Understanding Debt Consolidation: A Comprehensive Guide

Debt consolidation is a financial strategy that involves combining multiple debts into a single loan or credit card balance. This approach can simplify your debt repayment plan, potentially offering a lower interest rate, a more favorable repayment schedule, and a shorter payoff timeline. In this blog, we will explore the ins and outs of debt consolidation, its benefits and drawbacks, and whether it might be the right choice for you.

How Does Debt Consolidation Work?

Debt consolidation is primarily designed for individuals with multiple debts, such as credit card balances, unsecured personal loans, and medical bills. By using a new loan or credit card to pay off these balances, you can combine all your monthly payments into one. This can make managing your debt more straightforward and less stressful.

There are several ways to consolidate debt, but the two most popular options are balance transfer credit cards and debt consolidation loans.

Balance Transfer Credit Card

A balance transfer credit card offers an introductory 0% annual percentage rate (APR) promotion, which can last up to 21 months. During this period, you can pay down debt transferred from another credit card without incurring any interest. Some balance transfer credit cards also offer welcome bonuses, rewards, and other perks.

However, balance transfer credit cards typically charge an upfront fee of 3% to 5% of the transfer amount. Additionally, you may have a deadline by which you need to request the transfer to qualify for the 0% intro APR promotion. It’s also important to note that you won’t know your new card’s credit limit until you’re approved, which may not be sufficient to cover your full balance.

Debt Consolidation Loan

A debt consolidation loan is a personal loan that you can use to pay off credit cards, medical bills, and other types of debt. While personal loans don’t offer a 0% APR promotion, you may be able to secure a lower interest rate if you have good or excellent credit. This can be particularly beneficial for consolidating credit card debt.

Personal loans offer a fixed repayment schedule, typically ranging from one to seven years. This feature can be especially helpful for individuals with credit card debt who struggle to stick to a payment plan. Some personal loan companies charge an upfront origination fee, which can range from 1% to 12% of the loan amount. However, you may be able to avoid this fee if you have good or excellent credit.

Debt Consolidation vs. Debt Settlement

Debt settlement is another method for managing debt, but it differs significantly from debt consolidation and comes with several risks. With debt settlement, you negotiate with your creditors to pay less than what you owe. You can attempt this yourself or hire a debt settlement company to do it for a fee.

However, settling your debt for less than what you owe can have major negative consequences for your credit score, as your payment history is the most critical factor in your credit score. Additionally, debt settlement companies often advise you to stop making payments on your debts while saving up for the settlement amount, which can cause your credit scores to plummet further.

In contrast, debt consolidation can impact your credit score when you apply for and open a new loan or credit card. But as long as you make your payments on time, there likely won’t be any long-term damage. In fact, if it helps you avoid late payments and you pay the loan as agreed, debt consolidation can even improve your credit.

What Credit Score Do You Need for Debt Consolidation?

Balance transfer credit cards typically require good credit or better for approval. A good FICO® Score starts at 670, but credit card issuers may have their own minimum score requirements. They will also consider other factors, such as your credit history, income, and other debt.

Personal loans are available to borrowers across the credit spectrum. However, if you have fair or poor credit, you may struggle to qualify for an interest rate low enough to save money. Personal loans for bad credit are also more likely to charge costly origination fees.

While it’s not technically required to have good credit to get a consolidation loan, having good credit will give you a better chance of securing favorable terms.

Does Debt Consolidation Hurt Your Credit?

Consolidating your debt can cause a slight temporary decrease in your credit score due to the hard inquiry the lender makes when you apply for credit and the new credit account, which reduces your average age of accounts.

If you get a balance transfer credit card, your credit could also dip if the transfer results in a high credit utilization rate on your new card. However, as you pay down the balance, your credit score will likely improve.

If you use a consolidation loan to pay off credit card debt, your utilization rate won’t be a factor since credit scoring models only consider utilization of revolving credit (such as credit cards). In fact, reducing your utilization rate on your credit cards to 0% can potentially help your credit score.

Pros and Cons of Debt Consolidation

As you consider whether debt consolidation is right for you, it’s essential to weigh both the benefits and drawbacks.

Pros

• Interest savings: Whether you choose a balance transfer credit card or a personal loan with a lower interest rate than what you’re currently paying, you could potentially save hundreds of dollars on interest charges.
• Repayment flexibility: With a balance transfer card, you could get a 0% intro APR promotion for anywhere between 12 and 21 months. If you have a lot of debt and need more flexibility with your monthly payment, a debt consolidation loan offers more options, making it easier to find a term that works for you.
• Easier to manage: Consolidating your debts combines multiple monthly payments into one, making it easier to manage your repayment plan.

Cons

• You may not qualify: If you don’t have good or excellent credit, you may struggle to get approved for a balance transfer card or a low-interest debt consolidation loan. Even if your score is in good shape, you may not get the terms you’re looking for if you have a significant amount of debt.
• There may be upfront fees: Balance transfer credit cards often charge a balance transfer fee on a 0% APR promotion. While you can get a personal loan with no origination fee, your options may be limited if your credit isn’t near perfect. These fees aren’t necessarily a deal-breaker, but don’t forget to include them when calculating your potential savings.
• It could lead to more debt: Consolidating your debt can put you in a better position to pay it down, but it doesn’t change the circumstances that put you in debt in the first place. Unless you have a clear plan for avoiding more debt, freeing up available credit on a credit card with another card or a personal loan could put you in danger of racking up another balance.

Should You Consolidate Your Debt?

As you weigh the advantages and disadvantages of debt consolidation, think carefully about how they apply to your situation and goals.

Debt consolidation can be beneficial if you have good or excellent credit and enough debt that you stand to save at least a few hundred dollars in interest. If you’re considering a balance transfer card, ensure you can afford to pay off your debt within the promotional period and have the discipline to stick to your repayment plan. If you’re considering a personal loan, make sure you can afford the monthly payment—while extending your loan term can reduce your payment amount, it could neutralize your interest savings.

Finally, consider debt consolidation if you have a plan to avoid adding more debt. This may be easy if your debt is largely due to circumstances outside of your control. But if it’s a result of overspending, you may need to make significant changes to your budget and spending to avoid making matters worse.

Review Your Credit Before Applying for Debt Consolidation

In many cases, you can get prequalified for a personal loan or a credit card. To ensure you have all the information you need to evaluate your options, check your credit score and credit report for free with Experian. Knowing where you stand will help you pinpoint areas of your credit profile that need improvement before you start the consolidation process.

If you need assistance with debt consolidation or any other mortgage services, O1ne Mortgage is here to help. Call us at 213-732-3074 to speak with one of our experienced loan officers. We are committed to providing you with the best possible service and helping you achieve your financial goals.