Pros-and-cons-of-debt-consolidation

Pros and cons of debt consolidation

Being debt-ridden is nothing less than stress. In the second quarter of 2022, the American debt reached an astounding USD 16.5 trillion, according to New York Federal Reserve.

When you are knee-deep in debt, you want some quick relief. You need breathing space. Debt consolidation can be that exactly. It is a financial solution that helps you pay off your debts more quickly and reduces the overall interest rate on your debt. 

A debt consolidation loan is an agreement between a borrower and lender in which the borrower agrees to pay off all of his or her outstanding debts with one new loan. The borrower then pays back this single loan over time at a lower rate of interest than he or she would have paid on each individual creditor.

However, there are disadvantages, too, so you must weigh carefully before deciding. It’s crucial to understand the terms and conditions of the consolidation.

Read on to find out the complete pros and cons of debt consolidation.

How does debt consolidation work?

Debt consolidation is a debt relief option that consolidates multiple debts into one loan. People often take debt consolidations to reduce debt payment amounts, lower interest rates and receive reduced monthly payments.

Debt consolidation can also offer a consolidator credit counseling and loan repayment assistance.

However, debt consolidation can take longer than other debt-relief options, and it may not be the best solution for everyone.

Read: What is debt consolidation?

Pros of debt consolidation

So let’s have a look at some of the benefits of debt consolidation

Saves money by lowering interest rates

Debt consolidation is widespread because it helps you save money. It is a mutually beneficial relationship. The lenders benefit by buying your loans from several competitors and consolidating you as a payee will benefit from the low-interest rates they will provide to woo you. 

Depending on your situation (considering your credit score and income), you may want to window shop all of them. However, the best thing that can happen to you is a balance-transfer credit card. It can provide you with a 0% APR introductory rate. 

There is a cache to it. You will have to pay the loan amount within the given time frame of the introductory period. After that, you will have to pay interest on the remaining amount if you can’t. So our suggestion is to pay whatever you can as fast as possible and try to get rid of the bulk of the principal amount asap.

Reduce stress with one monthly payment

The last thing you need is to manage multiple loans and credit cards on top of everything else you have going on. You’ll probably miss a payment, which could cause your FICO to drop and incur late fees.

It is one of the pros of debt consolidation people ignore. You will now have only one payment to worry about instead of keeping track of the umpteenth monthly payment.

Lower monthly payments

It is a trade-off that you must understand. While the goal is to save money however, if lowering your monthly payment is your priority, you may end up paying more. 

However, even though you could lower the interest rate, because of the extended loan terms, you’ll end up paying more over the life of the loan. 

I suggest you consider it only if you are trying to get some room for your monthly budget.

It may boost credit score

Every lender will make a hard credit inquiry when you apply for a loan. Unfortunately, it will result in a temporary dip, but you can conveniently ignore it if you look at the overall picture. 

Once a lender approves you, you’ll see a boost in your score as your credit utilization ratio starts lowering. It is a credit card metric that reflects the available credit limit you can use.

The amount you owe and the length of your credit history make up for a whopping 45% combined. Also, as you have only one loan payment to make, if you pay on time every month, you will take care of the other 35% of your loan.

All in all, you have the opportunity to fix 80% with this one strategic move.

Disadvantages of debt consolidation

Well, now that you know some of the benefits of it, let’s understand the drawbacks and risks associated with it.

Added upfront costs

As we mentioned in the pros section, it would save you money over time due to lower interest rates; however, there is the upfront cost. Let’s look at the upfront costs you’ll have to pay.

  1. Loan origination fees– Lenders charge loan origination fees to offset the cost of underwriting and verifying new borrowers. Depending on your credit score and loan terms, the fees are between 1% to 8%.
  2. Balance transfer fees– The financial institute will charge you fees if you transfer the credit card balance from one to another credit card. It may vary from 3% to 5% and is mandatory, but you will also enjoy a 0% APR for a limited period.
  3. Annual fees– The lender may charge you annual fees upfront.
  4. Closing fees– The closing fees are paid for loan processing, home appraisals, etc. It can vary from 2% to 5%.

Higher interest rates

I know I’ve mentioned lower interest rates as the advantage of debt consolidation; however, lenders may offer you higher interest rates, too. It is possible if you have a poor credit score. Also, the loan amount and the term can affect the rates. 

As mentioned earlier, if your priority is lowering monthly payments for that additional breathing space, you will have to compromise on the interest rates. 

Missing payments can hurt you badly

Just like loans, if you miss your payment, the lender will slap you with a late fee and a returned payment fee if your cheque bounces. It can set you back financially. 

Lenders must report late payments, so your credit score can take a nose dive if you miss your payment.

When to consolidate your debt

However, it’s not worth it if you are at the end of your loan payments (in a year or less). Scenarios where you consider debt consolidations are:

  • Debt consolidation is a strategy you should use if you have a high-interest rate. Additionally, if your credit score is 670 and above, you can get a lower interest rate and save a lot of money.
  • If you are looking to bring down your monthly payments, you have extra money at hand by the end of the month to rotate.
  • If you want to combine all the loans, it will be easier for you to track and perhaps enjoy a fixed monthly payment.

Conclusion

Although debt consolidation provides relief, you must be aware of its demerits. Remember that it may solve your financial problems, but the real issue is your discipline with your money.

Before you sign any debt consolidation loan offers, review the monthly payments, repayment duration, fees, and other terms.

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