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Why consolidate your debt | The bank rate

If you are heavily in debt, you are not alone. According to Federal Reserve Bank of New York, total US household debt in the first quarter of 2022 was $15.84 trillion. This represents an increase of $266 billion from the fourth quarter of 2021.

As consumer debt — including credit cards, auto loans, personal loans, student loans and mortgages — continues to mount, many are looking for ways to find relief. A viable option to get out of debt faster is to consolidate, which can be done through a personal loan, balance transfer credit card, or home equity product. Before moving forward, weigh the pros and cons to determine if it’s right for your financial situation.

Reasons to consolidate your debts

Debt consolidation, which involves combining two or more outstanding balances into a single debt product, is the preferred choice for getting out of debt for several reasons. Here are some of the benefits of this approach.

Simplified payments

It can be overwhelming keeping track of payment due dates when you owe multiple creditors. But when you consolidate outstanding debt balances into a loan or credit card product, you only make one payment to one creditor per month. This minimizes the risk of making late payments that result in excessive charges or damage to your credit score.

Lower interest rates

Consumers with good or excellent credit generally qualify for competitive interest rates on debt consolidation loans. As of June 10, 2022, the average credit card interest rate was 16.53%, compared to between 10.3% and 12.5% ​​for personal loans for borrowers with excellent credit.

Even if you have good credit, the average rate is still between 13.5% and 15.5%, which is lower than what you’ll find with most credit card products. And the less interest you pay, the higher the amount applied to the principal balance each month, allowing you to get out of debt faster.

Fixed repayment schedule

A debt consolidation loan gives you a fixed payment schedule and predictable monthly payments. Plus, it’s much easier to fit the payments into your budget, because there won’t be any guesswork about how much the minimum payments will be each month.

Credit increase

When you apply for a debt consolidation product, your credit score may drop a few points due to the credit investigation. However, you might see improvements sooner rather than later for several reasons.

Every time you make timely payments on your debt consolidation loan or credit card, a positive payment history is added to your credit file. Payment history makes up 35% of your credit score, so you’ll likely see an increase over time.

Your credit utilization, or the amount of your credit limit currently used, will also improve if you consolidate and refrain from using the cards you are paying off. It’s a component of amounts owed and makes up 30% of your credit score, and keeping that number at 30% or less gives you the best chance of getting a solid credit score.

To illustrate how this works, let’s say you have five credit cards with limits of $1,000. You owe $500 on each, bringing your usage to 50%. If you take out a $2,500 loan and pay off the balances, your utilization will drop to zero, which will increase your credit score. But if you choose to use a balance transfer credit with a credit limit of $5,000, your usage will decrease to 25% ($2,500 for amounts owed / $10,000 total credit limit).

Faster debt payment

If you’ve been required to make minimum payments on your credit card each month, paying off what you owe could take years. To illustrate, suppose your credit card balance is $5,000 and the annual percentage rate (APR) is 18.9%. Paying only the minimum of $200 per month will cost you $3,109.16 in interest and you will spend 137 months paying off what is owed to you.

However, a debt consolidation loan helps speed up your debt repayment efforts by giving you a fixed interest rate, loan term, and monthly payment. Using the example above, if you take out a debt consolidation loan of $5,000 with a term of 3 years and a fixed interest rate of 11%, you will pay $164 per month and $892.97 interest over the term of the loan.

When not to consolidate your debts

There are also times when consolidating your debts may not be a good idea. If your credit rating is low, you’ll probably find it difficult to get a debt consolidation product with a lower interest rate than you currently have.

You should also avoid debt consolidation if you don’t have a realistic budget. The same applies if you are not yet disciplined with your spending. Both of these issues put you at risk of racking up even more debt, especially if you take out a loan to pay off your credit card balances and use credit cards again if you spend more than you earn and need to pay. money fast.

It is equally important to confirm that you can afford the repayments of a debt consolidation loan. Otherwise, you risk damaging your credit rating if the account becomes delinquent. There is also a greater likelihood of resorting to other debt options to stay afloat financially.

At the end of the line

You could get more affordable and predictable monthly payments and possibly eliminate balances faster by consolidating your debt. Also, your credit score may increase. But you’ll need to assess your situation to make sure debt consolidation makes sense and the option you choose is right for your spending plan.