Debt consolidation Solutions have been a topic of much debate for years. While financial institutions will try and entice you to transfer your higher interest debt to their new account with low introductory interest rates, financial experts say, “look before you leap” before applying for a debt consolidation loan or transferring your credit card balances.
Is loan consolidation a good idea? Will it solve your problem of a seemingly endless cycle of debt payments? How do consolidation loans work? Let’s answer these questions and more as we examine the pros and cons of debt consolidation.
Is loan consolidation a good idea?
While a consolidation loan is a good idea for some people, it’s not a one-size-fits-all solution to everyone’s issues with debt.
If you qualify, a consolidation loan lets you combine your debts into a new loan with more favorable terms than you previously had. For example, you may have two credit cards with interest rates over 18% but be able to take out a consolidation loan and combine the balances of those two cards into a new loan with a 12% interest rate.
While that may seem like a very easy decision to make, consolidation loans have some pitfalls. Let’s look at the pros and cons of consolidation loans so you can apply them to your situation and make the right choice regarding how you should proceed.
Pros and cons of debt consolidation
Like everything, debt consolidation has its advantages and disadvantages.
When looking at the pros listed below, they are very attractive if you are struggling or failing to make your monthly minimum loan payments. You’ll only have one monthly payment instead of multiple payments, and your monthly payment could be lower.
But, as the cons point out, with a debt consolidation loan, you may be putting a Band-Aid on a more serious underlying financial problem, such as poor budgeting or excessive impulse buying. And, if your credit is suspect because of late or missing payments on your existing loans, you may not qualify for a lower rate.
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The benefits of debt consolidation
There are many benefits of debt consolidation. Here are several:
- A lower payment: The average American family’s credit card debt in 2022 is just over $6,200. If that debt were spread over two cards with a 24% interest rate, the monthly payment would be about $190. However, that same debt, consolidated into a single loan with an interest rate of 17%, would carry a payment of around $150 per month.
- 0% introductory APR offers: there are numerous 0% APR (annual percentage rate) credit card offers for people with very good credit or better. Many of these cards offer that rate for the first 24 months, which can significantly reduce your payment and the amount of interest you’d pay over the life of the loan.
- Eliminate debt quicker: lower payments and less interest paid means you can get out of debt faster than tacking on interest to your monthly payment. By paying more than your new payment amount every month, you can accelerate your loan payoff even quicker.
After weighing the pros and cons of debt consolidation, if you’ve decided that a debt consolidation loan is a promising avenue for you to pursue, there are a couple of things you may want to consider.
First, there are many lenders out there who want your business, and they compete with each other. Sometimes you can get more favorable rates by shopping multiple lenders. Your neighborhood bank with which you’ve always done business may not be as competitive as an online lender. It can pay to be a good shopper.
Second, you may want to consult with a financial advisor to make sure your financial house is in order before you take out a new loan. Even though your new loan may have a lower interest rate and lower payment, it doesn’t necessarily mean it’s in your budget any more than your existing loans. An advisor can help you see your current financial picture and make adjustments that will enhance your short and long-term financial security.
What are the risks of debt consolidation?
The risks are negatively impacting your credit score, defaulting on the new loan, ending up with a higher payment than you had with your old debt, and spending more of your income on discretionary items than you did previously.
How do consolidation loans work?
Consolidation loans combine two or more existing loans into one new loan. Your old debt is paid off, and you will begin paying a new lender.
Does debt consolidation affect your credit score?
Debt consolidation can affect your credit score positively or negatively. Eliminating payments you were making on time can negatively impact your score, but establishing a new loan and paying it on time can favorably affect your score.
How long does debt consolidation stay on your record?
Settling your debts through a debt consolidation loan will stay on your credit report for seven years after you’ve completed all of your payments, whereas bankruptcy can remain on your record for ten years.