Pros and Cons of Debt Consolidation Explained

Posted by in Loans | Updated on May 30, 2023
At a Glance: Debt consolidation replaces multiple loans with one. It can simplify your finances, and potentially save you money. It is important to make sure you can afford the payments on the consolidation loan, and budget carefully to avoid unsustainable debt.

Making repayments on many different loans can take up a lot of time per month, especially if you do the payments manually. Debt consolidation is one way to combine those separate loans into one. Read on to learn about the pros and cons of debt consolidation, and whether it is a good idea for you.

What is Debt Consolidation?

Debt consolidation is a way of combining many loans to different lenders into a single loan to one lender. This is done by taking out one loan, called a consolidation loan, which is enough to repay all of the smaller loans at once. Then, you make payments on that single loan.

Pros of Debt Consolidation

There are several important benefits you can enjoy by using debt consolidation. A few of these are listed below:

  • Speed: Depending on the nature of the debt you are consolidating, the fixed-length nature of a debt consolidation loan means there is a possibility that you can achieve overall faster debt repayment.
  • Simplification: Juggling regular payments to multiple different lenders presents the risk that some payments could slip through the cracks, especially if they are manual payments. Only having to pay a single monthly payment to one lender makes things much simpler.
  • Rate: Debt consolidation loans are personal loans. If you qualify for a reasonable rate on a personal loan, and you are consolidating high-interest credit (such as a credit card) you could save some money because you will pay less interest at the lower rate.
  • Schedule: With a fixed-rate consolidation loan, you will always know exactly how much you have to pay each month, which makes planning and budgeting easier.
  • Credit: Consolidation can slightly boost your credit score. Although it might decrease the diversity of your credit, making on-time payments will improve your score. Also, if you consolidate credit card debt (then keep the credit card balances low), it will boost your credit score based on your credit utilization ratio.

Cons of Debt Consolidation

There are also some downsides associated with debt consolidation that you must keep in mind. These are outlined below:

  • Not magic: Debt consolidation is not financial magic, so it will not solve all your financial problems. If your debt load is unsustainable, it is important to understand and limit the spending behavior that led to it. It is important to create a realistic budget and stick to it.
  • Extra costs: Like any other loan, a consolidation loan comes with costs, which vary depending on the lender. In addition to this, many other lenders charge early termination fees for paying them off before the end of the term. Before you choose consolidation, make sure you understand all of the fees associated with taking out consolidation loans and with paying off your other loans. These fees could amount to hundreds or even thousands of dollars so it is important to take them into account when deciding if consolidation is for you.
  • Interest rate: Your consolidation loan may have a higher interest rate than the underlying loans. This is especially true if your credit score has decreased since taking out the original loans. Take this into account when deciding how much more you will pay in interest for the consolidated loan versus the individual loans in total.
  • Missed payments: If you miss payments on your consolidation loan, the impact on your credit score may impact your ability to get loans in the future and put you in a tight position financially. Consider setting up autopay for your repayments to decrease the chances of problems. Some lenders offer a small interest rate discount for autopay repayments.

Should You Use Debt Consolidation?

Once you know the pros and cons of debt consolidation, the next thing to ask yourself is whether it is appropriate for you. This depends on the details of your situation. There are some broad factors that, if they apply to you, might suggest that it is a good idea for you.

  • Good Credit: If you have a good credit score, you will probably be eligible for a personal loan with reasonably low interest. Chances are good your consolidation loan will have a lower interest rate than, for example, outstanding credit card debt.
  • Schedule: If your outstanding debt is variable-rate, a consolidation loan with a fixed interest rate can simplify your monthly repayments, because they would not change.
  • Simplification: Consolidation could be for you if you have numerous small loans with different lenders. Having a single payment to one lender can make things much easier for you, especially if your previous payments were manual.
  • Affordability: The key factor to consider with a consolidation loan is whether you can afford a single large payment (and associated fees). If your income is not high enough to make the monthly payments and still keep up with your other financial obligations, then a consolidation loan can only make things worse.

How to Apply for a Debt Consolidation Loan

Once you understand the pros and cons of debt consolidation, and you decide it is appropriate for you, the next step is applying for the loan. Every lender has unique processes but the general steps to apply for a consolidation loan are listed below.

  1. Check your credit: If you choose a lender with minimum credit score requirements, check your credit report beforehand and make sure you meet these limits, and that there are no mistakes on your report.
  2. Calculate the amount: You will need to borrow enough to cover:
    1. The outstanding balance on all your loans
    2. Fees on your consolidation loan (e.g. origination fees), and
    3. Fees on your outstanding loans (early termination/prepayment fees).
  3. Compare lenders: Check the APRs and fees charged by various lenders, as well as the benefits offered. Also, approach your bank or credit union. They may offer perks if they have a longstanding relationship with you.
  4. Get prequalification: Not all lenders offer prequalification, but if they do, it will give you a good idea of whether you will be approved and what rates you can expect.
  5. Submit application: Once you select the best choice, you can submit all the required documents and formally apply.
  6. Get the funds: If you are approved, the lender will transfer the money to your account within a few days. Some lenders do it on the same day.

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Final Thoughts 

Debt consolidation is a way of replacing many smaller loans and their payments with one large loan payment. There are several pros and cons of debt consolidation, which together determine whether it is appropriate for you. It can simplify your monthly payments, and potentially save you money if you can get a low rate for your consolidation loan. However, it is important to make sure you can afford the payments on the consolidation loan, and budget carefully to avoid unsustainable debt.