The Pros and Cons of Debt Consolidation

Debt consolidation involves taking out a loan and using it to pay off multiple smaller loans or debts. With just one debt, you don’t have to worry about different payment due dates and interest rates. Simplifying can be great, but debt consolidation isn’t for everyone. You can end up paying more in the long run or putting your assets at risk without realizing it. 

You can make the best choice for your financial situation by taking a look at the advantages and disadvantages of consolidation and your different consolidation loan options. 

The Pros of Debt Consolidation

Consolidating debts is a form of debt relief that involves taking out a single loan to pay off multiple debts. There are advantages and disadvantages. The advantages include:

• You just have one monthly payment. The consolidation loan has one payment. You can say goodbye to multiple debt payments and interest rates. This can also reduce the risk of missing a payment or making a late payment.  

• You can improve your credit score. Lowering your credit card debt can lower your credit utilization ratio. This ratio compares your total available credit to your unpaid credit balance. A lower ratio improves your credit score.  

• You may get a lower interest rate, A consolidation loan may have a better interest rate than your current high-interest debt. But you’ll need to consider this one carefully. The interest rate for the consolidation loan needs to be compared to the weighted average interest rate of the consolidated debts. If it’s lower, you’ll be saving money and you’ll have lower monthly payments. 

The weighted average interest rate is the average interest rate on all your loans, adjusted for how much you owe on each. It’s more accurate than just using the average interest rate because it accounts for the amount of each debt. A $10,000 loan, for example, carries more weight than a $1,000 loan. If the rate on the $10,000 loan is 12% and the rate on the $1,000 loan is 4%, the weighted average interest rate is 11%. 

This is computed in two steps. First, multiply each loan balance by its interest rate and add the amounts together: (10,000 x .12) + (1,000 x .04) = 1,240. Second, divide this amount by the total debt: 1,240 ÷ 11,000 = 11 (or 11%).

You should be able to get a fixed interest rate with most consolidation loans, which will help with your budgeting. Your payment amount may also be lower if the consolidation loan has a longer repayment term than the debts you consolidated. But this could mean you pay more in interest down the road.

The Cons of Debt Consolidation

Though there are several advantages of debt consolidation, that’s only half the picture. You’ll also want to consider the disadvantages, which include:  

• The interest rate may be higher. The interest rate can easily go the other way. Depending on your credit history, you may not qualify for a low enough interest rate for a consolidation loan to be worth it. If the rate on the consolidation loan is higher than the weighted average rate of the consolidated debts, it may cost you more and your monthly loan payments may be higher. For example, assume the weighted average interest rate for your consolidated debts is 11%. If the consolidation loan rate is greater than 11%, you’d be increasing your total debt cost.    

• You could get hit with late fees. The consolidation loan will likely have a longer term than your current debts. If your budget changes down the road and you miss payments, the late fees could add up.  

• You could use the credit you pay off. The consolidation loan will free up your credit cards. That may cause you to think you have more money to spend, which can lead to more debt. Using the freed-up credit cards can also increase your credit utilization ratio, which will lower your credit score.

• The underlying problem may still be there. Some borrowers may not be making enough money to pay off their debts. Debt consolidation won’t fix underlying financial problems and you could end up with too much debt to handle.       

Having a single payment each month is nice. But to figure out if a debt consolidation loan is right for you, you’ll need to know what interest rate you can get and check in with your spending habits. To make the right choice, you’ll also want to consider the pros and cons of the specific type of debt involved.  

Types of Debt Consolidation

There are two main types of consolidation loans: unsecured loans and secured loans.  

Unsecured Debt Consolidation Loans

Unsecured loans aren’t secured by any of your assets. Credit card debt is typically unsecured. There’s nothing for creditors to take back if you default on your credit card debt.  

• Pros: Your assets can’t be seized if you default. Also, in most cases, unsecured debt can be discharged in a Chapter 7 bankruptcy. You can also consolidate secured debt into an unsecured consolidation loan, which converts it to unsecured debt.  

• Cons: Unsecured loans often come with higher interest rates than secured loans. It may also be harder to qualify for an unsecured loan.  

The following types of unsecured loans also come with their unique advantages and disadvantages.  

Personal Loans

Many banks and online lenders offer personal loans which can be used as consolidation loans.    

• Pros: You get to choose how to spend the money. Personal loans have a set term, usually 3-5 years. This means you’ll know how long it’ll take to pay it off. Paying off credit cards with a personal loan is common, and it helps you avoid falling into the trap of making only the minimum payments. This is how interest charges pile up.  

• Cons: Because it’s unsecured debt, the interest rates are just okay. You need a good credit score to get favorable terms. There may also be application fees and prepayment penalties.    

Balance Transfers on Credit Cards

A credit card balance transfer involves transferring the debt from one or more credit cards to a new credit card.  

• Pros: It’s easy to do, and balance transfer cards usually offer a promotional 0% APR for a limited period of time, typically 6-18 months. That can save you a lot of money in interest if you pay off the card during that time.  

• Cons: There may be balance transfer fees, ranging from 3-5%. Also, the initial 0% APR period will end and the new interest rate could be high. Finally, there may be terms lurking in the fine print. For example, payments on the new card may be applied to the transferred balance first (with the 0% APR), which allows any new charges to accumulate higher interest rates.

