Debt Consolidation: Does It Make Sense for You [Definitive Guide]

If you have debt, you want to pay it off as quickly as you can. In order to do that, you may be considering debt consolidation. Not so fast. Don’t make any decisions until you read our complete guide.

We have always emphasized that if you have debt, you need a plan to pay it off. Attacking debt with a plan means you will pay it off more quickly and it will cost you less. Debt consolidation seems like it would be a useful facet of that plan. But is it, or will it cost you more in the long run?

A debt consolidation loan simplifies your financing. Rather than making multiple payments to multiple creditors, you just make a single payment to the company holding the new loan.

What to Consolidate

Credit card debt is a prime example of the kind of debt you want to consolidate because it has a high rate of interest. The average interest rate on a credit card is 17.30% When your interest rate is so high, it can take years to pay off debt especially if you are only making the monthly minimum payments.

Forty-five million Americans have student loan debt, and that debt is often spread out over multiple loans and multiple lenders making the payments hard to manage. The numbers vary by disbursement dates, but the federal student loan interest rate is between 4.45%-7%.

For private student loans, it can run over 14%. Even if your interest rate is manageable, your monthly payments may not be so you might consider consolidating your loans to lower that monthly payment.

If you have medical debt, you’re not alone. One in four Americans has difficulty paying their medical bills while this study expects national health spending to reach $6 trillion by 2027.

Medical facilities often use debt collectors to recoup this money, and if you’ve ever been on the receiving end of a phone call from these collection companies, you know how aggressive they can be and how distressing it is.

Unpaid medical debt can lead to your wages being garnished and even a lien being placed against your home.

Types of Debt

There are two kinds, secured and unsecured. Secured debt is backed by an asset and can be used as collateral if you’re unable to repay the loan. Your home is one example of a secured debt.

Unsecured loans aren’t backed by an asset which is why they typically carry higher interest rates. Credit card debt, student loans, and medical bills are all examples of unsecured debt.

Debt Consolidation Options

The four primary methods of consolidation are:

Personal loans: ideally, you want to secure one with shorter repayment terms and a lower interest rate than your current loan to pay off high-interest debt.

Credit card balance transfers: 0% balance transfers usually have a grace period which allows you to pay down your debt interest-free.

Home equity loan (or home equity line of credit): taking a loan out against your home is another example to lock in a lower interest rate compared to personal loans, especially if your debt-to-equity ratio is 20% or more.

401k loans: you might be able to borrow against your 401k depending on your employer’s plan type. However, you want to be cautious because if you’re unable to repay it on time, it’s viewed as a distribution and carries a 10% penalty

There are plenty of companies that prey on those looking to consolidate debt. But plenty of reputable companies do it too, some of whom we’ve interviewed and reviewed here at LMM.

Credit Card Debt

If you have credit card debt, consider getting credit consolidation loans at Prosper. Propser is a peer-to-peer lender. They grades borrowers based on things like their credit score, the amount of the loan they’re seeking, and the term of the loan.

The best-rated borrowers will get an average rate of 8.06%. As someone looking to consolidate debt, you probably won’t have a rating high enough to lock in that low-interest rate, but it’s worth going to the site and checking your rate which will not impact your credit score.

You may also be eligible for a credit card balance transfer. These cards have an introductory interest rate of 0%. You transfer the balance from your current high-interest credit cards to the new card. During the 0% APR period, you can tackle the balance without accruing more interest.

Beware though. Once the introductory rate is over, the standard interest rate starts, and it could be higher than what you were paying for the old cards. For a balance transfer card to be a solution to credit card debt, you have to pay off the entire balance before the new interest rate kicks in.

Also, be mindful of any balance transfer fees that may be included. Some companies charge between 3% to 5% of the total amount transferred.

Student Loan Debt

If student loan debt is what you struggle with, you can refinance through Earnest. They offer low rates of loans. And unlike consolidating with a bank, Credible offers some programs for borrowers who run into problems making their monthly payments.

