Do I Need Debt Consolidation?

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Written by Jonathan Petts, Esq.  
Updated May 31, 2019

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Debt consolidation is the process where you take out one loan to pay off multiple other loans which have a higher interest rate. Consolidation is a tool to optimize your finances, not to fundamentally restructure them. It does not erase debt, just reduces your interest payments going forward. But if you have a manageable amount of debt and good credit, consolidation is worth considering.

Our friends at the nonprofit GreenPath, who provide an excellent service, can help you navigate all of your debt consolidation options. GreenPath does not offer loans.

In this Article

  • How does Debt Consolidation Work?

  • Methods of Consolidation

  • When does consolidation make sense?

  • When is consolidation a bad idea?

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How does Debt Consolidation work?

Debt consolidation rolls multiple high interest debts into a single monthly payment, ideally at a lower interest rate. Debt consolidation works if you’re dealing with a manageable amount of debt and want to reorganize multiple bills with different interest rates and due dates into a single bill at a lower interest rate.

For example, let’s say you have $10,000 balance spread over five credit cards. Each of the cards has an interest rate ranging from 19% to 25%. You make your minimum payments on time and have a 700 credit score. Because you have good credit, you could qualify for a $10,000 unsecured loan at a 7% interest rate from your local credit union.

So you take the $10,000 from the credit union and use it to pay back the credit cards. Now you make one monthly debt payment at 7% interest to the credit union, rather than five monthly payments between 19% to 25% interest to the credit card companies.

In doing so, you save between 12%-18% interest each month. And you get the convenience of only having to pay one large bill each month rather than 5 smaller ones.

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Methods of Consolidation

There are a number of ways to consolidate your credit card debt into one monthly bill. Here are the four most popular.

0% Interest, Balance Transfer Credit Card

You take out a credit card that charges 0% interest for an introductory period, usually 12 to 18 months. And you transfer all of your other credit card balances onto this credit card. Then, you pay the new balance in full by the end of the introductory period.

You will need a very good credit score - above 690 - to qualify for most balance transfer credit cards. Most cards charge a balance transfer fee of roughly 3%, and many also charge an annual fee. So you need to calculate whether the interest you save will be significantly more than the cost of fees. And you need to make sure you are able repay the debt by the end of the introductory period, because any remaining balance after that time must be paid at the regular higher interest rate. There are many balance transfer credit cards, so make sure to choose the best one for you.

Personal Loans

Another approach is getting an unsecured bank loan at a lower interest rate than the credit cards that you are trying to consolidate. Then you can use the money from the bank loan to pay off your credit card debt immediately. Then you pay back the loan at a lower interest rate over a set time frame.

We recommend first checking a local credit union like this one for the loan. Credit unions will generally offer lower rates and more flexible terms than online lenders, particularly if you have a poor credit score. Credit unions can never charge more than 18% by law.

Online lenders like LendingClub or LendingTree may have low rates for those with excellent credit, but their rates go up to 36% for those with poor credit. Online lenders also may charge upfront fees for originating the loan, ranging from 1 to 3%.

The advantages of online lenders are they offer the loan without a “hard inquiry” on your credit report, so it won’t affect your credit score the way a consolidation loan from a credit union probably will.

Home equity loan Another method for debt consolidation exists for homeowners. You can take out a home equity loan with a fixed interest rate and use that money to pay off your credit cards or other debts. You then repay the loan over a fixed time period. Since this type of loan is secured by your house, however, it is risky it you fail to repay it, you could lose your home.

401(k) loan A fourth a final option is taking a loan against your 401K retirement account to pay down your debt. The option only relates to a 401k account held with your current employer. Since the loan is secured by your retirement account it will usually have a low interest rate and will not affect your credit score.

That said, consolidating using a 401K loan for consolidation is usually a poor decision. If you lose or leave your job, the loan will be due in 60 days. And if you fail to repay the loan you will owe a big penalty plus taxes on the unpaid balance. So you may lose all your retirement savings. By contrast, 401ks are protected in the bankruptcy process while debt is erased.

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When does debt consolidation make sense?

Debt consolidation only makes sense if the following is true:

  • You have at least $5,000 in total debt

  • Your total debt is under 50% of your annual income

  • You have good-to-excellent credit to qualify for a balance transfer credit card or a low-interest personal loan

  • You make enough money each month to make debt payments

  • You know you you can prevent running up debt in the future

And make sure you know who your creditors are! If you don’t remember, don’t worry. Try checking out your credit report for that information.

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When is debt consolidation a bad idea?

Debt consolidation is not always a good idea. It won’t fix your financial problems if:

You have poor credit. If you have poor credit, you likely will not qualify for a debt consolidation loan. Moreover, debt consolidation will usually have a negative impact on your credit score. That’s because old credit accounts usually have a positive impact on your credit and consolidation turns all old accounts into a single new one.

If your credit score is not where you want it to be, know that it’s not permanent. Consider looking into other ways to repair your credit.

You have an excessive spending habit. Consolidation is not a magic pill for all your financial worries. If you have poor spending habits and aren’t sticking to a reasonable budget, you will likely fail to repay your consolidation loan or line of credit. And consolidation will only further weaken your finances. Consolidation only makes sense if you have a plan to avoid getting into debt in the future.

You are buried in debt. If your total debt is over half your annual income, then consolidation likely won’t be effective. You may need to explore more vigorous debt relief options like the fresh start of Chapter 7 bankruptcy.

You have under $5,000 in debt. If you have a very small amount of debt that can be paid off in under a year at your current pace, consolidation will not be effective. In this case, you only save a small amount on interest and would still have to pay fees associated with consolidation, so it would not be worth it.

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If you owe a manageable amount of debt and have good credit, debt consolidation is an important tool worth considering. Debt consolidation does not erase debt, but it can be helpful in reducing your interest rate on debt you owe. We suggest using the nonprofit Greenpath for debt consolidation to help you think through the options if that is the direction you choose. They’ve prepared this resource on how to get started: Looking To Get Out of Debt in 2019? Here’s How to Start.

If debt consolidation does not sound like the right choice for you, maybe it’s time to consider bankruptcy. Even after bankruptcy, there are ways to take advantage of your fresh start and to rebuild your credit.

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