Americans are racking up debt, specifically credit card debt. The Federal Reserve Bank of New York found that credit card balances hit $1.17 trillion in the third quarter of 2024. That’s up by $24 billion from the prior quarter.
To make the problem worse, credit card interest rates are also at an all-time high. Interest rates are averaging 24.26%, making carrying a credit card balance very expensive. On top of that, inflation is causing more people to rely on credit for everyday expenses.
If you’re carrying credit card debt, it’s time to get out. Debt consolidation may the answer you’re looking for.
How does debt consolidation work?
Debt consolidation combines multiple debts into one. It simplifies repayment since you end up with only one monthly bill. If done right, it can also lower your interest rate so that you pay less on your debt.
Consolidating debt typically involves taking out a new loan or credit card to pay off existing debts. Debts that qualify for consolidation are unsecured. Think credit card balances, medical bills, or personal loans. Instead of managing several payments with varying due dates and interest rates, you make a single monthly payment to your consolidation lender.
There are different ways to consolidate debt. You can take out a personal loan, apply for a balance transfer card, or dip into your home’s equity. The goal is to secure a loan that costs less than your current debts. When done right, you will save on interest, reduce stress, and pay off debt faster.
Ways to consolidate debt
When considering debt consolidation, it’s important to choose the method that best fits your financial situation. Below are three popular options:
Debt consolidation loans
A debt consolidation loan is a personal loan designed to combine multiple debts into a single payment. You take out a loan at a lower interest rate and use the funds to pay off your current creditors. You are left with a single monthly bill.
Debt consolidation loans are typically installment loans with fixed terms. When you agree to the loan, you know exactly how much you’ll pay each month and when the loan will be fully repaid. A significant advantage that you don’t get with credit cards.
You can find debt consolidation loans at banks, credit unions, and online lenders. Eligibility is based on credit score, income, and debt-to-income (DTI) ratio like with other loans.
For those with good credit, debt consolidation loans can be easy to get. You can secure a much lower interest rate, save money, and simplify debt repayment. Borrowers with lower credit scores may face higher interest rates, which could offset the benefits. That said, finding a bad credit debt consolidation loan is not impossible. Check the interest rate and fees before you agree to borrow to make sure you will save money – especially if you have bad credit.
It’s also important to avoid accumulating new debt after consolidating. Continuing to use credit cards as you’re paying off debt will only worsen your financial situation.
When used responsibly, a debt consolidation loan can be a valuable tool to reduce debt efficiently and pay less overall.
Balance transfer credit cards
A balance transfer credit card is another way to consolidate credit card debt. These cards allow you to transfer balances from multiple cards to a single card. Most offer a low or 0% introductory APR for a set period, typically 12 to 18 months. Pay off the balance during the promotional period, and you won’t accrue any additional interest. You can potentially save a significant amount of money. Once the promotional period ends, a higher APR will apply.
To get a balance transfer card, you will need good to excellent credit. The offers simply aren’t available for consumers with scores below 670.
Balance transfer cards aren’t without costs. Most cards charge a balance transfer fee of 3% to 5% of the amount transferred. Depending on how much debt you have, this fee could be significant. While you don’t accumulate interest, you still must make minimum payments on most cards. If you fail to pay off the balance before the promotional period ends, you will be subject to a higher interest rate, potentially negating the initial benefits.
Before you take out a balance transfer card, make sure you can pay off your debt within the interest-free period. Do not charge any new purchases to the card as this will undermine your consolidation efforts.
For those with good credit and a clear repayment plan, a balance transfer credit card can simplify debt repayment and reduce costs. It’s a strategic option to manage high-interest debt efficiently, provided it’s used responsibly.
Home equity loans or lines of credit
A home equity loan or line of credit (HELOC) can be a valuable tool for consolidating high-interest debt. By borrowing against the equity in your home, you can access funds at a lower interest rate than credit cards or unsecured loans. Home equity loans offer fixed rates and consistent monthly payments. HELOCs provide flexible access to funds as needed, usually with variable rates.
The lower interest rates and longer repayment terms make monthly payments more manageable and reduce overall interest costs. These methods aren’t without risks. Your home serves as collateral. If you fail to make payments, you may lose your home.
Before choosing this option, assess your ability to repay the loan and ensure it aligns with your financial goals. This method is best suited for those with substantial home equity and a reliable repayment plan.
When used responsibly, a home equity loan or HELOC can simplify debt repayment, lower costs, and help you regain financial stability. As with the other methods, it’s essential to avoid taking on new debt while paying off the loan.
When is debt consolidation a good idea?
Multiple high-interest debts: Consolidating multiple debts into one with a lower interest rate can reduce the overall costs and save you money. Plus, you can potentially get out of debt faster.
Several monthly payments: Keeping track of varying due dates and minimum payments is difficult. Consolidating debt into a single loan or credit card means you only have one monthly payment to worry about. You are less likely to miss a due date and incur a late fee or other penalties.
Good to excellent credit: To secure a debt consolidation loan with a low interest rate or balance transfer card, you need a good score. When your score is poor, it will be hard to find lenders who offer low interest rates to make consolidation worth it. You can always bring your score up.
Stable income: A stable income will make it easier to stick with a repayment plan and pay off debt. Lenders know this and are more willing to approve candidates with a stable employment history.
