Wouldn’t it be awesome to be able to take all your many debt payments and just make one each month instead?
If ease and simplicity are your goals then, of course, it would be terrific. Oh if life were only that simple.
In general, debt consolidation may be able to:
- reduce the overall interest rate you pay on your total debt;
- make it easier to stay on top of one payment instead of a bunch of separate payments.
That is what debt consolidation is all about.
What is Debt Consolidation?
The phrase debt consolidation can mean many things.
- It can mean getting one loan to pay off your other debts, so you are just making one payment to one company.
- Some people say sending one payment to a credit counseling company is debt consolidation.
- Some debt relief sales people say you are consolidating your debt when you send one payment to a debt settlement company.
But let’s stick with the most common and purest form of debt consolidation — getting a personal loan to pay off other smaller accounts. A balance transfer offer can fall into that category as well.
Typically these smaller accounts that are paid off are credit card balances, smaller secured loans, or other nagging debts.
In thinking about consolidating your debt into one loan, it might be easier to visualize pouring a bunch of different obligations into one bigger bucket. That bigger bucket becomes your new debt consolidation solution.
Now how you get that debt consolidation loan is a more complicated matter.
Some of the ways to get a debt consolidation loan may seem easy, like borrowing from your retirement plan, but the overall cost of doing that is prohibitive. We’ll talk more about that in just a bit. For now, just keep in mind there is a lot to learn and myths and assumptions to get rid of before you leap for a loan.
Benefits of Consolidation
When debt consolidation is used wisely, it can have some significant benefits. But like many things in life, apparent benefits can have unintended consequences if you don’t pay attention to the risks.
But for right now, let’s talk about the happy benefits of debt consolidation.
- Can Reduce Bill Paying Stress – It can be easier to make one payment each month instead of multiple payments to several individual creditors.
- Can Make It Easier to Keep Track – If you only have one payment to make each month instead of several it can be easier to stay on top of the due date and payment status.
- Might Save You Money – Rolling several higher interest rate debts into a debt consolidation at a lower average interest rate can save you money over the life of the loan.
- Might Help to Improve Your Credit – If you’ve had trouble keeping up with on-time multiple payments in the past, a single consolidation payment that is easier to track will boost your credit with payments made on time.
- Can Make Access Easier to Future Loans – An excellent payment record on your new debt consolidation loan with your lender can give you a leg up and easier access if you need a second loan later on.
When is Debt Consolidation a Good Idea?
Thinking about debt consolidation can make logical sense if you want to eliminate payments on several other smaller debts. But it can also make sense if:
- You’ve survived a difficult financial time and now want to make your financial life easier and improve your payment history moving forward.
- You are paying several high-interest rate debts, and the debt consolidation interest rate would be lower.
- You’ve been stuck on some annoying payday loans that just keep rolling over and over.
- You are separating from your company and have an outstanding 401(k) loan that now needs to be repaid in full.
- You have unexpected financial demands like expensive auto repairs, or you need a new roof. A new larger loan can consolidate the immediate need and other smaller debts.
- You need to rebuild your credit history and demonstrate you are responsible with credit now that your hardship is behind you.
- If you need access to a large chunk of money to satisfy or settle another debt for less than you owe.
When Could Consolidation be a Bad Idea
The problematic thing about when debt consolidation can be a bad idea is that these are emotional issues that are hard to see with when you are living through them.
Here are some real examples I’ve seen people make over and over.
Debt consolidation may be a horrible idea if:
- Your debt is the result of an underlying issue like gambling, shopping addiction, mental health issues, divorce, co-dependency, addiction, etc.
- You will borrow from a 401(k) or some other retirement account, and that will rob you of a substantial future return. For example, if you borrow $25,000 from your 401(k), it is returning 10%, the interest rate you’ll pay is 5% over 5 years, and you expect to retire in 35 years then that loan will really cost you $65,000 in lost future retirement benefits. Keep in mind that lost $65,000 is on top of repaying the loan. Here is a calculator you can use. And it gets worse. If something happens and you can’t repay the 401(k) loan then with taxes and penalties the loss to your future retirement balance can be as much as $948,000.
- When you borrow from retirement funds, the interest rate seems deceptively low, but it is really not. For example, a retirement loan where you repay yourself 5% interest seems good. But if the stock market rises during the time you are repaying your loan, you are losing that return. A 5% interest rate and a lost 15% growth on your funds results in a 20% cost to use that money.
- Maybe the debt consolidation solution you are approved for does not consolidate all of your debt. Debt consolidation works best when it is part of an overall plan and not as a partial solution. Taking out a potentially expensive loan to only consolidate a few small debts might not make any sense at all.
- If you pay off old debt and find yourself running up new debts again, the debt consolidation may simply have enabled you to go further into total debt.
- If you pay off credit cards you’ve had for years and close them when you get your debt consolidation loan it can hurt your credit score. The length of time you’ve had a credit card account plays a role in calculating your credit score.
- If you’ve been struggling to make ends meet then other solutions to deal with the problem debt can make more sense. See how debt settlement, credit counseling, and bankruptcy might benefit you instead of debt consolidation.
- The math doesn’t make any sense. While a debt consolidation payment might be smaller every month, the length of the loan may be longer. The long repayment period can significantly increase the amount you are paying back and making the cost of the loan substantially more expensive.
- If you don’t pay attention to the rates and terms of the debt consolidation offers you can wind up paying much more if you get sucked into the offer by attractive marketing alone.
Ways You Can Accomplish Debt Consolidation
Getting a new unsecured loan from a commercial lender is not the only way to get some debts into one account. Some other options include:
- Credit card balance transfer.
- Borrowiing from friends or family.
- Home equity loan.
- Home equity line of credit.
- A debt consolidation loan from a bank.
- A loan from a peer-to-peer lender.
Which Option is GOOD for You?
Now there is a loaded question. There is no one simple way to identify if debt consolidation is a smart move unless you take extra time to honestly think through:
- How you wound up in your current financial situation.
- How you’ve dealt with the underlying issues and causes that got you stuck with expensive and problem debt.
- You have an emergency fund or savings account you can use to make your new debt consolidation payments if your income is reduced for an unforeseen reason.
- Borrowing against your home makes it more likely you might lose your home if your income is reduced.
- Are you willing to take the hit to your future retirement balance by borrowing from your 401(k) today?
- And most importantly, you’ve done the math and clearly understand the cost, risks, and consequences of consolidating your debt.