Did you know that 49% of Americans expect to live paycheck to paycheck this year?1 And, the average American household carries $8,398 in credit card debt?2 There are a lot of different strategies that can be used to pay down debt. One option is to obtain a consolidation loan. But, is consolidating debt a good idea? Before you decide if this option is a good fit for you and your financial situation, you should learn about the pros and cons.
What is a debt consolidation loan?
When you take out a debt consolidation loan, you use the money you borrow to pay off other debts, such as credit card balances, medical bills or other installment loans. Once the loan is active, you only have one monthly payment amount and one monthly due date, rather than having to pay several different lenders.
When should you consider debt consolidation?
If you have a reasonable amount of debt and have a plan in place to prevent future debt, then you may want to consider a debt consolidation loan. It may be helpful in lowering your monthly interest rate or potentially adjust the terms of a loan to lower the monthly payment, allowing you to save money and pay off your balances faster.
For example, if you have several different credit cards with different due dates and interest rates, it would make sense to look into consolidating the debt if you could get a debt consolidation loan at a lower interest rate than any of the credit cards. You can use our debt consolidation calculator to see how your numbers add up.
The benefits of debt consolidation
In addition to making just one payment each month, there are several advantages to a consolidation loan:
Lower interest rate and fixed payments - The interest rate you get on a debt consolidation loan may be lower than the rate you’re paying on your existing balances, which can save you a significant amount of money over time. In addition, if you choose a loan with a fixed interest rate, then your payment due each month will remain the same as you pay off your loan as scheduled. That can make budgeting easier.
You know when you'll finish paying off your debt - A loan has a set amount of time during which you’ll be paying back your debt. With a credit card, there is no set date when you know you’ll be finished paying off your debt and you can continue to use your card, which can increase your total balance and the amount of interest you’ll pay.
You don't have to put any collateral at risk - With some types of loans, like home equity loans or vehicle title loans, you have to use your home or vehicle to guarantee that you’ll pay the loan back. If you don’t pay it back, the lender can sell your collateral to pay off the loan. If you opt for an unsecured debt consolidation loan, you don’t have to use your home or vehicle as collateral.
The cons of debt consolidation loans
There are some cons you should also take into account before choosing debt consolidation, including:
Higher interest rates, fees or closing costs - Be sure to compare the fixed interest rate on a debt consolidation loan to the rate on your existing debt to ensure that it is lower. Lenders may charge origination fees, which are essentially upfront fees charged to cover the cost of processing your loan, or also charge application, prepayment, late and other fees. Before you sign on the dotted line, ask the lender to tell you if there are any fees associated with the loan and the total amount you’ll pay in fees.
Payments can be higher - Because you have a set amount of time to pay off your loan, your monthly payment may be higher than when you were paying the minimum possible amount on your debts before consolidation. Make sure the payment on your loan won’t strain your budget before deciding to consolidate.
A loan may not solve your underlying financial issues - If you consolidate your existing debts, but continue to overuse your credit cards, the loan won’t put an end to your problem. You also need to make a budget and change any spending behaviors that contribute to your debt.
By considering the pros and cons of debt consolidation, you can decide if it’s the right strategy to help you get on track to a stronger financial future.
This article was first published on May 13, 2016. Matt Diehl contributed to this article.