Key takeaways
- The benefits of debt consolidation include saving money on interest, paying off debt more quickly and streamlining finances.
- There are many options to consolidate debt, including balance transfer credit cards, home equity loans, debt consolidation loans and peer-to-peer loans.
- To choose the best debt consolidation strategy for your situation, assess your credit score and the types of debts you have, along with their balances and interest rates.
Debt consolidation involves rolling multiple credit accounts into a single loan or line of credit. This strategy can help you save money in interest and pay off your debts faster while simplifying your finances. That said, there are several ways to go about it, each with pros and cons that should be weighed before making a choice.
Reasons to consolidate your debt
Consolidation comes with multiple benefits that are worth considering if you’re struggling with debt, including the following.
Streamlined payments
It can be difficult to keep track of payment due dates when you owe several creditors. But when you consolidate outstanding debt balances into a loan or credit card product, you’ll only make one monthly payment to a single creditor. This minimizes the chances of making late payments that result in excessive fees or damage to your credit score.
Lower interest rates
Consumers with good or excellent credit scores generally qualify for competitive interest rates on debt consolidation loans. The average credit card currently has an interest rate of nearly 21 percent, compared to 11.93 percent, which is the average rate for personal loans. That said, if you have excellent credit, you may be able to secure a personal loan with a rate as low as 6.5 percent, depending on the lender. This lower rate could help you save hundreds — if not thousands — of dollars and make your payments more manageable.
Fixed repayment schedule
A debt consolidation loan gives you a set payment schedule and predictable monthly payments. Plus, it’s far easier to work the payments into your budget since there won’t be any guesswork regarding how much the minimum payments will be each month.
Credit boost
When you apply for a debt consolidation product, your credit score may drop a few points due to the hard credit inquiry. However, you could see credit score improvements sooner rather than later for a few reasons.
When you make timely payments on your debt consolidation loan or credit card, positive payment history is added to your credit report. Payment history accounts for 35 percent of your credit score, so you’ll likely see an increase over time.
Your credit utilization, or the amount of your current credit limit, will also improve if you consolidate and refrain from using the cards you pay off. It’s a component of amounts owed and makes up 30 percent of your credit score, and keeping this figure at or below 30 percent gives you the best chance at a solid credit score.
To illustrate how it works, assume you have five credit cards with $1,000 limits. You owe $500 on each, bringing your utilization to 50 percent. If you take out a $2,500 loan and pay off the balances, your utilization will drop to zero. But if you use a balance transfer credit with a credit limit of $5,000, your utilization will decrease to 25 percent.
Faster debt payment
If you’ve been stuck making the minimum payments on your credit card each month, repaying what you owe could take several years. To illustrate, assume your credit card balance is $5,000, and the Annual Percentage Rate (APR) is 18.9 percent. Paying only $200 monthly will cost you $3,109.16 in interest, and you’ll spend 137 months repaying what’s owed.
However, a debt consolidation loan helps fast-track your debt payoff efforts by giving you a fixed interest rate, loan term and monthly payment. Using the example above, if you take out a $5,000 debt consolidation loan with a three-year term and an 11 percent fixed interest rate, you’ll pay $164 per month and $892.97 in interest over the life of the loan.
Debt consolidation options
There are several ways to consolidate debt, including the following.
1. Balance transfer credit card
The best balance transfer cards often come with zero interest or a very low interest rate for an introductory period of up to 18 months. These allow you to move the balances from high-interest rate credit cards and other debts to the new card. The idea is to pay the entire balance before the promotional APR period ends. Otherwise, you risk racking up even more interest than you started with.
You’ll need a balance transfer card with a credit limit that is high enough to accommodate the balances you’re rolling over and an annual percentage rate (APR) low enough to make it worthwhile. Use a credit card balance transfer calculator to see how long it will take you to pay off your balances.
Pros
- Quicker and easier to get than many other loans.
- Potential to save money if the debt is paid during the intro period.
- No collateral is required, so there is no risk of losing assets.
Cons
- Does not address poor spending habits.
- A typical fee of 3 percent to 5 percent of the amount transferred on top of the balance.
- APR after the intro period is likely higher than other loans.
- Hard pull on your credit report.
Using a balance transfer credit card is best for those who can avoid using their existing credit cards once the balances have been shifted to the new card. If you choose to use a balance transfer credit card, have a plan to pay off the debt before the credit card’s introductory rate expires.
2. Home equity loan or home equity line of credit (HELOC)
Your home equity is the difference between the appraised value of your home and how much you owe on your mortgage. If you’re a homeowner with enough equity and a good credit history, you can borrow some of that equity at an affordable rate to consolidate your debts.
Your options for borrowing from home equity include home equity loans, which give you a lump sum of money at a fixed rate, and HELOCs, which give you a credit line to draw from at a variable rate. Both act as second mortgages, which means you’ll add an additional monthly payment to your plate. Still, they can be good options for debt consolidation if you have enough equity to qualify.
Pros
- Fixed rate and fixed monthly interest for home equity loans.
