For those currently paying off several debts at once, debt consolidation is an option that can make repaying your loans easier. Debt consolidation loans can allow you to simplify your debt repayments and even save money on interest rates.
After consolidating your debts, repayments are usually lower than what you’re currently paying because you’re only paying interest on one loan instead of several.
What’s a debt consolidation loan?
A debt consolidation loan means you take out a loan to repay all your other debts. This allows you to merge all your debts into one loan to either lower your monthly repayments and/or secure a lower interest rate.
Usually a debt consolidation loan involves applying for a new loan with a new lender. After approval, the lender will then either pay your creditors on your behalf or cut you a check that you will use to pay off your debts yourself. After your payments are processed with your previous creditors, you begin making one monthly payment to your new lender.
[ Read: What Is Debt Consolidation and What Are Your Options? ]
How debt consolidation affects your credit
“Does debt consolidation hurt my credit score?” This is one of the first questions people ask — debt consolidation can potentially help or harm your credit score, but this depends on how you approach it.
One way debt consolidation can improve your score is by removing the need to pay interest on several loans at once. Eliminating some of your interest payments makes the debt easier to pay off, meaning you can start to build a better payment history. This may take a while to show up on your credit score, but it will start to rise while you make regular payments.
Another benefit of clearing your debt faster is that it lowers your credit utilization ratio on your credit cards. This is the proportion of available credit you have taken out as debt. Generally, a credit utilization rate of no more than 30% of your total available credit is recommended.
On the other hand, debt consolidation can harm your credit score. A new loan application will provoke a hard inquiry on your credit that will temporarily lower your score. Remember, new credit is new risk.
[ Next: The Simple Guide on Building Credit ]
If you are using a credit counseling organization to help you manage debt,you may be asked to close other credit accounts as part of a repayment plan. This is so you stop spending on those accounts to keep your debt manageable. The downside to this is that with less available credit, your credit utilization increases, which reflects poorly on your credit score.
While a debt consolidation loan can affect your credit score, it’s important to know what your options are when your score is already low. For those with a low credit score, you might find it difficult to open up a new loan. However, it’s not impossible to find a loan. It just might take some research into lenders who approve those with bad credit.
Should you consolidate your debt?
If you can consolidate your debt into a low-interest loan with more manageable monthly repayments, then it’s definitely worth looking into. If some of your debts have over 20% interest rates, then debt consolidation is almost always worth it to save money. The best debt consolidation loans have reasonable interest rates to help you save money and clear your debt faster.
Overall, if you know consolidating your debts will help you clear your balances faster, then this is one of the best options for you. But, if you can’t keep up with repayments or you’re likely to start piling debt back on your credit cards once they’re cleared, then this may cancel out any of the benefits.
[ Read: 11 Ways to Get Out of Debt Faster ]
Pros and cons of debt consolidation
Pros
- Simplify your finances. Consolidating debt means you no longer have to manage several different debts, accounts or payments.
- Improve your credit. If the loan is more manageable with lower interest rates, you can pay off your debts faster, which improves your score.
- Save on interest rates. Rather than paying high interest rates on several credit cards and personal loans, you only have to worry about one, which can save a lot of money.
Cons
- Prepayment penalties. The downside to clearing old debts faster is that many loans have a prepayment penalty. Check the terms and conditions on your loans to see whether your potential savings can outweigh these costs.
- Credit score damage. Taking on a new loan can harm your credit score, but this is usually temporary. It will improve unless you start making late payments.
- It’s tempting. If you finally pay off a huge credit card balance, it’s tempting to start using that available credit again, but this can lead to more unmanageable debt.
Ways to consolidate your debt
Student loan debt
There are a few different ways to consolidate your student loan debt, depending on what type of student loans you took out. The main ones are federal consolidation and private consolidation. Both debt consolidation options work by combining any existing debt you have from various student loans into one single loan payment.
Federal consolidation only applies to federal loans. You won’t need to meet credit score requirements, but you might not get a lower interest rate. However, it will be a fixed interest rate. Private consolidation (also known as refinancing) can help you reduce the cost of your loans by giving you a better interest rate.
Business debt
It’s common for businesses to have several loans and business credit cards to pay off. Consolidating all your business debts is a way to simplify repayments, cut down on the admin and also save the business some money.
If this helps you pay off your debt faster, this can benefit your business credit score too. The only risk to your credit score is if you close old accounts (increasing your credit utilization rate) or struggle to repay on time.
Credit card debt
When it comes to credit card debt, there are two main options — balance transfers and consolidation loans. Balance transfers mean you open up a new credit card with better interest rates and transfer your balance from your old credit card to the new one. Opening up a new credit card or loan can cause a small blip in your credit score, but if it helps you make payments on time and clear the debt faster, this can improve your score overall.
[ Read: 6 Tactics for Handling Piles of Credit Card Debt ]
Too long, didn’t read?
Consolidating your debts into one simple-to-manage monthly repayment has multiple benefits. It can help you clear your debt faster and simplify your debts. This can have a good effect on your credit score.
However, there are some downsides that you should be aware of. The first thing to know is that applying for a new loan can temporarily damage your credit score. However, this should recover, providing you use the new loan well and make payments on time.
Editorial Note: Compensation does not influence our recommendations. However, we may earn a commission on sales from the companies featured in this post. To view our disclosures, click here. Opinions expressed here are the author’s alone, and have not been reviewed, approved or otherwise endorsed by our advertisers. Reasonable efforts are made to present accurate info, however all information is presented without warranty. Consult our advertiser’s page for terms & conditions.
