Is debt consolidation right for you? During turbulent times like these, facing unsustainable credit and loan payments is a real threat. Even if you scrape together enough money to make the minimum payments, a single emergency can derail you. Even without a crisis, hefty debt can be extraordinarily stressful.
Bankruptcy is one way to get out of debt, but it leaves a nasty stain on your credit record, and not everybody is ethically comfortable with it. Debt consolidation can be a strong alternative and attractive to people who aren’t in trouble but just want to maximize the money they spend on themselves and their families, rather than sending it to banks and lenders.
But debt consolidation is not for everyone, either. There is no one-size-fits-all, universal solution to personal finance. We can’t tell you if it’s the right fit for you, but we can run through the process to help you decide.
In This Article
Types of Debt Consolidation
Although you can find many debt consolidation options, most fall into one of three categories:
- Balance transfers, where you move debt from a high-interest account to an existing account with lower interest rates
- Consolidation loans, where you start a new loan at lower interest to consolidate your debt
- Consolidation companies, which handle the details of a consolidation loan for you and might negotiate with your lenders to reduce your balances
Whatever consolidation you pursue, the advantages are the same. You turn multiple monthly minimum payments into a single amount more significant than any of your previous individual minimum payments but smaller than the total of your expenses. The interest rate is lower than what you were paying. Often, the payment term is longer than your existing loans’, further reducing your monthly payments.
As we run the math, we’ll be looking at the potential disadvantages to consider.
Related: Prosper Debt Consolidation Calculator
The Math Behind Debt Consolidation, Step by Step
The goal of debt consolidation is to save you money over the life of the loan. As we move forward with the math, that’s the equation we will fill in. Keep that in mind.
The first number we’ll look at is the comparative interest rate. The concept is simple enough. If you were trading one loan for another, one at 10% APR and one at 6% APR, the decision would be obvious.
That’s not the situation for most people considering debt consolidation. In most cases, you’ll have five or six loans at different APRs, each with other balances. If the debt consolidation option has a lower interest rate than all of them, the answer is clear. But if one of the existing loans has a lower interest rate, it’s time to break out your spreadsheet and get to work.
It’s also important to consider the term of the loan. If you’re carrying $10,000 at 5% with a five-year payment plan, moving that to a 3% interest rate loan looks attractive. But if that loan is over a 20-year term, you end up paying more interest than you would have with your original lender.
Finally, look at how permanent the initial interest rate for your consolidation option is. If it’s a fixed-rate loan, it’s pretty simple. But a variable interest loan might cost you more money than the original debt. Be cautious with credit cards with a low introductory rate for balance transfers. Those only save you money if you can pay off most of the balance before the initial rate expires.
Cash Flow Comparison
The second consideration is your monthly cash flow with or without consolidating your debt.
Take a typical example of a family with six credit cards and a car loan. Every month, they’re making minimum payments on all seven. Let’s say the cards are $50 each, and the car loan is at $450, for a total of $750 in debt payments each month.
If they took out a home equity loan with a 15-year term, any deal where the monthly payment on that loan was $749 or less would free up money for them to spend in their monthly budget. It probably wouldn’t be worth the effort to save a dollar a month, but if the payment were $500, it would be a good deal.
By totaling your payments on debt before consolidation, then comparing it to the proposed monthly payment with consolidation, you can get a look at what your monthly expense rate would be.
If you can get a consolidation deal with lower interest and better cash flow, it’s almost always a good idea. In some cases, it can be worth paying a little more in interest over time if your cash flow improves substantially.
Not all debt consolidation options come with starting fees, but it’s essential to add those costs to the equation. Ask explicitly for a list from whoever is offering the product and include it in your calculations.
Some Payday lenders make their profit by publicizing low-interest rates but charging exorbitant fees. In some cases, those fees are as high as excessively high-interest rates.
Even more reputable lenders might charge enough in starting or initiation fees that the total cost of the loan makes it a bad idea. This is rare but always worth running the math on before making a final decision.
In addition to starting fees, some lenders charge you every month, year, or quarter. These might be labeled as “statement fees,” “membership fees,” “processing fees,” or other names. They’re usually small individually but can add up.
For example, if you took out $10,000 at 2% interest with a $20 monthly processing fee, it would cost you an extra $240 per year. That’s an additional 2.4% interest, more than doubling the actual cost of the loan.
When you do the math on periodic fees, work out the total cost based on how long it will take you to pay off the loan. Add that total to the interest to make an informed decision.
