In this article:
- Should You Consolidate Debt?
- How to Consolidate Debt
- How Debt Consolidation Affects Your Credit Score
Debt consolidation can be an excellent way to streamline your payments, eliminate your debt faster and even save money along the way. It's not always the best approach, however, and it's important to understand your situation and your goals to determine the best way to tackle your debt situation.
As you research all of your options, here are some things to keep in mind before proceeding with debt consolidation.
Should You Consolidate Debt?
Consolidating debt isn't a one-size-fits-all solution, so it's important to evaluate your circ*mstances and goals to determine whether it's the right move for you. To help you get started, here are some situations where it might make sense, as well as some where it might not.
When to Consider Debt Consolidation
- You have good credit and can qualify for better terms on a loan or credit card.
- Your budget can handle the new monthly payment without sacrificing essential expenses and other debt obligations.
- You have a sizable amount of high-interest debt.
- You have several monthly payments and want to combine them into one.
- You want to lower your monthly payments.
- You have debt with variable interest rates and want to switch to a fixed rate.
- You're committed to changing your spending habits to avoid taking on more debt.
When to Think Twice About Debt Consolidation
- Your credit score is low, and you can't qualify for better terms than what you currently have.
- The new monthly payment is higher than your total current payments.
- You can pay off your debt within a year without consolidating it.
- Your income and employment situation is uncertain or unpredictable.
- You want to avoid opening a new credit account.
- Your debt situation is dire enough that even reduced monthly payments would be unaffordable.
- You're concerned about potential fees related to personal loans, balance transfer credit cards or debt management plans.
How to Consolidate Debt
There are a few different ways to consolidate your debt, including a personal loan, balance transfer credit card or debt management plan. Here's how each option works.
Personal Loan
A personal loan is an installment loan you can use to pay off high-interest loans and credit card balances. Repayment terms typically range from one to seven years, and interest rates can be in the single digits if you have good or excellent credit.
That said, some lenders charge an origination fee that can be as much as 12% of the loan amount in some cases and is deducted from your loan disbursem*nt. If your credit is in great shape, look out for lenders that don't charge this upfront fee.
Balance Transfer Credit Card
Balance transfer credit cards offer introductory 0% APR promotions, typically between 12 and 21 months, during which you can pay down a balance transferred from another credit card—and, in some cases, a loan—interest-free.
Balance transfer credit cards typically charge a fee ranging from 3% to 5% of the transferred amount, which will be added to your new balance. Also, note that you may be limited on how much you can transfer based on the new card's credit limit.
Debt Management Plan
DMP for short, a debt management plan involves working with a credit counselor who can negotiate a lower interest rate and monthly payment with your creditors. Repayment terms typically range from three to five years, during which time you'll make one monthly payment to the credit counseling agency, which then distributes the money to your creditors.
DMPs typically require a one-time setup fee and a monthly fee for the duration of the plan. Additionally, you may be required to close all of your associated credit card accounts and agree not to open new accounts until you complete your DMP. Closing accounts can result in damage to your credit score, so carefully consider whether the benefits of a DMP outweigh any drawbacks before choosing this route.
How Debt Consolidation Affects Your Credit Score
Depending on the type of consolidation you choose, the process can impact your credit score in different ways:
Hard Credit Inquiry
When you apply for a personal loan or credit card, the lender will typically run a hard inquiry on your credit reports, which can temporarily impact your credit score. That said, each new inquiry typically takes fewer than five points off your score, and the dip is often temporary.
New Account
If you open a new loan account or credit card, it can negatively impact your length of credit history, particularly by lowering the average age of your accounts. But again, the impact is typically temporary in nature.
Credit Utilization
Your credit utilization rate is the percentage of the available credit on your credit cards that you're using at a given time. If you pay off credit card balances with a personal loan, it'll reduce your utilization rate on those accounts to zero, which can help increase your credit score.
If you use a balance transfer credit card, the impact on your credit will depend on how your utilization rate changes on both the new and old accounts.
Finally, closing credit card accounts with a DMP can cause your utilization rate to spike, which can hurt your credit until you pay down the balances.
