Debt consolidation is usually billed as a smart financial move, because it can boost your credit score and save you money.
But a few mistakes could actually hurt your credit or cost you more money in the long run. Here’s what to keep in mind when deciding whether to consolidate your debt and how to choose the best way to do it.
How Does Debt Consolidation Work?
Debt consolidation usually means taking out a loan to pay off existing debts, most commonly credit card debt.
These are technically personal loans that lenders often market as “debt consolidation loans,” which isn’t inaccurate; it’s just their way of letting you know how they can help you.
You’ll take out the loan, receive the funds and use them to pay off your credit card balances. Then you’ll repay the loan over time like any other loan.
You could also consolidate with a balance-transfer credit card or other kind of loan, such as a retirement account loan or home equity loan. However, personal loans typically have the advantage of lower interest rates and no collateral requirement.
People with a lot of high-interest debt tend to look to consolidation because it simplifies repayment, and could reduce the cost of the debt through lower monthly payments, a lower interest rate or both.
Pros of Debt Consolidation
- Replace a bunch of monthly payments with just one.
- Potentially get a lower interest rate.
- Potentially owe less each month.
- Boost your credit score — we’ll talk about how below.
Cons of Debt Consolidation
- The debt might cost you more over time.
- Some mistakes could hurt your credit score — we’ll talk about what to avoid below.
- You’ll owe one large monthly payment, instead of several spread over the month.
- Your payment could be larger than minimum credit card payments.
- You might pay fees upfront or over time.
Alternatives to Debt Consolidation
You might come across companies offering one of several ways to fix your debt. They’ll each have a different effect on your credit score and apply to different situations:
- Consolidation refers to “combining” several debts into one. A single loan or credit card pays off the balance on several others, so you’re left with just the one line of debt. Consolidate debt when you want to streamline repayment of several debts.
- Refinancing works like consolidation, but the term usually refers to paying off a single debt. You pay off one loan balance with a new loan that gives you a better interest rate and repayment terms. Refinance your debt if your credit and finances have improved since you first borrowed.
- Debt relief is an umbrella term that includes consolidation and refinancing, and it often includes some amount of debt forgiveness. The term is often used by companies that facilitate debt consolidation or a “debt management plan” — you’re generally best off doing a little research and managing the debt on your own.
- Settlement is when you agree with a creditor on a reduced repayment amount that it’ll consider payment in full. This will show up on your credit report and could have a negative impact for several years, but will help you pay off the debt faster.
- Restructuring is more common for companies than individuals and usually happens in dire situations. The effect is similar to refinancing, but it involves reorganizing the existing debt rather than replacing it with a new one.
Do You Need Good Credit to Consolidate Debt?
You don’t necessarily need a high credit score to take out a loan for debt consolidation, but better credit gives you a better chance at a low interest rate and favorable terms.
Watch out for predatory lenders if you have a low credit score; some unscrupulous companies are willing to give you a loan you can’t afford with a super high interest rate. A loan you can’t afford to repay could put you in a worse situation than you are with credit card debt.
Does Debt Consolidation Affect Your Credit Score?
Consolidating debt could help your credit score in two major ways:
- Lower your credit utilization: The amount of available credit you use weighs heavily into your score. A bunch of maxed-out credit cards looks bad. Consolidation pays off those balances and reduces your utilization.
- A positive line on your credit report: The loan is a way to demonstrate your creditworthiness as long as you stay current on payments.
Consolidation itself doesn’t leave a negative mark on your credit report, like debt settlement does. But the loan (or credit card) shows up as a new credit line, which could temporarily lower your score.
How to Consolidate Credit Card Debt Without Hurting Your Credit
A few common debt consolidation mistakes could hurt your credit score or cost you money. Here are a few tips to make the right decision for your situation.
Don’t Close the Paid Accounts
After you pay off credit cards, don’t close every account. Having them on your credit report affects these factors that make up your credit score:
- Age of credit history: Creditors want to see you’ve been around the block with credit. When you close old cards, your average credit history gets shorter.
- Credit mix: This is the variety of types of debt you have — installment loan versus credit card versus mortgage, for example. It has a small but significant effect on your credit score.
- Utilization: More cards open means more available credit. Cut up your cards to avoid growing that balance again, and that unused credit will keep your utilization ratio low.
Keep up With Payments
Your credit card consolidation loan or balance-transfer credit card is still debt with monthly payments you have to keep up with.
Budget before you take out the loan so you know you can afford the monthly payment. Staying on top of the payments should help your credit score over time — but getting behind will hurt.
If you opt for a balance-transfer card — which usually comes with an introductory 0% APR for about a year — plan to pay the debt off during the introductory period. Any longer, and you’ll probably face a high interest rate and annual fees.
Compare Consolidation Options
Shop around before committing to any debt consolidation option. Consider what kind of consolidation — personal loan, balance-transfer card or secured loan — works best for you based on your budget, existing debt and creditworthiness.
Online loan marketplaces can help you quickly see and compare personal loan offers from lenders side by side.
To evaluate a debt consolidation loan, consider:
- Interest rate: Aim for an interest rate that’s lower than the combined rate on your existing debt. A loan with a higher rate could still give you the relief of a lower monthly payment and fewer creditors, but it will cost you more money.
- Monthly payment: Reorganizing your debt to land a smaller monthly payment could outweigh the long-term savings you’d get with a shorter repayment term or lower interest. A smaller bill could make the difference between paying on time or not, which has a major impact on your credit score.
- Fees: Read the fine print to understand the total cost of consolidation. A personal loan might come with an origination fee, and a balance-transfer card might charge an annual fee after the first year.
- Repayment term: The longer you have to repay the debt, the smaller your monthly payment will likely be — and the more time the balance will have to accrue compounding interest, which will cost you more money over time.
Refinance Again in the Future
Maybe your best option now is to take out a loan at a high interest rate and a long repayment term. If that gets you on track with debt payments, it could be what you need to boost your credit score.
Just don’t stick yourself with those bad terms for the long haul.
As your score rises and you get a handle on your monthly budget, consider refinancing the loan to get better terms in the future.
Dana Sitar (@danasitar) has been writing and editing since 2011, covering personal finance, careers and digital media.