Avoid new debt: You must not add to your credit card balances or take out an additional loan while paying off debt. Taking on new debt will leave you in the same position you started in.
When debt consolidation isn’t worth it
Poor credit score: Debt consolidation likely won’t help if you have a poor credit score. It will be very difficult for you to qualify for a loan with better terms or balance transfer offer when your score is below 580.
Debt burden is low: Debt consolidation works best when you have multiple high-interest debts to combine. If your interest rate is already low or you could pay off your debt within six to 12 months, consolidation won’t do you much good. The potential savings may not outweigh the fees you’d pay for the loan or card.
Struggle with overspending: For any debt relief method to work, you have to address the reason you ended up in debt in the first place. If you don’t reign in your spending, you risk accumulating new debt. In the end, you’re right back where you started.
Unstable income: Paying bills when your income is unstable is challenging. Before committing to a debt consolidation loan, you must know you can make the monthly payments. A balance transfer card won’t do you much good if you don’t pay off the balance before the promotional period ends.
Won’t save money: The biggest appeal of debt consolidation is that you pay less. Calculate how much you will save before you commit. Consider the interest rates, loan fees, and balance transfer fees. If consolidation won’t save you money, it’s not worth doing.
How to apply for a debt consolidation loan
Applying for a debt consolidation loan involves several steps to ensure you get the best terms and effectively manage your debt. Here’s how:
1. Assess your finances: Start by reviewing your current debts. Add up all the balances across your cards to determine how much you need to borrow. Write down the APRs so that you can make sure the new one is less. Knowing the details of your current debts will help you determine if a consolidation loan is right for you.
2. Check your credit score: Your credit score plays a significant role in qualifying for a loan and securing favorable terms. Higher scores lead to lower interest rates and fewer fees. If your score needs improvement, consider addressing it before applying. One thing you can do immediately is check your credit reports for errors via annualcreditreport.com. If you see any mistakes, dispute them with the issuing bureau.
3. Shop around and prequalify: Research local banks, credit unions, and online lenders to find a loan with low interest rates, minimal fees, and suitable repayment terms. Many lenders will let you prequalify online. Prequalifying lets you see if you’re eligible without impacting your credit score. The whole process only takes a few minutes.
4. Compare lenders: After you’ve successfully prequalified with at least three lenders, take a look at their offers. Compare the APRs, fees, repayment terms, and loan amounts. Choose the one who gives you the money you need with the best terms.
5. Submit your application: Gather the required documents and complete your application. Most lenders require proof of income and government-issued identification. Some will ask you how much you owe and to which creditors. At this step the lender will conduct a hard inquiry, which can impact your credit score.
7. Use the funds to pay off debt: Once approved, the lender will either deposit the money into your bank account or pay your creditors directly. If you receive the money, resist the temptation to spend it on other purposes. Use the loan funds to fully pay off your existing debts.
8. Repay the loan: Make consistent, on-time payments on your consolidation loan. Paying on time each month will help improve your credit score and keep you out of debt.
Does debt consolidation impact your credit?
Debt consolidation can impact your credit both positively and negatively. The overall result depends on how you manage it. Initially, when you apply for a consolidation loan or balance transfer card, the lender will conduct a hard inquiry. A hard pull will temporarily lower your score by five to ten points.
Opening a new account or closing your credit cards after you consolidate them may also shorten your average credit age. The length of your credit history makes up 15% of your score. Neither of these factors is very big.
While your score may be lowered initially, paying off your debt will help build credit. As you pay off credit card balances your credit utilization ratio will go down. Credit utilization is the amount you’ve spent vs. your credit limit. The lower your utilization ratio, the better your score. Credit utilization accounts for 30% of your FICO score.
Payment history is even more – 35% of your score. Make on-time payments every month and your score will go up. As long as you stick to your repayment plan and avoid taking on new debt, consolidation should improve your score.
Frequently asked questions
1. What are the risks of debt consolidation?
Potential risks include high fees, foreclosure if you use a home equity loan or HELOC, or a lower credit score. Before you consolidate debt, make sure that you can afford the payments and that the interest rate and fees are lower. The goal is to get out of debt efficiently and save money.
2. What is the best way to consolidate debt?
The best method is the one that saves you the most money. Choose the balance transfer card or debt consolidation loan with the lowest interest rate and favorable terms. Make sure that you can repay the loan as agreed or pay off the balance transfer card during the promotional period. The right choice depends on your financial situation.
3. Can you consolidate debt if you have bad credit?
Yes, but it may be challenging to secure a low-interest loan or balance transfer offer. Look into credit union loans, secured loans, or adding a co-signer to receive more favorable terms.
Bottom line
Debt consolidation can be a powerful tool to help you regain control of your finances. You simplify your payments, reduce overall interest costs, and get out of debt faster. Pay off your consolidation loan or balance transfer card responsibly, and you’ll even build credit. The key is to stick to your repayment plan and avoid new debt.
Before you go down this path, consider if it’s a good fit for you. Make sure that you will save money with lower interest rates and few fees. Be ready to commit to living without credit as you pay off debt. Figure out how to address the underlying issues that led to debt in the first place. Consolidation will not help if you can’t change your spending habits.
Once out of debt, stay out of debt. Anyone can learn how to live debt-free.