High interest debt can feel like quicksand. The more you struggle to get out from under it, the deeper you seem to sink. When interest rates on debt are high, it creates a vicious cycle where many consumers are stuck paying off the interest part of their obligation without making a dent in the principal. If you’re stuck in one of these seemingly endless debt spirals, you need a plan that involves more than just treading water. One way to manage your debt is through consolidation, but this may not be theperfect solution that many financial gurus claim. Here are some of the pros and cons of consolidating your debt.
How Does Debt Consolidation Work?
Before streaming services took over our televisions, there was (and still is!) cable TV services. Cable TV is a large package of channels that can be accessed through your cable provider for a single price. You don’t need to pay the ESPN bill, the HBO bill, and the HGTV bill; you simply pay the cable company a single bill for all the included services.
That’s kind of how debt consolidation works – putting all your obligations into a single payment. If you have high interest debt, it likely comes from a few different sources like credit cards and student or auto loans. Debt consolidation allows you to pool all these different debts together into one monthly payment, which is often much easier to manage than tracking multiple loans and credit cards every month.
Debt consolidation is usually achieved in one of two ways: through a personal loan or a balance transfer on a new credit card. Personal loans almost always have lower interest rates than credit cards, and balance transfers provide you a 12 to 18 month window to play “catch up” without being hit with interest fees.
Consolidating debt can lower your overall monthly obligation while also reducing the timeframe over which you’d be paying down your debt.
What Type of Debt Should Be Consolidated?
Not all debt is bad debt. For example, taking out a 30-year fixed mortgage isn’t a bad idea. In fact, a 30-year fixed mortgage at today’s rates is one of the better uses of your capital since the borrow rate is around 3% and inflation is currently ticking in at over 6%. Student loan debt is another type of obligation that may not be the best to consolidate. If you have federal student loans that could be forgiven under a program like Public Service Loan Forgiveness, you could lose that benefit if you consolidate or refinance your loans.
The main culprit you should be looking for is high interest debt, like the kind incurred from credit cards, auto loans, or private student loans. Credit card debt is an especially nasty little vulture that can sink your credit score and keep you in a perpetual interest-only payment cycle. You never want to carry a balance on your credit card month over month thanks to exorbitant interest rates that often top 20%. Imagine paying 20% interest on your house or car – you’d never want to finance a home or vehicle again!
Who Should and Shouldn’t Consolidate Their Debt?
Even if you have high interest debt, a consolidation plan may not be ideal. Remember, the goal of debt consolidation is to reduce your burden through either a lower monthly payment or a reduced interest rate to shorten the life of the loan. If your credit score has improved enough since you accumulated the debt, you may even be able to achieve both.
But, also remember that balance transfers and personal loans aren’t free. A personal loan will have an origination fee that’s tacked on top of your debt load and a credit card balance transfer will usually charge you between 3% and 5% of the amount you’re transferring. If you don’t have a plan for escaping your debt within the time frame of the balance transfer, you’ll likely find yourself right back where you started: paying off interest-only each month as your principal doesn’t budge. A balance transfer card doesn’t solve your debt woes, it just provides a little extra time to formulate a plan.
A personal loan is usually the best way to go for a reduction in your debt load. But getting a good rate on a personal loan means having good credit. And if you’re struggling with paying down debt, you may not have the type of credit history lenders are eager to capture. Let’s say you have $20,000 in credit card debt (with an average interest rate of 15%) and you want to pay it off in three years. You apply for a personal loan, but the best offer is a 3-year loan at 12% with a $1500 origination fee. Paying down $20,000 at 15% over 3 years would mean the total sum of your 36 monthly payments is $24,959. The personal loan at 12% with a $1500 origination fee would result in a 36 payment sum of $25,707 – nearly $1000 extra over the life of the loan!
If you can get a good rate on a personal loan that reduces your overall debt load, consolidation is a great idea. Balance transfer cards are a great way for debtors to buy time by only paying a monthly minimum at a 0% introductory rate. But if you can’t access a good loan or balance transfer card, consolidation is just rearranging the deck chairs on a sinking ship. Consider both your monthly payment AND the overall amount you’d owe over the life of the loan when debating debt consolidation.
Disclosures
The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.