Is Debt Consolidation Good or Bad?
Debt consolidation is an option that many people consider when they need to find a manageable solution for multiple high-interest debts, which are often attached to credit card accounts. The question of whether debt consolidation is a wise or risky financial move is very common, and it has a simple answer: sometimes it’s good, and sometimes it’s not.
In this guide, we’ll explore both scenarios with an eye to helping you figure out whether it’s something you should consider in your personal situation.
Debt consolidation can be good if…
Your debt levels are manageable
Many people mistakenly believe that debt consolidation is a magic wand that will make their money troubles go away. In reality, it typically works out in your favor if you’re carrying manageable levels of debt and simply want to save money on the interest rates you’re currently paying.
Personal finance experts use a general rule of thumb to assess whether debt consolidation is a good idea for any given person. It goes like this: if your total debt load is no more than 40% of your current pre-tax annual income, you’re within range. That 40% figure does not count your mortgage if you are a homeowner.
If it exceeds 40% of your gross income, chances are you will end up paying more in the long run. Debt consolidation loans don’t just lower your interest rate. They also typically extend your repayment term, and if you’re carrying too much debt, you will usually end up paying more in the long run, even with a slightly better interest rate, because the interest will accumulate for a longer period of time.
Your FICO credit score is relatively healthy
All lenders, whether they’re traditional banks or innovative alternatives, use credit scores as a kind of risk metric. The more risk you pose, the better the return needs to be for the institution to take a chance on you. Thus, the better your credit score is, the lower your interest rates will be.
The whole point of debt consolidation is to lower your interest rates so you can save money on your debt. If your credit is in the fair to poor range, chances are you’ll struggle to find rates that beat the ones you’re already paying.
You can comfortably afford your new monthly payments
This tip ties in with the earlier point about ensuring that your current debt levels do not exceed about 40% of your pre-tax income. People seek debt consolidation not only for respite from high interest rates, but also to reduce their monthly debt payments. If you can’t afford the monthly payments on your consolidation loan either, you’re not helping yourself financially. In fact, you could very easily end up doing more harm than good.
Before you formally apply for a loan, use a debt consolidation calculator. These widely available online tools are great for helping borrowers estimate their costs, both in terms of their monthly payments and their total costs over the lifetime of the loan.
You can control your spending
There’s another danger with debt consolidation loans: they essentially forward you the money to pay off all your current credit card balances, then bundle that debt into a single loan. This means your credit card balances will be erased, which in turn means that you’ll have access to your full credit limits all over again.
If you’re not disciplined about your spending, you could very easily end up in a much worse position than you started. Debt consolidation works best for people who are in control of their spending and tend toward more conservative consumer habits.
Debt consolidation can be bad if…
You’re carrying too little or too much debt
Debt consolidation works best when your debt load is in the “sweet spot” that allows you to reduce your monthly payments while saving money on interest charges in the long run. If you’re carrying relatively little debt, or if your debt load is beyond a manageable limit, you may not be the best candidate for a consolidation loan.
How do you know if you’re carrying too little debt to make consolidation worthwhile? Here are some clues:
- You could become debt-free in less than one year if you lived within your means and implemented an aggressive plan to attack your current balances
- Your debt-to-income ratio, or the percentage of your pre-tax monthly income that goes toward your existing debts, is less than 20%
- You wouldn’t stand to save much money by consolidating
- Your consolidation loan would take you longer to pay off than your current credit card balances
Similarly, here are some red flags that indicate you may need a more aggressive solution than debt consolidation can offer:
- You would still struggle to make the monthly payments you’d be responsible for with the consolidated loan
- A consolidation loan would increase the total amount of money you would spend to become debt-free due to an extended repayment term
- You cannot qualify for loans or other solutions with interest rates that are lower than the ones you’re already paying
You have poor credit
If you have a FICO credit score in the “fair” or “poor” range, it’s unlikely that the numbers will work out in your favor if you take out a consolidation loan. The increased interest rates you’ll have to pay will likely just add to your existing financial problems, and there’s little point in consolidating all your debt into a single loan if that loan carries higher rates than your credit card providers are already charging.
You don’t get a meaningful change from your current interest rates
Here’s something else to watch out for: consolidation loans that beat your current interest rates by just a little bit, but come with repayment terms that extend across many years. Paying slightly less interest for a much longer period of time could cost you thousands of extra dollars over the life of your loan.
Again, use a debt consolidation calculator to run the numbers. It’s important to work with accurate figures, so the best thing to do is shop around to see what kind of rates you qualify for. Reputable lenders will always offer no-obligation, up-front quotes free of charge.
If you decide to dig a little deeper by seeking firm quotes, be sure to source them from companies that do what’s known as a “soft pull” of your credit data in evaluating your request. A soft pull won’t negatively affect your credit score the way a “hard pull” does when you make a formal loan application.
You don’t have good spending habits
To have a successful consolidation experience, you’ll need to rein in your spending while you pay down your current debt. This means you’ll need to avoid the “worst of the worst” spending habits, which include:
- Using credit to purchase nonessential consumer items that have no resale value
- Buying big-ticket items impulsively
- Paying for services you don’t draw enough value from, like unlimited-access gym memberships you use once or twice a week
- Buying things to give yourself a pick-me-up on a bad day
Finally, remember that debt consolidation is only one of multiple options for consumers who are having a hard time keeping pace with their payments. Others include picking up a side job to earn extra income, selling off unused or unwanted possessions and using the proceeds to pay down debt, or seeking debt resolution. No matter what, you should only consider declaring bankruptcy as an absolute last resort.