Debt consolidation is the process of using a single large loan to pay off multiple smaller debts. This allows the debtor to make a single regular payment, rather than several smaller ones. If the interest rate on the new loan is lower than that on the previous ones, this can save the debtor money on his or her monthly payments. If used wisely, debt consolidation can be a lifeline. However, if misused, consolidation can make bad debt even more difficult to manage. This article explains how (and when) to consolidate your debt.
Know when debt consolidation is (and isn’t) appropriate. Debt consolidation can be a godsend to someone who’s in dire financial straits. It can even be useful for someone who isn’t in danger of financial catastrophe by allowing him or her to roll many debts into one convenient payment. Generally, for people in difficult financial situations, debt consolidation is appropriate when it allows a debtor to avoid bankruptcy by reducing his or her payments to reasonable levels. If you are able to secure a loan with a lower interest rate than your existing debts, debt consolidation may be a good choice for you.
- However, if you’re financially struggling and you’re not able to secure a loan with lower interest, debt consolidation isn’t a good idea, even if it makes your numerous monthly payments into one single, convenient one. This is especially true if you’re considering using a commercial debt management service, as these usually come with their own associated fees.
Understand the limitations of consolidating your debt. Debt consolidation isn’t for everyone. Understand that, while debt consolidation can make month-to-month payments smaller, it also has disadvantages. Before deciding on a debt consolidation plan, consider the important facts below:
- While consolidating your debt can lower your monthly payments, it does not change the overall balance of your debt. In other words, you will still owe the same amount of money after you consolidate your debt as you did before – you’ll just pay less in interest per month.
- If your consolidating loan has a lower interest rate than the debts it replaces, this usually means it will have a longer repayment schedule. Because of this, it’s possible to actually pay more money overall with a consolidated loan than without one.
- Depending on how it’s used, debt consolidation can damage your credit scores. Applying for any type of loan can cause a small, temporary dip in your credit scores, but if you use a consolidation loan to, for instance, pay off and close multiple credit card accounts, the damage can be more significant and longer-lasting, as this can max out your credit utilization.