Pros and Cons of Debt Consolidation
Deciding if consolidation is the right solution for your needs.
When you’re having problems with debt, the right solution can help you rein in your payments and save your credit from the damage of bankruptcy. At the same time, there are always certain risks and downsides to any debt solution that you use. So it’s important to understand the upsides and downsides of debt consolidation before sign up for anything to solve your debt problems.
The information below can help you understand the advantages and disadvantages of debt consolidation, in general, as well as the pros and cons of specific consolidation options you can use.
The pros of debt consolidation
Here are the upsides of consolidating debt. The points below apply to any debt consolidation method you choose:
- All of your credit card debt payments are rolled into one monthly payment. This means it’s easier to manage debt in your budget because you only have to worry about one bill payment to cover all of your unsecured debts.
- The interest rate applied to your debts is much lower. High-interest credit cards tend to have rates higher than 20 percent. The right debt consolidation option will typically reduce the interest rates applied to your debt to around 10 percent or less.
- You can pay off debt faster. Since the interest rate is lower, each payment you make puts more of a dent into your actual debt instead of getting drained away on added interest charges. As a result, you can pay off debt within a few years or less, instead of the decades it would often take on a minimum payment schedule.
- You can avoid credit damage. By consolidating debt, you stay ahead of it. As a result, you avoid the potential credit score damage that can come with late or missed credit card payments and defaulted accounts. You also stay out of bankruptcy, which according to studies, usually drops your credit score below 600 so you can get approved easily for most types of financing.
The cons of debt consolidation
In most cases, if debt consolidation is the right option in your financial situation, then there shouldn’t be too many downsides to using the process in general. Any disadvantages are usually specific to the particular method you use for consolidating – more on that below.
Here are the downsides of debt consolidation, in general:
- If you use credit before you pay off the consolidated debt, you dig yourself into a deeper hole. With some options, your existing accounts will have zero balances and you’ll be able to use them from day 1, so it can be tempting to starting making purchases on plastic. Even if your accounts are frozen because you’re using a debt management program, you may still have other credit cards or be able to open new accounts. Taking on any debt before you eliminate your consolidated debt is dangerous!
- If your payoff plan doesn’t work, you’ll be back where you started – or worse. Once you’ve consolidated your debt, you need to stick with the payment plan and make sure to make all of the payments on time. Otherwise, you risk damage to your credit and may face additional penalties. In some circumstances, if your creditors agreed to remove penalties and added interest when you consolidated, these will be brought back if you fail to keep up with your payments.
Comparing the pros and cons of consolidation options
Although all debt consolidation works in largely the same way, there are several different methods you can use that do the same thing. The different methods of debt consolidation have benefits and risks associated with each specific option, so it’s important to understand these so you can decide which way is the right way to consolidate for you.
The following chart can help you understand the upsides and downsides to the different options available for debt consolidation:
|Credit card balance transfer||Unsecured debt consolidation loan||Home equity loan||Debt management program|
|Credit score required to qualify||Excellent||Good||Fair||Any|
|Fees||High fees for each balance transferred||Loan origination / administration fees||Loan origination / administration fees||Low fees rolled into plan based on budget|
|Interest rate||Based on credit score – can be as low as 0% APR for up to 2 yrs.||Based on credit score – must qualify for APR lower than 10%||Based on credit score – must qualify for low APR||Negotiated by credit counselor – usually between 0%-11%|
|Collateral required?||No||No||Yes – you put your home at risk of foreclosure because it is put up as collateral||No|
|Accounts frozen during payoff||No||No||No||Yes|
|Credit score impact (if executed correctly)||Positive||Positive||Positive||Positive|
|Financial support||No||No||No||Free access to certified credit counseling|
In a basic sense, a balance transfer is usually a viable option for anyone with an excellent credit score who catches their debt problem early. The biggest downside is the higher fees you usually face for the transfers. Still, in the right circumstances, you can qualify for a new credit card that offers 0% APR on balance transfers for up to 24 months. That gives you two years to pay off your debt without any interest added.
When it comes to using a loan to consolidate your debt, an unsecured consolidation loan is almost always the better option if you can qualify for a low interest rate. If you can’t it is usually easier to qualify for a secured version like a home equity loan, but you’re putting a major asset at risk just to reduce your credit card debt. This is why most experts advise against using home equity loans to eliminate credit card debt because it’s just not worth the risk.
If you can’t use balance transfers and can’t qualify for an unsecured debt consolidation loan at the right interest rate, then the best option is often a debt management program because you protect your assets and still make an effective plan to eliminate your debt. You also get the added bonus of financial education and support from a certified credit counseling service so there’s a lot to gain from a DMP.
The only real downside is that your accounts are frozen while you’re enrolled, so you have to learn to live without your credit cards – but on the other hand, is that really a bad thing considering your credit cards are what got you into this situation in the first place? It’s often useful to use a DMP to break your bad credit use habits, so once you complete the program, you’re not so reliant on credit to get by day-to-day.