What is Debt Consolidation, and Why is it Helpful?

Debt is a big worry, lingering in the back of your mind, even if you’re good at ignoring it. Sliding into debt can make you feel stuck and helpless, with limited options for escape. Credit card balances, student loans, car payments, and medical bills add up. Keeping your head above water can take work once you’re in debt. Debt consolidation is a valuable tool to help you find a way out. But before you begin the process, you’ll want to understand, what is debt consolidation? 

What is Debt Consolidation?

Debt consolidation is the process of rolling multiple debts into a single, larger debt, usually with a lower interest rate, a smaller monthly payment, or both. Consolidation can streamline payments for student loans, credit card balances, and other debts. Before consolidating, review your account balances, interest rates, and credit score. Run the math and consult an expert. 

Consolidating your debt may be a good idea if:

  • It’s Substantial. If you can’t pay off your debt within a year, you may need help. Consolidation isn’t worth the fees and credit checks needed if your current payments allow you to be debt free within a year. If you can pay off your debt within 12 months, consider other payoff strategies, like the snowball or avalanche approach
  • Your Credit Improves. You might qualify for a lower interest rate if you improved your credit score since taking out your other loans. The lower rate would help you pay off debt more quickly. 
  • You Can Pay. Consolidating your debt is only good if you can pay your current monthly debt. You’ll still need to make monthly payments, which means you need regular income.

Benefits of Debt Consolidation

Debt can seriously threaten your financial security because it keeps you from making the most of your money, so committing to paying down debt comes with many benefits. Still, every person’s financial situation is unique, so it’s best to examine your options and determine if the time is right for you.   

Benefits of debt consolidation include:

  • Paying Debt Quicker. Only making minimum payments stretches your repayment timeline. Consolidation allows you to accrue less interest. You can use the extra cash to pay off debt earlier. 
  • Simplifying Payments. Combining debt reduces the number of payments you need to track and minimizes the chances of missing a payment. It’s easier to manage if you only have to make one payment to a single source once a month. 
  • Improving Your Credit Score. Applying for a new loan creates a hard credit inquiry, resulting in a temporary dip. Still, long term, it can improve your score by reducing your credit utilization percentage. 
  • Saving You Money. Interest adds hundreds, even thousands, to your debt. Consolidating your debt can provide access to better interest rates, lowering your monthly payment. 

Let’s look at an example. Say you have multiple credit cards with different interest rates and monthly payments:

  • Credit Card 1: $4,500, 25.00% APR
  • Credit Card 2: $3,500, 19.00% APR
  • Credit Card 3: $2,000, 12.00% APR 

You consolidate balances into a single loan for $10,000 with an 8.49% APR. You budget to pay off the loan in four years. Combining debt, you pay $1,828.92 in interest. By comparison, if you made a 4% monthly minimum payment on your three original cards, you would pay more than $7,397 in interest. It would take you nearly 14 years to ultimately pay off the debt. 

Disadvantages of Debt Consolidation

There are few downsides to not having debt hanging over your head. But there are some things you’ll want to consider before rolling your debt together.

Disadvantages of debt consolidation include: 

  • Prolonged Timeline. Moving debt to a new loan can sometimes involve extending the term of the loan. This means the borrower will be in debt for longer.
  • Lack of Learning. If overspending and irresponsible money management is what landed the borrower in debt in the first place, consolidating debt on its own will not solve the problem.
  • Interest Rate Changes. Many low- or no-interest credit cards only offer these features as a temporary promotion. Once an introductory period ends, the borrower will be hit with high-interest rates.

What to Do Before Consolidating Debt 

The average credit card user carries a balance of $5,474, and the average student loan debt is $37,574. Pile on auto loans and other debt, and it adds up to a big chunk of change. A large debt load and high annual percentage rates create a cycle that’s difficult to escape. 

If you’re swimming in debt, the one thing you may wish for more than anything else is a chance to clean the slate and start over. Of course, barring a winning lottery ticket, nothing will make that much of a change overnight. But you have opportunities to get your debt under control. 

Consolidating into a single loan will streamline your finances, but it won’t fix underlying financial challenges.

Before consolidating your debt, step back and understand what led you down the path and what changes you need to make to stop the spiral. Debt consolidation without a plan is a temporary solution that may worsen matters in the long run. Was it a medical bill, loss of a job, or other temporary hardship that caused you to get behind with charges? If you now have a job or the medical issue is resolved, it means you solved the source of the debt problem. If, on the other hand, you accumulated debt by overspending on credit cards, debt consolidation may not be the answer just yet.  