Penalty fees take two forms. The first is like periodic fees, where you’re charged a flat rate or a percentage of the balance if you make a late payment. For these, make a pessimistic estimate of how often you’ll pay late, then add that total to the cost of the loan.
The other form is penalty interest. Many debt consolidation loans start with a meager interest rate, even zero. But if you make a late payment, the contract says they get to increase your interest rate.
If you used a credit card with a low-interest balance transfer offer, it might rise to a higher percentage rate for the card. For some consolidation options, it even backdates the change to when you made the initial transfer.
Think very carefully if you’re considering a debt consolidation option with penalty interest. In most cases, one mistake can make the whole deal more expensive than not consolidating. Only you know how much actual risk there is of making that mistake.
Your Credit Score
If you consolidate debt by taking on a new loan, it will impact your credit score. On the bright side, you’ll have more available credit when the loan activates, which can immediately improve your credit. However, applying for a loan will reduce your credit score.
Over the long term, if you’re able to make the lower payments regularly, consolidation can help you improve your credit rapidly as you’ll have an easier time making all your payments on time.
It’s hard to run the exact math of how much your credit score will improve and when, but it’s worth keeping in mind as you make this decision.
Only you will know if the interest savings and cash flow outweigh the risks of fees and are worth the effort and time it takes to make it happen. But if you run the numbers on the points we discussed here, you’ll be able to make an informed decision.
To decide if debt consolidation is right for you, ask yourself these questions:
- Do you have a lot of unsecured debt? Unsecured debt is any debt that does not have physical property as collateral against it, like your credit card bills. If yes, then consolidation is a good option. Don’t consolidate against secured debt, like your home, or you may end up losing it if you miss payments.
- What are the APRs on your credit cards? The average credit card rate can range from 16 to 19 percent, but when you don’t pay your minimums, this range jumps to 23 to 29 percent. If you are in the latter range, you should look to consolidate, as you will likely get a better rate.
- Do you have good credit? Your credit score will dictate how low a rate you can get. If you have a credit score of 640 and above, online marketplace lenders such as Prosper could be a great option to make it easy for borrowers to consolidate high-interest debt. Instead of juggling multiple bills with varying high interest rates, you can take out a loan to pay off all your debt, and then simply repay the one loan at a lower interest rate. Loans offered through Prosper have rates that are typically lower than credit cards. In addition, loans are fixed-rate, fixed-term with no prepayment penalties.
If you want to explore consolidating your debt, here is what to do next.
- Set up a counseling session. A credit counselor can help you look at your finances holistically and identify the best avenue to reach your debt-free goals.
- Do the math: Consolidating via a marketplace lender like Prosper can save you a lot of money. Let’s say you put a $10,000 medical expense on your credit card. According to Bankrate.com, if you just pay the minimum each month, it will take 28 years to pay off your debt, and you will end up spending more than $12,000 in additional interest payments. Compare that to marketplace lending, where you can pay off your debt in three years with a fraction of the interest payments—savings could amount to more than $11,000.
- Research a good credit agency. Many agencies have high service fees and interest rates that are very comparable to other creditors, so do your homework. Look for an agency that belongs to either the National Foundation for Credit Counseling or the Financial Counseling Association of America. Marketplace lending is a smart approach for debt consolidation because of its low interest, fixed rates, fixed terms, and lack of prepayment penalties or hidden fees. It’s also fast, with most people getting their money in 3-5 days.
- Know that your work isn’t done. Refinancing your debt is only the first step. As you would with a credit card company, make sure to stick to your plan to make timely, regular payments over the course of your loan term. Remember that your debt still exists—it just looks different (and a lot better!).
If all of this sounds and looks overwhelming, don’t be deterred. You’ve taken the first step of educating yourself about your options. With the right partner and some reorganization, discipline, and perseverance, you will be on your way to financial well-being.
Is debt consolidation right for you? Final Thought: Changing Habits
Before considering a debt consolidation offer, also consider the circumstances that got you into debt in the first place. If it was a one-time event like a medical bill, period of unemployment, or going back to school, you’re likely in good shape.
If you got into debt trouble through the accumulated effects of bad spending habits, then debt consolidation could be a wrong move. After you commit to the (often substantial) payment for your consolidation loan, you might start racking up balances on your credit cards again. A year later, you’d be in trouble again, plus you’d still have the burden of your consolidation — and you’d likely be out of luck for reconsolidating again.
Benjamin Baker is a freelance writer who specializes in consumer finance.
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