Debt consolidation is a process that allows qualified consumers to take out a new loan that pays off most or all of their outstanding debt. By aggregating all of the individual debts and paying them off, the new debt consolidation loan might become the only unsecured debt to which a consumer makes payments.
Debt consolidation loans usually come with interest rates considerably lower than the debts the borrower has and is trying to pay off, such as car loans, personal loans and high-interest rate credit cards.
By rolling debts into one debt consolidation loan, consumers can potentially save thousands of dollars over the life of the loan, simplify their financial lives and lessen constraints on their budgets with fewer monthly payments.
The basics of debt consolidation
When you get a debt consolidation loan, it pays off all or most of your outstanding debts, reducing the number of lenders to which you owe money from several to just one. This helps you get a handle on your finances because the new loan amount, while sizable, may come with a lower interest rate than you were paying on some or all of their outstanding balances, thus making the monthly outlay more affordable. It also has the added benefit of simplifying payments.
For example, let’s say you owe $10,000 total to five lenders, three of which are credit cards. By consolidating that loan into one balance, you will still owe the $10,000, plus any fees associated with the new loan. However, because debt consolidation loans generally have lower interest rates than credit cards, you will be paying less over time on the new loan. Also, budgeting for the new payment is now simpler, as there is only one payment to send off each month.
A look at the drawbacks
There are some negatives when it comes to debt consolidation loans. For one thing, it may be difficult to qualify. Also, depending how much debt you have already, you may not get the lowest interest rates available. You also have to be aware that some interest rates on debt consolidation loans may be “teaser rates” that only last for a certain period of time before increasing.
However, the biggest challenge associated with debt consolidation loans is not amassing more debt. With a new, convenient “one-payment” loan, you easily can fall into the trap of continuing the spending habits that got you into your present situation in the first place. Unless you exercise great discipline and adjust you spending habits, you might find yourself in even deeper debt than before you took out the debt consolidation loan. One way to avoid this is to cancel all the credit cards and lines of credit you had open as soon as paying off their outstanding balances with the debt consolidation loan, eliminating temptation.
How to approach it
You need to look at your debt as a sum total, and not just in terms of monthly payments. If you look at a debt consolidation loan as an “easy way out,” then in all likelihood it will not help you reach your goal. The Consumer Financial Protection Bureau advises:
- Taking on more debt to pay off debt might just be putting off your problems into the future. You can’t pay off debt by taking on more debt.
- The loan you take out to consolidate your debt may end up costing you more in costs, fees and rising interest rates than if you had just continued to pay on your existing debts.
- If your credit score is less than stellar because of your debt load, you probably won’t be able to get the lowest interest rates, so you will want to determine whether consolidation is worth it.
- A nonprofit credit counselor can help you figure out your options.
Theory vs. practice
In theory, if you have good enough credit to qualify for a debt consolidation loan that covers all or most of the higher interest debt you carry, you can probably save money in interest and lower the stress on your budget and your life. Just remember that in practice, it takes financial discipline on your part for a debt consolidation loan to have its desired effect and make you debt-free. If and when you are ready, check out SuperMoney’s guide to debt consolidation loans.