Pros and cons of debt consolidation loans can help you decide if consolidating your debts is the right choice for you. Debt consolidation involves taking out a new loan to pay off multiple other debts and loans. It allows you to combine multiple payments into one, often with a lower interest rate. Here is an overview of the potential pros and cons of debt consolidation loans:
Pros of debt consolidation loans
1. Lower interest rate
One of the biggest pros of debt consolidation loans is getting a lower interest rate than you currently have. By consolidating high-interest debts into one loan with a lower fixed rate, you can save money on interest charges. This allows more of your payments to go toward paying down the principal balance.
2. Single payment
Instead of keeping track of multiple payment due dates and amounts for various credit cards and loans, a debt consolidation loan allows you to make one payment per month. This simplifies the payment process.
3. Set payoff date
With a debt consolidation loan, you can have a set payoff date when the loan will be fully repaid. This clarity can help motivate you to stick to your payment schedule and pay off your debts faster.
4. Improve credit score
Pros of debt consolidation loans include the ability to improve your credit score. By paying off credit cards and other debts, you lower your credit utilization ratio. Keeping balances low on credit cards can boost your credit score.
5. Decrease stress
When you’re struggling with debt, it can cause significant stress. A Federal Trade Commission study found 40% of Americans lose sleep over money issues. Debt consolidation leads to less stress by simplifying payments and lowering interest costs.
6. Avoid bankruptcy
If your debts become completely unmanageable, bankruptcy may feel like your only option. However, a debt consolidation loan allows you to avoid declaring bankruptcy and damaging your credit for years.
7. Get out of debt faster
With multiple high-interest debts, it can take years to pay them off. A debt consolidation loan can help you get out of debt years faster by lowering your interest rate and monthly payments. This saves you money on interest.
8. Fixed interest rate
A debt consolidation loan offers borrowers a fixed interest rate. Your monthly payment and interest amount will stay the same over the life of the loan. This stability allows you to budget and plan ahead.
9. Access cash quickly
After being approved for a debt consolidation loan, you typically have quick access to the funds, often deposited directly into your bank account. This allows you to pay off debts right away and start benefiting from the consolidation immediately.
Cons of debt consolidation loans
1. Closing accounts
When you pay off credit cards with a debt consolidation loan, you’ll likely need to close those card accounts. This can lower your total available credit and negatively impact your credit score temporarily.
2. Paying more interest overall
Even though debt consolidation loans have lower monthly payments, you may pay more interest over the full loan term. Paying off high-interest debt over 3-5 years with a consolidation loan means interest charges continue accumulating.
3. Deferment period
Some lenders offer deferred payments for the first few months of a debt consolidation loan. While this temporarily lowers your payments, interest still accumulates during this period, increasing your total cost.
4. Loan origination fees
Most lenders charge origination fees for debt consolidation loans. This one-time fee is based on the total loan amount and deducted from the money disbursed. Typical origination fees range from 1-5% of the loan amount.
If any of your debts are secured loans, such as a car loan or mortgage, consolidating them into an unsecured debt consolidation loan means losing that collateral. The lender can no longer seize the asset if you default.
6. Credit damage if you default
Failing to make payments on your new debt consolidation loan can severely damage your credit. Defaulting on the loan results in collections calls, potential lawsuits, and being reported to the credit bureaus.
7. Debt accumulates again
Some borrowers find themselves in growing debt again soon after consolidating. Without changing spending habits, any freed-up cash flow after consolidation can quickly be consumed by new credit card balances and consumer debt.
8. Lengthening repayment term
To make the monthly payments on a debt consolidation loan more affordable, the repayment term is often extended to 5-7 years. By lengthening the term, you end up paying more interest costs over time than with a shorter term.
9. Tax consequences
If any of the debts you consolidate were tax-deductible, such as a home equity loan, that benefit goes away when consolidating into an unsecured personal loan. You can no longer deduct that interest on your taxes.
10. Higher monthly payments
In some cases, the monthly payment on a debt consolidation loan can be even higher than your combined payments before consolidating. This usually occurs if your credit score is low and you only qualify for a consolidation loan with a high interest rate.
Who should consider a debt consolidation loan?
In general, a debt consolidation loan may make the most sense for borrowers who:
- Have high credit card balances with APRs of 15% or higher
- Have multiple accounts and struggle to keep track of due dates and payments
- Want to simplify their payments into one monthly bill
- Need to lower their monthly payment amount
- Want to pay off debts faster and save on interest
- Have good credit scores to qualify for the lowest interest rate on a consolidation loan
Who should avoid a debt consolidation loan?
On the other hand, a debt consolidation loan may not be the right choice for:
- Borrowers with recent late payments or defaults – they may not qualify for a competitive rate
- Those who rely on deducting interest from taxable income
- People who would end up with a longer repayment term and higher total interest costs
- Individuals wanting to close all their credit card accounts – this can damage credit scores
Alternatives to debt consolidation loans
Some alternatives to a debt consolidation loan include:
- Credit counseling – A non-profit credit counseling agency can negotiate lower interest rates and fees directly with your creditors on your behalf. They also offer money management and budgeting assistance.
- Balance transfer credit card – Transferring balances from high-interest credit cards onto a card with a 0% introductory APR for 12-21 months allows you to pay down balances faster without interest building up.
- Debt management plan – A DMP through a credit counseling agency lets you consolidate multiple debts and make one payment per month to the agency. They disburse payments to your creditors.
- Bank personal loan – If you have an established relationship with a bank where you have accounts, you may be able to qualify for a personal loan at a lower rate than a debt consolidation loan.
- 401(k) loan – Borrowing against your 401(k) retirement account allows access to cash quickly. However, if you leave your job, the loan must be repaid in full immediately. The interest also goes back into your own account.
- Home equity loan – If you have equity built up in your home, a home equity loan or line of credit have lower rates and allow tax-deductible interest. However, your home is at risk if you default.
Key considerations when deciding – Pros and cons of debt consolidation loans
Carefully consider these factors when deciding if a debt consolidation loan is right for your situation:
- Interest rates on current debts vs. available consolidation loan rates
- Amount of savings on monthly payments and interest fees
- Impact on credit score and credit history
- Consolidated repayment term length
- Total interest paid over the full repayment term
- Flexibility – some loans allow prepayments or early payoffs
- Fees for the consolidation loan, including origination fees
- Potential lost benefits from existing loans, like tax deductions
Making a chart to compare your current debts with the proposed consolidation loan can help analyze the key numbers and determine if it makes financial sense for you. Getting advice from a credit counselor is also recommended when weighing the pros and cons of debt consolidation loans.
|Debt||Current Balance||APR||Monthly Payment|
|Visa Credit Card||$5,200||17.99%||$175|
|Mastercard Credit Card||$2,850||16.24%||$90|
Table comparing current debts vs. proposed debt consolidation loan:
|Current Debts||Consolidation Loan|
|Repayment Term||Various||5 years|
|Total Interest Paid||$XXXX||$3,123|
In summary, pros of debt consolidation loans include lower monthly payments, fewer bills, and potentially saving on interest costs. The cons include paying more interest overall, closing accounts, and the risk of default. Conducting a full analysis of your situation is important to determine if the benefits outweigh the drawbacks. Seeking assistance from a financial advisor can help you make the most informed decision when comparing your debt relief options.
- Debt Consolidation Loans: What They Are & When to Use Them. NerdWallet.
- The Pros and Cons of Debt Consolidation. Forbes.
- The Pros and Cons of Debt Consolidation. Investopedia.
- 2021 Consumer Debt Consolidation Report. Federal Reserve.