Debt consolidation involves acquiring a new loan or credit card and using it to pay off multiple outstanding debts, effectively combining them. It reduces the number of your monthly payments and may help you improve your repayment terms.

However, debt consolidation doesn’t reduce the total amount of debt you owe and can make your financial situation worse in certain circumstances. Here’s what you need to know about the process to determine if it’s right for you.

How To Consolidate Your Debt

You can use several different types of financing to make debt consolidation work, but the process is always fundamentally the same. It involves applying for new credit, using it to pay off your existing debt, then paying off the new account.

The two options consumers typically use to complete debt consolidations include the following:

• Debt consolidation loan: These are a type of personal loan. They let you combine your existing debts and then pay off the balance in monthly installments of principal and interest over a fixed loan term, usually three or five years.
• 0% interest balance transfer credit card: These cards let you transfer existing debts to them for a fee. They don’t charge interest for a limited promotional period of around 18 months, but your rate will increase significantly afterward.

It makes the most sense to perform a debt consolidation when you have outstanding balances spread across multiple accounts with high interest rates. As a result, it’s more common with credit card debt than with debts like auto or student loans.

For example, say you have three credit cards with the following balances, interest rates, and minimum monthly payments:

• Card 1: $3,000 at 16% with a $120 payment
• Card 2: $2,000 at 18% with a $80 payment
• Card 3: $2,800 at 14% with a $112 payment

You only have enough cash flow to make the minimum monthly payments on each card, which equal $312. In this scenario, it would take you eight years and 11 months to pay off every credit card balance, during which you’d incur $3,540 in interest.

However, if you qualify for a $7,800 consolidation loan with a 6% interest rate and a 5-year repayment term, your monthly debt payment would decrease to $151. At the same time, you’d get out of debt four years sooner and pay only $1,248 in interest.

Pros of Debt Consolidation

Debt consolidation can offer several significant benefits in the right circumstances. Here are the primary reasons to consider pursuing it.

Potential for More Favorable Terms

Generally, the primary reason to consolidate your debts is to lock in terms more favorable for your financial situation. Depending on your needs, credit score, and the type of debt used to execute the transaction, that can mean reducing your:

• Overall interest rate
• Total financing costs
• Time spent in debt
• Monthly payment

For example, if you use a debt consolidation loan, you can generally expect to pay between 6% and 36% interest and have a three- or five-year repayment term.

Alternatively, you could use a 0% interest balance transfer card. You’d receive an interest-free promo period between roughly 12 and 24 months, but your rate would return to regular credit card rates afterward.

Reduce the Number of Monthly Payments

Another common reason people pursue debt consolidation is to reduce the number of monthly payments they have to manage.

Keeping track of several due dates at once can be challenging when your net monthly cash flow is low or negative, but debt consolidation lets you combine some or all of them into one.

For example, say you have a variable income and are barely making ends meet. Each month, you’d need to track your due dates and paychecks to determine whether you have enough funds to fulfill your obligations.

Using a debt consolidation loan to pay all of them off would mean that you only have to keep track of a single monthly due date.

Opportunity to Improve Credit

In addition to reducing the financial burden of your outstanding balances, debt consolidation may help you improve your credit score, though the initial application for a new loan or credit card can cost you points.

Remember, debt consolidations are primarily about gaining more favorable terms. That always means reducing the number of payments you have to manage, and it also often means reducing the total payment amount.

Both of those make it easier to complete your monthly payments on time and in full. Since payment history is the most significant factor in your score, consolidation often improves your credit in the long run.

Cons of Debt Consolidation

Debt consolidation is beneficial in some circumstances, but it’s not ideal for everyone. Here are the reasons you may want to avoid it.

Potential Upfront Costs

Unfortunately, you’ll probably incur fees when you initiate a debt consolidation, whether you use a loan or a balance transfer card to complete the transaction. Before you apply for either, make sure you confirm that you can afford the upfront costs.

The origination fee is the charge to watch out for with debt consolidation loans. While they vary significantly depending on your credit score and lender, they often range from 1% to 8% of the principal balance.

Generally, you’ll pay less with a traditional financial institution such as a bank or credit union, while an online lender will be more expensive. Fortunately, you may be able to roll your origination fee into the loan balance if you can’t afford it.

Similarly, balance transfer cards usually charge a balance transfer fee between 3% and 5% of the amount you’re moving to the new account. However, a credit card company may let you execute the transaction for free during a brief intro period.

More Favorable Terms Aren’t Guaranteed

Debt consolidation can help you acquire more favorable debt repayment terms, but improvement isn’t guaranteed. In fact, most debt consolidations have pros and cons, benefitting you in some ways but forcing you to sacrifice in other areas.