Medical Debt

If you have medical debt, you can consider a loan with a peer-to-peer lender like Propser or a loan with your local bank or credit union. A credit union may offer lower rates than a traditional bank, so it’s worth looking into joining one.

Your debt is an emergency.

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What Loan Terms to Look For

The terms are the essential parts of choosing consolidation loans. Consolidating debt does not automatically mean you will get a lower rate of interest than what you currently have. Nor does it mean that you are guaranteed to save money.

The interest rates on consolidation loans can range from 5%-36%! The interest rate you will be offered is based on your credit score. The better your score, the lower your rate.

When you are considering consolidating debt, what you should be concerned with is not lowering your monthly payment but reducing the amount of interest you pay and getting the loan amount repaid quickly. Remember, your debt is an emergency, and like an emergency, you want it over with as soon as possible.

Is It Smart to Consolidate Debt

The promise of a lower monthly payment can be seductive if you are struggling with debt, but the reason the monthly payment is reduced is that the life of the loan is increased. When that happens, you haven’t saved any money at all, you’ve spent more. 

If the number of loan payments increases, you’re paying more money (in interest) because you’re taking longer to repay it.

In this instance, consolidating doesn’t make sense.

While some people may have a good handle on their finances and are just considering a debt consolidation loan as a way to save money, that is not the typical case. The majority of those contemplating consolidating debt is in a dangerous financial place, scared and desperate

There are unscrupulous organizations that claim to help you pay off debt but really just take advantage of frightened, uninformed people. How can you spot a disreputable debt consolidation company?

They often make outlandish promises like guaranteed results, promise to give you a loan no matter how weak your credit or without asking you to provide any financial information. You will be asked for some kind of upfront fee or payment before the loan can be approved. The company offers you a debt settlement plan rather than a debt consolidation loan.

If you see any of these signs, run!

Beware of Fees

Some consolidation loans have initiation fees, origination fees, or fees for paying the loan off early. These fees can eat up any savings you might be getting from a loan with a lower interest rate.

Debt Settlement

Debt settlement companies offer to negotiate with your creditors to settle your debt for much less than you owe. Sounds great right? Well, sometimes it isn’t. There are predatory companies out there that will advise you to stop paying your debts and instead, send the money to them.

At worst, this is a flat-out scam, and the “company” runs off with your money. At “best” you will destroy your credit score. You see, most creditors will only agree to settle a debt if it is way past due. So the settlement company saves up the money you have been sending to them and then calls up your creditors and offers to settle for that amount.

The creditors figure getting something is better than nothing so agree to settle. And you walk away debt-free. Only you have just destroyed your credit score, absolutely nuked it.

All of those payments you were sending to the settlement company rather than to your creditors have been reported as late payments and are going to be on your credit report for the next seven years.

If you did this with credit card companies, they would cut off your cards, and it will be a long time before you’re approved for another. For some people, that might be a blessing. They can’t responsibly handle them, but life is harder without a credit card.

Credit cards offer some protections that debit cards do not and some things like renting a car or hotel room may require a credit card. If your debit card or bank account is hacked, it will take a few days to sort out.

During that time you will not be able to access your money. If you don’t have a credit card, you are going to have to borrow money from a friend or family member to pay for essentials like food and gas.

Do Consolidation Loans Hurt Your Credit?

If you consolidate debt, it will almost certainly have a negative impact on your credit score. Part of your credit score is based on the age and the number of credit accounts you have.

Consolidating is going to close some of your accounts leaving you with a single, brand new account and shortening your credit history.

Lenders also execute a hard inquiry when you apply for debt consolidation, which temporarily reduces your score.

The impact on your score will be worse if you are making late payments or going into default, but if you are managing your debts well enough and just considering credit consolidation as a way to simplify your finances, it’s probably not worth it.