- Larger loan amounts.
- Long repayment terms.
- Lower interest rates than credit cards or personal loans.
- Variable rates for HELOCs.
Cons
- Home is the collateral that secures the debt.
- Interest on the loan is not tax deductible.
- Longer funding timelines on average.
- Longer repayment timeline can mean higher costs overall.
HELOCs are often best for those who have significant equity in their home and prefer a long repayment timeline. That being said, it’s important to shop around to find the most competitive rate to avoid racking up thousands in interest. Also make sure you have confidence in your repayment ability, both now and down the road.
3. Debt consolidation loan
A debt consolidation loan can be a smart way to consolidate debt if you qualify for a low interest rate, enough funds to cover your debts and a comfortable repayment term. These loans are unsecured, so your rate and borrowing limit hinge on your credit profile (or your co-signer’s, if applicable).
With how debt consolidation loans work, you’ll use all or a portion of the loan proceeds to pay off the balances for debts you want to consolidate. Like a balance transfer credit card, instead of paying each creditor monthly, you’ll now make a single monthly payment on the personal loan to streamline the debt payoff process.
Pros
- Collateral is not required.
- Funding and approval can be fast from many lenders.
- Loan amounts range from $1,000 to $100,000.
- Lower interest rates than credit cards in many cases.
Cons
- Loans can come with fees for origination, late payments and prepaying early.
- Low rates require excellent credit.
- Scams are rampant in the debt consolidation loan marketplace.
Debt consolidation loans are generally a good option for those with good to excellent credit. This is generally considered a credit score in at least the mid-600s and a history of making on-time payments. That being said, bad credit personal loans exist — but the interest rates may be too high to make consolidation worthwhile.
Bankrate’s take: Debt consolidation loanscan be used for consolidating credit card debt, medical debt and student loan debt.
4. Peer-to-peer loan
Peer-to-peer (P2P) lending platforms pair borrowers and individual investors for unsecured loans that generally range from $25,000 to $50,000. Like personal loans, P2P loans are unsecured, so your credit history is a key factor. The higher your credit score, the lower the interest rate and the more you can borrow.
In addition, eligibility requirements for P2P loans are not always as strict as other types. Some P2P lenders allow applicants to qualify with a lower credit score, so before making a decision, compare the fees and interest rates with other options.
Pros
- Application, approval and funding is generally fast.
- Initial application uses a soft credit check.
- Lower credit scores may still qualify.
Cons
- Fees may apply.
- High interest rates with bad credit.
- Less time to repay the loan than with credit cards and home equity loans.
- Potentially higher monthly payments because of shorter repayment terms.
- Rates are generally higher than those on home equity loans.
P2P loans may be a good fit if you have a lower credit score or limited credit history. But like with a debt consolidation loan, ensure that the total amount you pay is less than what you are already paying your current creditors.
5. Debt management plan
If you want debt consolidation options that don’t require taking out a loan or applying for a balance transfer credit card, a debt management plan could be right for you — especially as an alternative to bankruptcy.
With a debt management plan, you work with a nonprofit credit counseling agency or a debt relief company to negotiate with creditors and draft a payoff plan. You close all credit card accounts and make one monthly payment to the agency, which pays the creditors. You still receive all billing statements from your creditors, so it’s easy to track how fast your debt is being paid off.
Pros
- Credit score can improve over time.
- Free options from some organizations if you need it.
- Some of the best loan rates.
Cons
- Credit score will generally lower for a while.
- Many nonprofit organizations have strict requirements on how you use money while you go through the plan.
Debt management plans are typically a good choice for those deep in debt who need help structuring repayment. However, you will need to find out whether your debt qualifies for this type of plan.
How to choose a debt consolidation option
When considering debt consolidation strategies, first, assess your credit score and the types of debt you wish to consolidate along with their balances, interest rates and monthly payments. This will help you better understand the type of loan you’ll need.
For instance, if you’re trying to consolidate about $5,000 worth of credit card debt and have good or excellent credit, a balance transfer credit card could be the best option. On the other hand, if you have less-than-stellar credit and a considerable amount of debt (upwards of $10,000), then a home equity loan could be a better option, as you could potentially secure a lower rate than if you applied for a debt consolidation loan.
Regardless of the route you choose, always calculate the total cost of your current debts and compare it against the total cost of any consolidation method or alternative option. This way, you’ll avoid spending more and ensure you’re choosing the best debt consolidation option for your finances.
How to qualify for a debt consolidation loan
If you’re considering applying for a debt consolidation loan, you’ll typically need a credit score of 700 or more to qualify for the most favorable terms. Though having a lower score won’t necessarily disqualify you from approval, your loan will likely be more costly due to higher rates.
You’ll also need to show proof of income in order to qualify for a loan. Lenders want to see a reliable source of income available to repay the money you’re seeking to borrow. Steady income also reduces risk in the eyes of lenders. If you’re applying for a larger loan, you may also be asked to provide collateral to secure the loan.
