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According to Experian’s 2021 State of Credit report, American consumers with credit card debt carry an average balance of $5,525, while the average credit card interest rate currently sits at well over 16%.
For people who fall behind on payments, a high debt load and a high annual percentage rate (APR) can combine in the worst possible way, often creating a cycle of high-interest debt payments consumers can’t escape from. And, even for those who can keep up with monthly payments, too much credit card debt can keep them from reaching other financial goals, like saving for the future.
Either way, debt consolidation offers a way out of credit card debt that’s far less severe than bankruptcy. You just have to be willing to create a plan and stick to it until you’re debt-free. If you’re interested in getting out of debt for good, read on to learn how debt consolidation can help.
How does debt consolidation work?
If you’ve tried budgeting your way out of debt or earning more money but nothing seems to work, debt consolidation could be the answer you’re looking for. With debt consolidation, you’ll essentially trade the loans and credit card balances you have for one new loan product with better rates and terms, thereby either lowering your monthly payments or making it easier to put more of your money toward reducing the principal on the debt, or both.
Essentially, with a debt consolidation, you take out a new loan and use the proceeds of that new loan to pay off all your old debt, then make monthly payments only on the new loan. Generally speaking, there are three financial products consumers use for debt consolidation:
- Debt consolidation loans, also called personal loans, make it possible to refinance your debts into a new loan with a fixed interest rate and fixed repayment term.
- Balance transfer credit cards let you consolidate debt on a new credit card that offers 0% APR for a limited time.
- Home equity loans can help you consolidate debt into a new loan product that is secured by the value of your home.
Whichever product you decide to use, just remember that debt consolidation really only works if you stop racking up more debt. If you consolidate debt with a personal loan or a balance transfer credit card and you continue charging more purchases to other lines of credit, debt consolidation is probably a waste of time.
Is debt consolidation a good idea?
Debt consolidation may or may not be a good idea. It all depends on how serious you are about the process, and whether you have the discipline to see it through.
As an example, let’s say you currently have $5,525 in credit card debt at an APR of 19%. In this scenario, you could pay $100 per month toward this debt for 133 months — or more than 11 years — before it was paid off. Over that time frame, you would fork over $7,701 in interest.
But what if you consolidated that $5,525 in debt into a single personal loan? While personal loans vary, most let you borrow money anywhere from two to seven years. Personal loans also come with fixed interest rates, fixed repayment terms and fixed monthly payments.
In this example, it’s possible you could qualify for a 60-month personal loan with an interest rate of 7%. In that case, you would pay down your balance with a monthly payment of $109 for five years (60 months). Over that time frame, you would pay approximately $1,039 in interest payments. That’s an enormous savings of over $6,000.
You can also consolidate debt with a credit card. However, it’s important to note that while balance transfer credit cards offer an introductory 0% APR on transferred balances, the longest possible term currently offered is for 21 months. After that, your interest rate will revert to the regular APR, which will always be on the high side.
For that reason, a credit card balance transfer is only a good idea when you have an amount of debt that you can pay off during the card’s introductory period. If you need more time to get your debt under control than a balance transfer affords, you should consider a personal loan instead.
Finally, you can also consolidate debt with a home equity loan that uses your house as collateral. In many cases, this can be a good idea since home equity loans can come with low fixed rates as well as a fixed monthly payment and fixed repayment term. Just remember that you need good credit to get a home equity loan, and that you can lose your home if you default.
But, in any of these cases, if after you consolidate your debt you overspend and run up another $5,000 in debt on that same original credit card you used before and you can only afford to pay $100 in monthly payments on that debt, you’ll end up paying an additional $4,985 in interest. Add that interest together with the additional $5,000 in debt and you’ll be worse off than you started. That’s why it’s so important to stay disciplined and not continue to spend more than you have when you pursue a debt consolidation.
Debt consolidation alternatives
There are other debt consolidation options you can consider, some of which offer help from third-party companies. For example, you could consider signing up for a debt management plan (DMP), which takes place when a credit repair agency helps you negotiate interest rates and pay down your debts over a fixed period of time.
Just note that DMPs aren’t for everyone, and that the credit repair agencies that offer DMPs can’t do anything that you can’t do for yourself. Also, a number of credit repair agencies have earned bad reputations, so make sure you do plenty of research before going down this path.
Another alternative is debt settlement, which is a process that helps you settle your debts for less than you owe. However, it’s crucial to know that debt settlement companies ask you to stop making payments on your debts while they work on your behalf. Not surprisingly, this can cause considerable damage to your credit score that may last for years.
Should I consolidate my debt?
Debt management becomes considerably easier when you have a reasonable interest rate and a monthly payment that makes sense with your income. For the most part, this is what debt consolidation does — it helps you move debts with high interest rates to a new financial product with better terms.
Debt consolidation also comes with the benefit of letting you downsize the monthly payments you’re making. If you’re currently trying to keep up with five or six credit card bills, consolidating debt with a personal loan company or peer-to-peer lender can help you switch to making just one payment each month.
With that in mind, there are several factors that can determine whether debt consolidation is for you. These include:
- Your creditworthiness: You’ll need good credit or better to qualify for a personal loan with the best rates and terms. If your credit is poor, you may not qualify for a new loan with better rates than you have now.
- Your desire to pay off debt: Debt management takes time and effort, and paying off debt completely can take years. If you aren’t serious about debt consolidation, a debt consolidation loan may not leave you any better off.
- Your ability to avoid new debt: To make your debt consolidation a success, you have to stop accruing more debt. While you pay off your debt consolidation loan, you should use cash or debit only. At the very least, you should use credit sparingly.
So, should you consolidate your debts? If you’re paying off credit cards with high APRs, it’s possible that debt consolidation may be exactly what you need. Just remember that you’ll only pay off debt if you craft a plan and, most importantly, stick to it. If you take out a personal loan and keep racking up debt on credit cards, you could end up worse off over the long term.