When you’re committed and ready, you’re going to want to:

  • Create a Budget. Creating a budget doesn’t automatically solve your money problems, but it will help you gain financial awareness and make more responsible decisions. Once you build a budget, review it monthly to determine if you’re staying on track. You must adjust the numbers initially or as your financial situation changes.
  • Learn to Save. When it comes to saving, small changes add up quickly. Look for ways to adjust your habits. Simple changes like cooking at home versus eating out, switching cell phone plans, cutting streaming services, or stopping impulse purchases help you keep more money in your pocket. Look at every decision involving money for ways to save.
  • Develop Skills to Prevent Debt. As challenging as it is to get out of debt, understanding the math is simple, you either increase your earnings or decrease your spending. Ideally, you work toward a combination of both. Be consistent and stick to your financial goals.

Download Ebook: Debt Management

What Options are Available for Debt Consolidation?

Now that you know what debt consolidation is, you’ll want to consider your alternatives. The best option depends on your circumstances, credit score, and the amount of money you need to borrow. Loans and other financing options can access funds via secured or unsecured debt. The primary difference is the presence or absence of collateral. Let’s examine these two options to determine what’s best for your needs. 

Secured Loans

You can get a secured loan through a credit union or bank. This type of loan requires collateral, such as a car, house, or other investment account, as part of the application process. You pledge the asset in case you’re unable to repay the loan. The lender can seize the asset if you don’t make payments on time.  

Secured loans are easier to qualify for and typically offer lower interest rates and higher loan amounts than unsecured loans. The lender considers your credit score, history, income, and debts. Adding collateral to the application lowers the lender’s risk and gives them more confidence to lend to you. It does have a lengthener application process, and secured loans come with a penalty for not repaying.  

Types of secured loan options include:

  • Personal Loan. The most common way to consolidate debt is through a secured personal loan. A personal loan offers fixed interest rates and repayment terms. The duration of the loan and your credit score determine the interest rate. Once approved, you use the loan to pay off existing debts and make payments on the new loan.
  • Home Equity Line of Credit. If your home has appreciated or you paid down a portion of the mortgage, you can use the equity to consolidate your debts through a Home Equity Line of Credit (HELOC). It provides a revolving credit line to consolidate higher-interest-rate debt on other loans. HELOCs offer lower interest rates, and the interest may be tax deductible. 
  • Secured Credit Card. Secured credit cards are like traditional credit cards but require a security deposit. The deposit is the collateral on the account. If you can’t make payments, the lender keeps the deposit. With a secured credit card, the amount you put down in a deposit becomes your credit limit for the card. 

Unsecured Loans 

An unsecured loan doesn’t require collateral. It gives you quicker access to funds through a faster approval process. The lender decides to give a loan based on your credit history. Unsecured loans have stricter requirements to qualify, which often means you pay a higher interest rate with lower limits.  

Common types of unsecured loans include:

  • Unsecured Personal Loan. With an unsecured loan, you borrow a lump sum and repay it, plus interest, in monthly installments. You have the best chance of qualifying if your credit score is 690 or higher. Unsecured loans are risky because your credit will be affected if you default. 
  • Personal Lines of Credit. A line of credit provides access to a set amount of money for a specified time frame. The time is known as the draw period, which is when you can draw money from the account.  
  • Credit Card Balance Transfer. Unsecured credit cards are the most popular and commonly used form of unsecured credit. Your credit score, credit history, and income are crucial factors. You may decide to consolidate multiple credit card payments on a new card. Many credit cards provide offers of 0% APR on balance transfers. 
  • Student Loan. You can consolidate student loans through federal or private programs. Federal consolidation combines multiple student loans into one. The new loan won’t lower your interest rate, but it will simplify payments.

Strategizing the Use of Personal Loans 

Debt consolidation doesn’t work for everyone. Before you speak to a bank or credit union, you’ll want to determine how much you can afford to put toward getting out of debt. The lender will work backward from there to figure out terms, interest rates, and the total amount borrowed.

Debt consolidation may not be a good option if you struggle to make minimum monthly bill payments. Although it may lower your interest rate, bundling all your debt together could result in a higher monthly payment over a shorter period. Debt consolidation doesn’t work for everyone, but it can do wonders for many people. 

Critical to understanding debt consolidation and how it can help you is determining the order of how you want to tackle it. Prioritize loans or credit cards with the highest interest. This approach will allow you to tackle your most significant problem first, freeing up extra interest payments for smaller balances.  

How Can FFCU Help with Debt Consolidation?

Debt consolidation can be a good way to reset your finances. The ability to eliminate high-interest debt and simplify monthly expenses into one payment for debt servicing can change your financial picture. If you’re dealing with multiple bills with different interest rates, amounts, and due dates, you should weigh the benefits and drawbacks of debt consolidation. Contact Focus Federal for help answering the question, “What is debt consolidation?”