Debt consolidation is combining your debt, such as high-interest credit card debt into one loan. The idea is to simplify your debt and make one monthly payment. If you can find a lower interest rate than what you’re currently paying for your credit cards, it can help save you money while you pay off your debt.
Debt consolidation is a tool to help repay your debt—the best way to do that is to come up with a plan or timeline for how long it will take you to pay it off. Your plan should include paying it off quickly and on time each month. Late payments may lower your credit score, so making payments on time is also an important part of debt consolidation.
What to understand before you consolidate your debt
Many personal loans come with low rates and can help you save on interest.
Here’s what you need to know before choosing debt consolidation loan:
- Debt consolidation is a refinanced loan with extended repayment terms, you can have a debt consolidation loan with shorter terms.
- Extended repayment terms mean you may be in debt longer.
- You may not get a lower interest rate just because you consolidate.
- Debt consolidation isn’t the same thing as debt elimination.
With responsibility on your side, these are some debt consolidation risks to look out for.
1. You may end up paying more interest over time
This risk really depends on how much debt you have and how quickly you can pay it off. If your debt consolidation loan has a longer term for you to repay it, you may end up paying more in overall interest than if you had kept your other loans.
Sometimes with debt consolidation loan rates, your payment each month could be smaller than what you were paying before. Instead of making minimum payments, consider paying extra each month. With the lower interest, it could help you pay down the principal loan amount and pay off the loan faster.
2. Fees associated with consolidation
Watch out for high fees that some debt consolidation loans may come with. These include origination fees, which take a percentage of your loan amount. Keep in mind that if you decide to consolidate your debt with a balance transfer credit card, you could get charged for each transfer.
3. The potential to lose your collateral
If consolidated with a secured loan and can’t pay the loan back, the lender could take possession of the collateral that you put up for the loan. This could be the case with a HELOC or home equity line of credit, which may require borrowers to put their homes up as collateral.
4. High credit utilization
If you have a lot of debt in general, you may have a high credit utilization ratio. This means your debt is eating into your overall credit. For example, if you have three credit cards with a limit of $2,000 each ($6,000 total credit limit) but use up $3,000, you have a credit utilization of 50 percent.
5. Debt—it’s a slippery slope
Falling deeper into debt may depend on your spending habits. While debt consolidation helps wipe away credit card debt, if you continue to use your credit cards, it’ll put you deeper into debt.
You may have simplified the process of having only one payment to make each month, but you don’t want to make your debt problem worse by continuing to spend.
When debt consolidation makes sense
While debt consolidation is a means to an end and can help you if you have high-interest debt with multiple balances, it’s best if you’re ready to make habitual changes in your spending habits.
Think about why you got into debt in the first place. Are you an emotional spender? Do you spend too often and don’t save enough? Consider reasons why you got into debt and empower yourself to make positive changes so you can reach your goal of wiping out your debt for good.
These are the best situations for someone who wants to use debt consolidation:
- If you have a solid credit score, you may qualify for the lowest interest rate
- You have a plan in place to get out of debt and stay out
Debt consolidation is a helpful way to help you pay down your debt, but you also need to think about not going deeper into debt by continuing to spend. Have a plan and a timeline to get out of debt.
Make sure you shop around for the best rates and understand all of the debt consolidation risks before moving forward.