Questions to Ask When Considering Debt Consolidation

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Juggling multiple debts and monthly bills can feel overwhelming. The truth is that having a lot of debt is stressful. The good news is that you have some options, and debt consolidation may be one that can help.

With debt consolidation, you pay off your unsecured debt — personal loans, credit cards and store cards — with a single debt consolidation loan or balance transfer credit card — usually with a lower interest rate. You then make just one payment each month on the consolidation loan or credit card.

Here, we'll cover some questions to ask when considering debt consolidation. These should help you better understand your options and how to handle your financial situation moving forward.

1. Do I need debt consolidation — or something else?

There are three main options when it comes to managing unsecured debt: debt consolidation, debt management and debt settlement. They all can help with your debt, but there are some very big differences.

Debt consolidation

As we mentioned before, debt consolidation involves paying off all your unsecured debts with one loan or credit card. A debt consolidation loan may be secured by collateral or unsecured. The main reason to go through personal debt consolidation is to simplify your bill paying and get a lower interest rate.

When you pay off your creditors through debt consolidation, they report a zero balance to the credit reporting agencies. You may see your credit score rise as a result of your improved overall credit utilization ratio. Your new debt consolidation loan will also show up on your credit report, so making each payment in full and on time will help boost your score even more.

One downside is that if you don’t have a good credit score, you may find it difficult to qualify for a consolidation loan. And if you do qualify and get a loan, you need to be sure you address the root cause of your debt. Many consumers continue to use their credit cards even after consolidating their debt, which not only defeats the purpose but may dig you into debt even further.

Debt management

A debt management plan (DMP) is offered through a nonprofit credit counseling agency. It is sometimes considered a form of debt consolidation because you’ll end up making one payment each month to the credit counseling agency. The agency will, in turn, distribute the agreed-upon amounts to your creditors.

A DMP typically requires you to include all your eligible unsecured debt. Your credit counselor gets to know your financial situation, then works with your creditors to lower your interest rates and come up with a repayment plan that fits into your budget. Expect to close your accounts when entering into a debt management plan, which will lower your credit utilization ratio and may therefore hurt your credit score for a while. But paying your bills on time over a long period will help your credit score, especially if you had been missing payments before.

If you decide to pursue this option, look for a nonprofit debt management company with credit counselors certified by the National Foundation for Credit Counseling or the Financial Counseling Association of America.

Debt settlement

Debt settlement is different from debt consolidation and debt management in that the goal is for you to pay less than what you owe on your debts.

Debt settlement companies will tell you to stop making payments on your unsecured debts, usually for six months or more. At that point, the debt settlement company will offer to "settle" the debt by negotiating with debt collectors on your behalf.

Your credit score will take a huge hit throughout this process, and creditors will call you and send you letters. Your lower credit score will hurt your ability to get loans and credit cards with good terms.

Another disadvantage of debt settlement is that there is no guarantee that the negotiations will be successful. If they are and the amount your creditors write off is $600 or more, you’ll pay taxes on the amount as if it were ordinary income. Still, if you simply cannot pay what you owe on your debts, this may be a better option than bankruptcy.

2. When does debt consolidation make sense?

If you have unsecured debt that makes it difficult for you to pay your rent or mortgage and keep up with your utilities, it may be wise to consolidate your debts to help you get organized and reduce your interest rates.

Also know that you will need a good credit score to get the best terms on a loan or balance transfer card. If you have fair or poor credit, it may not make sense to consolidate with a loan or credit card. You may instead need to consider working with a credit counselor to come up with a debt management plan.

Of course, if you can address your debt by cutting expenses and sticking to a budget, you should do so. It's also important to consider the reason you have such a high level of debt. If your spending and budgeting habits need some work, debt consolidation may offer a temporary fix, but it won't address the real problem.

3. Which debt consolidation product is best for me?

If you want to consolidate your debts, you can do so with a personal loan, balance transfer credit card or even a home equity loan. Here are some things to consider with each.

Balance transfer credit card

These days, many balance transfer credit cards offer 0% APR for up to 21 months. You will often have to pay a fee — usually around 3% — to transfer your balances from other credit cards. If you can pay off your debts within the 0% introductory period, this may be your best option.

Note, however, that if you pay your balance transfer credit card bill late, you may trigger the new interest rate, which could be higher than the interest rates on your old cards. Also, new purchases may have a different interest rate than the transferred balance.

Personal loan

A personal loan will have a higher interest rate than 0%, but rates are often lower than regular credit card APRs. Also, most personal loans have a fixed interest rate. That means you’ll have set monthly payments, which may make it easier to budget every month. On the other hand, it could mean that your monthly payments will go up for a while.

Typically, a personal loan needs to be paid off in one to seven years. Note that a personal loan may come with an origination fee, so you’ll need to figure that into your calculations when deciding whether a personal loan makes sense for your debt consolidation.

Home equity loan

A home equity loan uses the equity in your home as collateral. While this usually means you’ll get a lower interest rate on a home equity loan than on a personal loan, you are trading your unsecured debt for secured debt. This can be very risky because if you default, your home could be foreclosed. For this reason, experts often recommend against using a home equity loan for debt consolidation.

4. How much money can I save by consolidating my debt?

When considering any of these methods of consolidating your debt, calculate how much you’ll pay in interest on the new loan or credit card, and how much you’ll pay if you don’t consolidate. Be sure to take into account any balance transfer or origination fees, as well as any other fees such as late fees.

While there is inherent value in the convenience of replacing multiple monthly payments with one payment, you’ll usually only want to consolidate if you can save money. At the very least, you don’t want to be paying any more on your debt.

The bottom line

Debt consolidation isn't a quick fix. You’ll need to address the root cause of your debt, so you don’t rack up debt again on your old credit cards, which will just leave you worse off than when you started. But if you are diligent about paying down your new loan or credit card balance, debt consolidation could be a solution that saves you time and money.

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