Americans can’t seem to get out of debt. The total household debt is over $14 trillion.
That leaves many people swimming upstream financially because they hold so much debt. Many had to take on more debt during the pandemic just to cover basic needs.
Now that the economy is opening up again, you can look to brighter days ahead. You can look at your options to clean up your finances and put yourself in the best position to save money.
There are several financial tools to consider, including debt consolidation. There are pros and cons of consolidating debt. You should weigh these options carefully as you look to give yourself the opportunity to improve your financial picture.
Is debt consolidation a good idea? Read this guide to learn what debt consolidation is and if it’s something that you should do.
What Is Debt Consolidation?
Debt consolidation is a financial tool that helps you manage your debts, especially if you have debt with high interest rates.
You take out a loan and use those funds to pay off your high-interest debts. After those debts are paid, you pay the loan back with one monthly payment.
There are loans that are marketed as debt consolidation loans, but they’re not your only option to consolidate debts.
Debt consolidation loans are really nothing more than personal loans. Personal loans are used for any purpose, including debt consolidation.
Pros and Cons of Consolidating Debt
The biggest advantage to debt consolidation is that you have one bill to pay each month, instead of several debt payments. That can help you manage your cash flow better.
Another check on the pro side of debt consolidation is that you can improve your credit score. This is the case if you consolidate credit cards.
That’s because you lower your credit utilization rate, which is one of the biggest factors that make up your credit score. It’s the ratio of debt that you carry and the amount of credit available.
Personal loans don’t impact your credit utilization rate. Revolving lines of credit and credit cards do.
Debt consolidation is often a better choice than other options like debt settlement and bankruptcy.
Debt settlement allows you to negotiate with creditors to accept less than you owe. There are agencies that specialize in debt settlement.
Many of these programs cost a lot. They also don’t mention that any amount of forgiven debt over $600 is reported to the IRS. You may have to report it as income and pay taxes on that forgiven debt.
Bankruptcy is the other option that many consider. You have to think carefully about this option because this stays on your credit report for 10 years. It becomes public record, too.
If you want to buy a home or obtain credit in the future, bankruptcy appears. Potential lenders are likely to disappear when they see that on your credit report.
Debt consolidation is by far the better option in the majority of situations.
Risks of Debt Consolidation
Debt consolidation does carry some risks that you need to be aware of. Debt consolidation might not pay off if you have fair to poor credit.
You’d be able to qualify for a loan with bad credit, but those loans carry high interest rates. It wouldn’t be favorable to consolidate debt.
The best credit score to get a favorable interest rate for your loan is about 700. Some lenders can still give you a great deal with a score of 690.
Is your credit lower than that? Your best bet is to tackle as much debt as you can without the loan. You could still raise your credit score and then apply for a loan.
You don’t know what the future holds. With a loan to consolidate debt, you could be paying off the debt for at least the next three to five years.
You could face financial difficulty and find yourself unable to pay the loan. This does much more damage to your credit score.
The biggest risk is your mindset. Many people get a debt consolidation loan and think that they have more freedom to move.
You might decide that it’s a great idea to buy a TV or go on vacation. Of course, the credit card pays for that.
The reality is that you didn’t eliminate your debt. You just moved it elsewhere. You still have to pay the loan back, so don’t get caught thinking you can start charging things on your credit cards again.
How to Consolidate Debt
Do you think the pros and cons of consolidating debt make it a good option? There are a few things to consider before you go through with debt consolidation.
Look at your financial goals. Ask yourself what you want debt consolidation to do for your financial picture.
You might want to increase your credit score so you can buy a home in a year. You might have a goal to become debt-free in two years.
Your goals will help you make the right choice and get the right loan to fit your needs.
Determine If Debt Consolidation Is a Good Fit
The pros often outweigh the cons when it comes to debt consolidation. You have to look at your particular financial situation to determine if it’s the best move for you.
When is debt consolidation a good idea? It’s a no-brainer if you carry several credit cards with thousands in debt.
If you struggle to meet the minimum payments each month, then debt consolidation might be a good option. You’ll have the one monthly payment at a lower interest rate.
There are times when the answer isn’t that clear.
Let’s say that you have about $6000 in credit card debt. You can pay off that debt in 18-24 months, even though the interest rate is about 24%.
You can get a personal loan that has a lower interest rate and lower monthly payment. The loan is for 36 months, so you carry that debt for an extra year.
Is it worth it to get a debt consolidation loan? This is a situation where there’s a gray area.
It depends on what your financial goals are. If you want to improve your credit score and pay off high-interest debt, then it could be.
However, if your goal is to get out of debt fast, then you should think carefully about debt consolidation. You could still reach your goal by paying more than the monthly payment.
You’ll enjoy the benefits of the low interest rate and still reach your goal. Just be sure to get a loan without prepayment fees.
Look for Lenders
You don’t have to look for debt consolidation loans. You can apply for a personal loan to consolidate your debt.
Be sure to get quotes from several lenders before you commit to a loan. You might find that lenders are very close when you compare them head-to-head.
The deciding factor should be the fees and customer service. Look for reviews and testimonials before you apply. Take a look at a Plenti personal loan as an example. The company’s site has thousands of reviews and ratings.
Complete the Loan Application
A personal loan application asks for things like your income, debt, and monthly obligations. The lender wants to make sure that you can make the monthly payments.
You’ll need to provide documentation, such as pay stubs, recent bank statements, W-2 forms, and tax returns.
Check with your lender to learn what they need and have that information ready to go.
Making Debt Consolidation Work
When you get the loan and pay off the debt, you’ll feel a wave of relief. You’ll see the benefits soon afterward.
You’ll see changes to your credit score in a couple of months. You’ll notice that it drops a couple of points because of the loan application.
Once the credit card debt is paid off, your credit utilization rate drops zero. Expect your credit score to jump.
You’re going to work hard to make sure your utilization rate stays that way. Don’t close out your accounts because that lowers your credit utilization rate.
Make a small purchase each month with your credit cards. Pay off the balance each month to keep your score high.
Is Debt Consolidation a Good Idea?
If you’re like most Americans, you’re in debt. If your debt spiraled out of control during the pandemic, you need to look at your options to improve your financial standing.
You just learned the pros and cons of consolidating debt. Is debt consolidation a good idea for your financial situation?
You can increase your credit score and pay off debts with high interest rates faster. You have to carefully examine your financial situation and determine if it’s the best move for you.
For more resources to help you live a more fulfilled life, check out the other articles on this site today.