Debt settlement is another option to eliminate credit card debt. Unlike consolidation, debt settlement involves asking the creditor to accept less than what you owe.     

401(k) Loans

A 401(k) is an employer-sponsored retirement plan. There are penalties for withdrawing funds before you reach age 59½, but you can often borrow from the plan. The money in the plan is yours, so you’re essentially borrowing from yourself and paying yourself back over time. You just don’t get to make the rules.     

• Pros: These loans often have very low interest rates. You can also get the money quickly with a simple application process and no credit check. You have five years to pay it back.

• Cons: The five-year term can also be a disadvantage if it catches you short. If you can’t repay the loan, it will be considered a withdrawal and you’ll owe the IRS taxes and penalties. The borrowed money loses the investment benefits it had in the plan. The money inside the 401(k) is protected from creditors, but the loaned funds aren’t.  

Secured Debt Consolidation Loans

Secured loans are secured by your assets which the lender can take back if you don’t pay the loan. A home mortgage is a type of secured loan. When you default on your mortgage, the lender can repossess your home through foreclosure.      

• Pros: Secured loans usually come with lower interest rates than unsecured loans. It may also be easier to qualify for a secured loan because there’s less risk for the lender. You can often get a longer term with a secured loan, which can spread out and reduce your payments.    

• Cons: If you fail to pay the loan, the lender can take back the collateral and possibly other assets. With the longer term, you may end up paying more over the life of the loan in interest. As a general rule, the sooner you can pay off debt the better. If you consolidate unsecured debt with a secured loan, you will be converting the unsecured debt into secured debt.  

The following types of unsecured loans also come with unique advantages and disadvantages.  

Mortgage Refinance

Mortgage refinancing involves replacing your current mortgage with a new one, often with a new interest rate, loan term, and principal amount. The lender will use the new debt to pay off the old loan. If you borrow more than you currently owe, you can use the remaining funds to consolidate your debt. You’ll need equity (value exceeding debt) to do that.  

• Pros: The interest rates are usually lower than other home equity loans, discussed below, because the lender has a first mortgage on the property. There’s also a flexible repayment term from 10-30 years.  

• Cons: You could lose your house through a foreclosure sale if you don’t make the payments. You’ll also have to pay closing costs and they can add up. These include origination fees, appraisal fees, credit report fees, and title service fees.

If you do refinance, ask for your mortgage officer’s Nationwide Mortgage Licensing System (NMLS) number. It lets you know they’re licensed and the NMLS number allows you to check for past violations and suspensions. 

Home Equity Line of Credit (HELOC)

Another way to cash in on the equity in your home is with a HELOC. This is an open-ended line of credit where your home serves as the collateral. The amount you can borrow will depend on the equity you have in your home.     

• Pros: You can draw on as much of the line of credit as you want and choose how to spend the money. You’re only charged interest on the amount you borrow. The interest rate will be low but may be higher than the mortgage refinance rate. The term of the loan is relatively long, often with a 10-year borrowing period and a 20-year repayment period.  

• Cons: You may lose your house if you don’t repay on time. Variable interest rates are common with these loans, so the interest rate may go up over the life of the loan. Also, loan fees may be high. The terms are often so good it will be easy for you to access and spend the money. That can lead to problems if you overspend.  

Second Mortgage

You can also take out a second mortgage on your property. Like a HELOC, this involves borrowing money against the equity in your home (also called a home equity loan). It differs in that the loan is fixed and you receive the money upfront. The pros and cons are similar to those of a mortgage refinance.  

• Pros: There’s a low interest rate, but it may be higher than the mortgage refinance rate. The first mortgage generally has a better interest rate because they’re first place in line if there is a foreclosure sale. You’ll also have a flexible repayment term.  

• Cons: As with the other home equity financing, you could lose your house if you can’t make the payments. Closing costs can be high, but they’re generally less than the costs for a mortgage refinance. People often borrow more money than they need and pay for it later with even more debt.  

Federal Student Loans

Consolidating federal student loans into one loan with a single payment and interest rate can simplify your payments. You can consolidate all federal loans into a new federal loan or into a private loan. You can also extend the term and reduce the payment each month, but you’ll pay more in interest over time. 

If you combine the loans into a new federal loan, the interest rate will be the average rate on the old loans. You won’t get a rate reduction. You can get a better interest rate if you consolidate with a private loan. But by converting the loans into private loans, you may lose out on federal loan benefits, including possible deferment and forgiveness. These loans don’t qualify as secured debt, but they’re also not like traditional unsecured debt due to some unique repayment rules.  

Let’s Summarize…

Consolidating debt means taking out one loan and using it to pay off multiple debts or loans. This can simplify your life by eliminating the hassle of having to make multiple monthly payments on loans with different interest rates. But that’s just the beginning when it comes to knowing whether or not a consolidation loan is the right kind of debt relief for you. 

Consolidation comes with advantages and disadvantages, as does each type of consolidation loan. If you can get a better interest rate, you can save a lot of money. Secured loans have lower interest rates than unsecured loans, but you have to put your assets on the line. Home equity loans are a popular type of secured consolidation loan, but they can have significant fees. Knowing all of the pros and cons can make the decision a lot easier and, more importantly, help you make the choice that helps you the most.