Debt is a common problem that plagues many people. It can be overwhelming and stressful to keep up with multiple payments, especially when interest rates are high. Debt consolidation is a strategy that can help you simplify your finances and potentially save money on interest. In this guide, we will cover everything you need to know about debt consolidation, including how it works, the two primary ways to consolidate debt, when consolidation is a smart move, when it isn’t worth it, and more.
What is Debt Consolidation?
Debt consolidation is the process of combining multiple debts into one single payment. This is usually done to simplify your finances and potentially save money on interest. Essentially, you take out a new loan or credit card with a lower interest rate than your current debts, and use it to pay off your outstanding balances. This leaves you with just one payment to make each month, which can make it easier to manage your debt.
How Does Debt Consolidation Work?
There are two primary ways to consolidate your debt: using a balance transfer credit card or taking out a debt consolidation loan.
Balance Transfer Credit Card
A balance transfer credit card is a credit card that offers a 0% interest rate for a promotional period, usually between 6 and 24 months. You can transfer your existing credit card balances to this new card, and pay off your debt interest-free during the promotional period. This can save you a significant amount of money on interest, and simplify your finances by consolidating all of your credit card balances into one payment.
To qualify for a balance transfer credit card, you typically need good or excellent credit (690 or higher). You will also need to pay a balance transfer fee, which is usually around 3-5% of the total amount transferred.
Debt Consolidation Loan
A debt consolidation loan is a personal loan that you take out to pay off your existing debts. You then make payments on the loan over a set term, usually between 2 and 5 years. The interest rate on a debt consolidation loan is typically lower than the interest rates on credit cards, which can save you money in the long run.
You can qualify for a debt consolidation loan even if you have bad or fair credit (689 or below), but borrowers with higher scores will likely qualify for the lowest interest rates.
When is Debt Consolidation a Smart Move?
Debt consolidation can be a smart move in certain situations. Here are some factors to consider when deciding if debt consolidation is right for you:
Your Monthly Debt Payments Don’t Exceed 50% of Your Monthly Gross Income
If your debt payments, including your rent or mortgage, exceed 50% of your monthly gross income, debt consolidation may not be the best option for you. In this case, you may want to consider seeking debt relief instead.
Your Credit is Good Enough to Qualify for a Low-Interest Loan or Credit Card
To qualify for a debt consolidation loan or balance transfer credit card with a low interest rate, you typically need good or excellent credit. If your credit is poor, you may not qualify for the best rates, and debt consolidation may not be worth it.
Your Cash Flow Consistently Covers Payments Toward Your Debt
If you struggle to make your current debt payments, debt consolidation may not be the best solution for you. You need to have enough cash flow to consistently make payments on your new loan or credit card, or you risk falling further into debt.
You Can Pay Off Your Consolidation Loan Within 5 Years
If you take out a debt consolidation loan, you should aim to pay it off within 5 years. This will help you avoid paying more in interest over time, and ensure that you can become debt-free as soon as possible.
When Isn’t Debt Consolidation Worth It?
While debt consolidation can be a helpful strategy for some people, it isn’t always the best option. Here are some situations where debt consolidation may not be worth it:
You Have Excessive Spending Habits
Debt consolidation won’t solve the root cause of your debt if you have excessive spending habits. If you don’t address these habits, you may find yourself in debt again in the future.
You’re Overwhelmed By Debt
If your debt load is too high and you have no hope of paying it off, even with reduced payments, debt consolidation may not be enough. In this case, you may want to consider seeking debt relief or bankruptcy.
You Can Pay Off Your Debt Within 6 Months to a Year
If you have a small amount of debt that you can pay off within 6 months to a year, debt consolidation may not be worth it. You may not save enough money on interest to justify the fees and hassle of consolidating your debt.
Your Total Debt is More Than Half Your Income
If the total of your debts is more than half your income, debt consolidation may not be your best option. In this case, you may want to consider seeking debt relief instead.
Debt consolidation can be a helpful strategy for simplifying your finances and potentially saving money on interest. By combining your debts into one payment, you can make it easier to manage your finances and pay off your debt faster. However, debt consolidation isn’t always the best option, and it’s important to consider your individual financial situation before deciding to consolidate your debt. If you’re unsure whether debt consolidation is right for you, consider speaking with a financial advisor or credit counselor for guidance.