Summary:
When you consolidate debt, you’re combining multiple debts into a single loan. This is commonly done by using a personal loan or a balance transfer credit card to pay off multiple high interest credit card balances. Debt consolidation can simplify payments and ideally reduce the amount of interest you pay.
In this article:
What is debt consolidation?
What is a debt consolidation loan?
Balance transfer credit cards
How does debt consolidation work?
Does debt consolidation hurt your credit?
If you’re struggling with credit card debt, you’re not alone. A Q2 2024 TransUnion report showed that consumer credit card balances are over $1 trillion, with an average credit card debt per borrower of $6,329. High interest debt can feel like a weight that is dragging you down. Debt consolidation may be one way to help lift the burden and is a common strategy for people who have multiple lines of high interest debt. Here is what consolidation is and things to consider as you try to manage your debt:
What is debt consolidation?
Essentially, debt consolidation is when you combine multiple loans or lines of credit into a single loan. A personal loan or a balance transfer credit card are two common ways to do this. Ideally, the new debt will have a lower interest rate than the original debt. Consolidating into a single loan or card can help save money in interest and make managing payments easier, since you’re no longer juggling multiple loans or credit card payments.
What is a debt consolidation loan?
A debt consolidation loan is basically a personal loan with the primary purpose of paying back other debt you have. Many banks, credit unions and online lenders offer personal loans, so it’s a good idea to shop around to find a loan that works best for you. Personal loans are installment loans and tend to offer a lower interest rate than credit cards. Installment loans have regular, fixed payments that include your principal balance and interest charge.
Depending on your circumstances, you may qualify for personal loans with a range of terms (months to pay it back), interest rates and borrowing amounts. Generally, the longer you take to pay back the loan, the more you’ll pay in interest. So carefully sitting down and analyzing your budget and how much you’ll be able to dedicate each month to this new loan is an important step.
Balance transfer credit cards
Credit card balance transfers are also used to consolidate credit card debt. Typically, balance transfer credit cards offer a promotional 0% interest grace period. If you’re approved for the card and able to pay off the debt before the grace period ends, it could save you money on interest payments.
However, if a balance remains when the grace period ends, the outstanding balance may be subject to a higher, standard interest rate. Also, credit card balance transfers typically have a transfer fee, usually between 3% - 5%. A balance transfer card may work for you, but you have to know how long the grace period is, the transfer fees and whether you’ll be able to pay down the combined balances quickly enough to know if it’s the most productive choice.
Other types of credit can be used as a solution to debt consolidation like home equity lines of credit and 401(k) loans. Which type of loan you use depends on your personal circumstances. Consider seeking help with a non-profit credit counselor if you want additional guidance.
How does debt consolidation work?
When you take out a loan to consolidate your debt, the bank or credit union will give you the funds you were approved for and accepted during the application process. You’ll then use those funds for the intended purpose; in this case, to pay off your higher interest debts. You will make your payments directly to the new loan provider.
If you’re using a balance transfer credit card, you won’t receive money directly. Rather, you can transfer the balances of other credit card accounts to the new account. This can usually be done online. As an alternative to transferring online, the credit card issuer will also provide special paper checks you can use to transfer the balances as well.
Does debt consolidation hurt your credit?
When applying for a new loan or credit card, it may result in a hard inquiry, which can have a negative impact on your credit score. New credit is one of the least influential of the credit score factors, but you should still be aware of the potential impact when you apply for credit.
If you move credit card balances into an installment loan, it can lower your credit utilization rate. Generally, the lower your credit utilization rate, the better it is for your score. Credit utilization is one of the more influential factors in credit score calculations.
Your credit utilization rate may also improve if you use a balance transfer credit card. Though, instead of improving your credit utilization rate by consolidating it into an installment loan, you’re opening a new line of credit, which adds to your combined credit lines. This may not substantially improve your credit utilization rate, but it can make it better (lower) if you pay down your balances and keep from making new purchases.
And this is one of the most important factors in determining whether consolidating your debt will be successful. Make sure you’ve addressed the underlying cause of the debt you have. For some people, it may be just circumstantial, like an unexpected emergency or medical bill. But if undisciplined spending caused balances to grow, do your best to manage your spending and budget so you’re not relying on high interest credit for purchases. If you continue to spend on credit cards, a balance transfer may only be shifting debt around, not making it better.
Paying off your debt is a great financial goal. Before you apply, make sure you understand how a potential debt consolidation loan works and will impact your credit and finances as a whole, so you can make the best decision for you.
