What is Debt Consolidation?

Imagine staring down multiple student loans, a few credit cards, and a car loan. Each loan has a different lender, interest rate, and balance. Managing several sources of debt can become overwhelming. You may be thinking, “How do I make it easier to track my loans and manage monthly payments?” Debt consolidation is one way to simplify your situation, making it easier to tackle your debt.

However, it doesn’t make sense for everyone. To help you navigate this decision, our debt consolidation series covers debt consolidation basics, when debt consolidation makes sense, and three common ways to consolidate.

What is debt consolidation?

Debt consolidation involves rolling multiple debts into one new loan with one monthly payment. Typically, debt consolidation loans can be used for unsecured debt, that’s debt that is not linked to an asset like a car or a home. Common types of debt people consolidate include credit cards, medical bills, personal loans, student loans, or payday loans.

Consolidating debt can be one approach to simplify your debt payments. However, it’s important to recognize that consolidation doesn’t erase your debt, it simply restructures it. This could be helpful or this could be costly.

What are the pros and cons of debt consolidation?

Lenders often market debt consolidation as a silver bullet to solve all of your financial problems. Of course they do! If you transfer your loans, then you’re paying them interest and not your previous lender. In truth, there are several pros and cons to consider before bundling your loans.

Advantages:

• Lower interest rates: If you have multiple loans at different interest rates, you may be able to lock in one loan with a lower interest rate, especially with interest rates around historic lows.
• Lower monthly payment: By lowering your interest rate, or extending the term of the loan (for instance, rolling a student loan with 7 years left into a 10 year loan), you could reduce monthly payments.
• Simplify your finances: Going from 4 or 5 loans to one can simplify your financial situation, and give you one loan to attack over time.

Disadvantages:

• Paying more total interest: If you extend your payment timeline, you may pay more total interest over the life of the debt.
• Putting assets at risk: If you use secured debt to pay off your unsecured debt (like using a home equity line of credit, or a 401(k) loan to pay off debt), then you’re putting those assets at risk if you can’t pay back the loan.
• Avoiding the real problem: If you consolidate loans but don’t stop overspending, you may end up just repackaging your problem without actually fixing it.

Advantage or Disadvantage?

Your credit score: Debt consolidation may help your credit score by decreasing your credit utilization ratio, but it can also hurt it by adding hard credit inquiries, and reducing your credit mix and lines of credit outstanding. As a rule of thumb, increasing your credit score shouldn’t be a factor in debt consolidation.

What to do before consolidating

So how do you weigh these advantages and disadvantages and make a decision? Start with a plan. Debt consolidation is one way to address debt you have incurred, but it’s not a universal need. What everyone does need is a debt reduction plan that helps them to visualize every loan, summarize monthly payments, and commit to paying more than the monthly minimums.

So if you’ve got a bunch of loans, start by linking them all to BrightPlan and creating a debt reduction goal. That may be all the organization you need. If you find you have a lot of high-interest debt or desire to simplify your loans, then give debt consolidation a close look. With a plan in place, you can decide if you want to consolidate or not.