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Debt Management

Is debt consolidation right for you?

Debt consolidation can be a helpful tool to get out of debt, but only if you're willing to change your spending habits

Summary

With fewer payments each month and a potentially lower interest rate, a debt consolidation loan can help you get out of debt quicker and easer. But if you’re still spending above your means, this isn’t a permanent solution.

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If you’ve run up so much debt that you’re struggling to pay your bills each month or face dozens of payments every month from credit card companies, lenders, hospitals and other creditors, debt consolidation might help.

Debt consolidation combines several different types of debt – typically credit card, student loan and personal loan debt – into one single loan. You then make just one payment each month to your new lender instead of making several payments to different lenders.

While it can help you lower debt, “consolidating debt is a risky practice,” says Michael Sullivan, personal financial consultant with Phoenix’s Take Charge America, a nonprofit credit counseling agency. “Unless the consumer can change old spending habits, it can quickly lead to a much worse situation.”

According to Sullivan, unless people change their spending habits they will typically fall back into debt, even if they pay off what they owe now with a debt consolidation loan.

But combined with smart financial practices, a debt consolidation loan can be a powerful tool to help you lower debt quickly.

See related: Which debt consolidation method is right for you?

How does debt consolidation work?

Debt consolidation lets you organize your debts and schedule one payment that you can afford to make each month. Not all debts are eligible for debt consolidation, though. Typically, you can only consolidate debts that are unsecured, meaning they aren’t connected to a physical asset that lenders can take if you don’t pay your bills.

Since mortgages and auto loans are secured debts connected to property, neither are eligible for debt consolidation. Credit card debt, medical bills, student loans, cable bills, cell phone bills and utility bills are eligible for debt consolidation.

Different debt consolidation options

While debt consolidation loans are the most common way to consolidate debt, there are other options.

Balance transfer

If you want to consolidate only your credit card debt, you can transfer the balances from your existing card onto one new card, hopefully one that offers an introductory period of 0% interest on all transfers.

Credit cards limit how much existing credit card debt you can transfer, so you might not be able to move all your debt at one time. And those 0% offers are temporary. If you don’t pay off your transferred debt before that introduction period ends, your leftover debt will get hit with your card’s new interest rate, which is generally slightly lower APR than the national average credit card APR.

See related: Best balance transfer credit cards

Cash-out refinance

If you own a home, you can apply for a cash-out refinance and use the money from that to pay off your other debts. The challenge here is that refinances aren’t free – they can cost 2% or more of your outstanding mortgage loan amount.

You’ll need enough equity in your home to qualify for a refinance, and lenders often limit the amount you can take out to 80% of your existing equity. While you can get a low interest rate with this option, it does come with risks. If you stop making payments on your new refinanced loan, your lender could take your house.

Home equity loans and lines of credit

Home equity loans and lines of credit provide you with a certain amount of cash or a credit limit that is based on the amount of equity in your home. You can then use your home equity loan cash or home equity line of credit to pay off other, higher-interest-rate debt.

The downfalls are the same as with cash-out refinances, though: You must have enough equity in your home, and you could lose it if you fall behind on your payments.

Is debt consolidation right for you?

Paul Mankin, founding attorney at the San Diego-based Law Offices of L. Paul Mankin, said debt consolidation works for people who can tackle three big tasks – study the debt-consolidation plan to make sure there aren’t any hidden fees or interest rate jumps, have a plan to help them control their future spending and have enough income to afford the new monthly payment.

“The pros of debt consolidation can be great,” Mankin said. “People can get overwhelmed with having to make three, five or 10 different payments each month when they are behind on all of them. If you can consolidate those payments into one payment, it is much simpler for many people to manage.”

But for debt consolidation to work, you must commit to addressing the bad habits that caused you to run up too much debt. If you start running up your credit cards again, a debt-consolidation loan won’t solve your financial problems.

It’s also important to create a household budget showing your monthly expenses and income. Once you do, you can determine how large of a monthly debt-consolidation payment you can afford, Mankin said.

“Whatever the payment is, can you actually make it?” Mankin asked. “If you can’t make it, don’t consolidate it.”

Can you consolidate debt with bad credit?

Lenders want to know that you have a history of paying your bills on time and can afford to pay your bills every month. To determine this, they will look at your credit score, income and debts. Usually, they want to see a credit score of at least 630 or higher and a debt-to-income ratio below 40%.

If you have poor credit, using debt consolidation to help you get out of debt is going to be more of a challenge. Michael Gerstman, a financial planner and founder of Gerstman Financial Group in Dallas, said different lenders will require different credit scores for debt-consolidation loans.

“If you have god-awful credit, you typically will be declined,” Gerstman said.

If you are approved for a loan, you might not be able to save as much, because the lower your score, the higher the interest rate lenders will charge you. If that interest rate is higher than the interest rate you currently have on your loans, you could end up paying more than you would have simply tackling your debts one by one.

If you have a strong relationship with a neighborhood bank or credit union you might be able to get a lower interest rate even with bad credit, Gerstman said. If your local financial institution knows that you’ve paid other payments on time each month, lenders there might be willing to overlook a less than ideal credit score.

What are the risks of debt consolidation?

Howard Dvorkin, CPA and chairman of Debt.com, said consolidating debt can be a good move if you are signing up for the right debt consolidation program.

If the debt consolidation loan has a higher monthly interest rate than you’re currently paying, it’s best to walk away. You’ll likely end up paying more and staying in debt longer. But that’s not the only thing to watch out for.

“It often makes sense to do a debt consolidation, but the pitfall is it can be difficult to determine if there are any tricks in the program,” Dvorkin said.

For example, a lender might promise an interest rate of 0% for six months. But after that six-month period ends, your interest rate might kick up to a far higher level, potentially bringing your monthly payments to a number that you can’t afford.

Lenders might also charge you a fee to take out a debt consolidation loan. Gerstman said many consolidation lenders often charge origination fees of 2% of the original amount or more. Others don’t charge any origination fees.

“At the end of the day, consolidation loans are a good idea if you go with the right consolidation loan,” Dvorkin said. “If you have an accountant, [have them] review the terms. Get a second opinion. There are lots of hidden tricks in these loans.”

Gerstman also warned that too many people who rely on debt consolidation loans will run up new debt after paying down their consolidated debts.

“There’s a reason why you’ve built up all this credit card debt,” Gerstman said. “That’s why you are going for the debt consolidation loan in the first place, to get breathing room. Don’t let your credit card debt inch back up again. That’s a recipe for disaster.”

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The editorial content on this page is based solely on the objective assessment of our writers and is not driven by advertising dollars. It has not been provided or commissioned by the credit card issuers. However, we may receive compensation when you click on links to products from our partners.

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