidation loan will be reported on your credit report. "That can lower your credit score,” says Freeman.
Finding a Loan
If you have a good payment history with a bank, credit union or credit card company, asking that institution about a debt consolidation loan should be your first step. “If you can get your bank to approve a loan, that’s great," says Tim Gagnon, assistant academic specialist of accounting at the D'Amore McKim School of Business at Northeastern University. "But your bank may not be looking to keep you as a client and your credit scores may not be high enough to meet their lending requirements.”
If you’re turned down by your bank or credit union, Gagnon suggests exploring private mortgage companies or lenders. “They tend to be less rigid on scores and ratios."
Be especially leery of consolidating debt by putting it all on a new credit card, Gagnon says. “Most credit cards charge a percent of the amount transferred.” That could negate any savings offered through debt consolidation. For more information, read Debt Consolidation: When It Helps, When It Doesn't and Using Home Equity Loans For Debt Consolidation.
The Bottom Line
Debt consolidation loans can help reduce the amount you owe every month and ease stress. Cunningham says they’re not magic bullets, however, and they have one major drawback: “If a consumer isn’t very disciplined, they can end up with the bill consolidation loan payment and other bills if they begin charging again,” he cautions. “Some things simply don't play out in real life as well as they do on paper.”
If you’re uncertain whether a debt consolidation loan is the right choice for you, consider talking to a credit counselor or financial advisor. Some credit-counseling companies are less than reputable. Before you choose one, read How To Find A Credit Counselor and click here for the Federal Trade Commission's advice on avoiding a scam.
If you decide to go ahead with a consolidation loan, be sure to read the fine print very carefully before agreeing to the terms and conditions. One other word of warning: Student loans have special provisions that will disappear if you consolidate them with other debts. Read 7 Ways To Consolidate Debt for more details.