For example, extending your repayment period often lowers your monthly debt payment, but it keeps you in debt for longer and may increase your total interest charges.

Debt consolidation is most likely to be favorable when it lowers your overall interest rate. Otherwise, the downsides may outweigh the benefits.

Consolidations May Require Good Credit

Whether debt consolidation is worth pursuing depends primarily on the terms of the credit account you use to replace your previous debts. Unfortunately, the best credit cards and loans require you to have at least a good credit score, if not an excellent one.

Since people interested in debt consolidation are often struggling to keep up with their current debt payments, they’re less likely to have good credit. That can make the strategy unavailable to the people who need it most.

When Is Debt Consolidation a Good Idea?

Debt consolidation is usually most beneficial when you have multiple debts with high interest rates and a good enough credit score to qualify for a new account with more favorable terms.

As a result, consumers often use it to consolidate credit card debt. The average credit card interest rate is 21.59% in 2022, and you can often lower your costs by refinancing into a personal loan or interest-free credit card.

That’s the best reason to consolidate your debts, but the tactic may also be beneficial if it helps you meet your obligations. That usually means getting a lower monthly payment or reducing their number. 

However, consolidating for those reasons can cost you in other ways, often by extending your time in debt or increasing your total interest expense.

For example, say you have private student loan debt and a credit card balance. Your current monthly payments total $700, and you’re on track to get out of debt in a year and eight months.

Unfortunately, you can’t afford to keep up with your payments any longer. You have to take out a consolidation loan that reduces your total monthly outflow to $400, but it doesn’t get you a lower interest rate.

That helps you avoid missing your monthly payments, but it also extends your repayment term to five years. You’ll stay in debt longer and pay additional interest charges since it’ll have more time to accrue at the same rate. 

When Is Debt Consolidation a Bad Idea?

Debt consolidation is inadvisable when it doesn’t improve your financial situation. Not only does it take time and money to execute, but it also hurts your credit score, and it’s not worth pursuing if you get nothing in return.

That often happens when your credit isn’t good enough to qualify for an account with more favorable terms. For example, say you have three credit cards with the following balances and interest rates:

• $4,500 at 18%
• $3,000 at 20%
• $5,000 at 24%

Multiplying each card balance by its interest rate, adding the results together, and dividing them by your total debt amount of $12,500 gives you a weighted average interest rate of 20.88%.

Your minimum monthly payment would be $375, and you’d need 23 years and eight months to pay off your balance. During that time, you’d pay $16,891.26 in interest.

Unfortunately, you’ve been struggling to keep up with your payments for months, causing your payment history and credit utilization to suffer. You have a 550 credit score, which lenders consider bad credit.

As a result, you can’t qualify for a debt consolidation loan from a traditional institution or any 0% interest balance transfer cards. You only get one loan offer from an online lender, but the interest rate is 30%, which is much higher than your current average.

There’d be no benefit to the credit card debt consolidation because your monthly payment would increase to $404, making it even harder for you to keep up with your debts. You’d also pay an origination fee and add a hard credit inquiry to your report.

Also Read: Credit Score Statistics

How Long Does a Debt Consolidation Stay on Your Credit?

Debt consolidations don’t appear on your credit report as distinct negative entries. Consolidation is a strategy, not an official form of debt relief like bankruptcy. As a result, only the steps you take to execute the process are visible in your history.

When you apply for your debt consolidation loan or 0% interest balance transfer card, the creditor will check your credit score to see if you qualify. That initiates a hard inquiry, which stays on your credit report for two years.

Next, you’ll use your new loan amount to pay off the old debt balances. They’ll stay on your credit report for up to ten years after you close them.

Finally, you’ll pay off the new debt. It’ll remain on your credit report as long as the account remains open. Once you pay it off, it’ll be visible for up to ten years as well.

Does Consolidating Hurt Your Credit Score?

Debt consolidation usually hurts your credit score initially because most consumers need to apply for a new credit account to complete it. That triggers a hard credit check, which takes points off your score.

Fortunately, the damage is usually insignificant. Your credit inquiries are only worth 15% of your FICO score, and one application is unlikely to cost you more than ten points.

You can also avoid the issue altogether if you use a pre-existing account to consolidate your debts, such as a home equity line of credit.

The process can impact your credit score in a few other ways in the short term, but they depend on your current outstanding debt and the account you use to execute the strategy.

Ultimately, consolidation usually hurts your score less than other forms of relief like debt settlement, and it will benefit your credit in the long term if it helps you make your future payments on time.

Before choosing the debt consolidation option, consider signing up for credit counseling with a local non-profit organization. They can offer you a debt management plan which may help you get out of debt without having to apply for a new account.

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