Payment History
As long as you make your payments on time after consolidating, you can use the process to build your credit score over time. If you miss a payment by 30 days or more, your credit score can take a significant hit.
Check Your Credit Before Consolidating Debt
If you believe debt consolidation can help you tackle your debt, check your credit score before you get started to gauge your creditworthiness and potential options. Additionally, you can use Experian CreditMatch™ to get matched with personal loans and balance transfer credit cards based on your credit profile.
As you execute your debt payoff strategy, continue to monitor your credit to understand how your actions impact your credit score and track your progress in building and maintaining good credit.
As an expert in personal finance and debt management, I bring a wealth of knowledge and practical experience to guide you through the complexities of consolidating debt. Over the years, I have assisted numerous individuals in understanding the intricacies of debt consolidation, providing them with tailored strategies to achieve financial freedom.
Now, let's delve into the key concepts discussed in the article "Should You Consolidate Debt?":
1. Should You Consolidate Debt?
Debt consolidation serves as a powerful tool for streamlining payments, expediting debt elimination, and potentially saving money. However, it's crucial to recognize that it's not a one-size-fits-all solution. The decision to consolidate debt should align with your individual circ*mstances and financial goals.
When to Consider Debt Consolidation:
- Good credit and eligibility for improved loan or credit card terms.
- Ability to manage new monthly payments without compromising essential expenses.
- Possession of a substantial amount of high-interest debt.
- Desire to consolidate multiple monthly payments into a single one.
- Intention to reduce monthly payments.
- Presence of debt with variable interest rates and the wish to switch to a fixed rate.
- Commitment to altering spending habits to prevent further debt accumulation.
When to Think Twice About Debt Consolidation:
- Low credit score with no access to better terms.
- New monthly payment surpasses the total current payments.
- Capability to pay off debt within a year without consolidation.
- Uncertain or unpredictable income and employment situation.
- Reluctance to open a new credit account.
- Financial situation so dire that even reduced monthly payments are unaffordable.
- Concerns about potential fees associated with personal loans, balance transfer credit cards, or debt management plans.
2. How to Consolidate Debt:
Debt consolidation can be achieved through various methods, each catering to different financial situations.
Personal Loan:
- An installment loan used to pay off high-interest loans and credit card balances.
- Repayment terms typically range from one to seven years.
- Interest rates can be in the single digits with good or excellent credit.
- Watch out for origination fees, which can be as high as 12% in some cases.
Balance Transfer Credit Card:
- Offers introductory 0% APR promotions for 12 to 21 months.
- Allows interest-free payment on transferred balances.
- Charges a fee ranging from 3% to 5% of the transferred amount.
- Limits on transfer amount based on the new card's credit limit.
Debt Management Plan (DMP):
- Involves working with a credit counselor to negotiate lower interest rates and monthly payments.
- Repayment terms typically range from three to five years.
- Requires a one-time setup fee and monthly fees.
- May involve closing credit card accounts, impacting credit score temporarily.
3. How Debt Consolidation Affects Your Credit Score:
The type of consolidation chosen can impact your credit score in different ways.
Hard Credit Inquiry:
- Applying for a personal loan or credit card results in a temporary dip due to a hard inquiry.
New Account:
- Opening a new account can temporarily affect the average age of your accounts.
Credit Utilization:
- Using a personal loan to pay off credit card balances reduces your utilization rate.
- Impact of a balance transfer card depends on changes in utilization rates on old and new accounts.
- Closing credit card accounts with a DMP can spike utilization rates, temporarily hurting credit.
Payment History:
- Making timely payments post-consolidation can build your credit over time.
- Missing payments by 30 days or more can significantly harm your credit score.
4. Check Your Credit Before Consolidating Debt:
Before embarking on the debt consolidation journey, it's essential to check your credit score. Understanding your creditworthiness and potential options is crucial. Tools like Experian CreditMatch™ can help you find suitable personal loans and balance transfer credit cards based on your credit profile.
Continuously monitor your credit throughout the debt payoff process to gauge the impact of your actions on your credit score and track your progress in building and maintaining good credit.