Don’t Take On New Debt

DO NOT continue taking on debt after you have consolidated your current debt. You might think this goes without saying but consolidating debt has a strange psychological effect on some people. It makes them feel as though the emergency is over, that the debt is paid.

The debt is not paid, at best, the debt is now managed. You still have outstanding debt. Don’t add to it.

Ways to Eliminate Debt

If you’ve read this and didn’t think a debt consolidation loan is a solution for you, you aren’t destined to live with debt forever. There are plenty of ways you can do it yourself.

Make More

Here’s my favorite, or least favorite I guess, statistic. Americans spend five hours a day watching television. Unacceptable for anyone but absolutely forbidden if you are drowning in debt. You need to use some of that time to earn more money.

Drive for Uber, babysit with Sittercity, sell stuff on eBay or Poshmark. Even taking surveys on Survey Junkie can make you some extra money, certainly more than watching television. If you don’t like any of those ideas, we have a list of 23 ways to make money fast.

Ask your boss for a raise with plenty of evidence to back up why he or she should give you one. Work overtime, get a part-time job in retail or a bar or restaurant nights and weekends. Start looking for a new, higher-paying job.

And all of that extra money goes toward paying back your debt.

Spend Less

Every cent you earn should be accounted for, and you do that by making and sticking to a budget. Our favorite budgeting tool is Mint because it’s easy to use and free. We can help too.

We have episodes and articles on all kinds of ways to save money; saving on food, on fun, on moving, on your apartment. Listen to and read them and follow the advice.

Use tools like Trim and Truebill to save you money. Trim will go through your expenses and find recurring charges like your Pandora subscription or gym membership. If you want to cancel them (you do), Trim will take care of it for you.

Billshark will negotiate lower rates on things like your cable, phone, and internet bills. Whatever you’re paying now, Billshark can probably reduce that amount.

Improve Your Credit Score

It might not be that you didn’t want to consolidate your debt but that your credit score was not good enough to qualify you or not good enough to get you terms that would actually save you money.

You can work on improving your credit score. You can watch your progress at Credit Karma. When your score improves, you can try again to consolidate your debt. Even if you are not interested in doing so, having a good credit score is something to aspire to.

“Bad credit can suggest you’re a risky bet. While bad credit may only show the details of how you deal with debt, some will extrapolate the characteristics from your financial life to other situations and assume that your bad credit implies that you may be just as irresponsible driving a car, taking care of an apartment or showing up for a job”, Weston notes.

Spending Habits

Provided you use a reputable company, debt consolidation loans can be an excellent tool to get out of debt. But how did you get to the point of needing this kind of tool? If it was something like student loan debt, that is a one-off. Unless you decide to return to school, you’re not going to take on more student loan debt.

But if you consolidate credit card debt, why did you end up with so much that you couldn’t handle it? Did you lose your job, did you break your leg and have to charge all of the associated medical expenses because you hadn’t met your deductible? Did you charge things like clothes and vacations that you couldn’t afford?

The first two examples and many other expenses that plunge people into credit card debt are the kind of expenses that we create an emergency fund for. Having an emergency fund can be the difference between a small obstacle to your bigger financial goals or having to get a debt consolidation loan.

This whole thing has sucked, and you have learned your lesson. You are paying off the debts and building an emergency fund. But if you got into this position because you buy a lot of stuff you don’t need and cannot afford; you may not have learned a lesson. A year or two from now, you might find yourself in the same position.

Debt Relief

There is credit counseling available to help you if you feel your financial situation spinning out of control. The National Foundation for Credit Counseling and Debt.Org are worth a look.

The above-mentioned companies, and ones like them, can help determine which kind of debt management plan is right for you.

If you don’t get a handle on your spending, you will never be out of debt, no matter how much money you make. We can help you learn to manage your money, grow your wealth, and achieve financial independence. You have the power to change these destructive behaviors.

Use your debt consolidation experience to turn your financial life around. We all make mistakes, but we don’t have to repeat them. LMM is here to help.