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Debt Consolidation is the act of combining multiple debts into a single debt. It is both a powerful and a misunderstood tool. In this article, I will go over not only the facts and myths of debt consolidation but also the mechanics of how to conduct a consolidation. Then I will help you consider if it makes sense for your own personal finance situation.
What is Debt Consolidation?
As mentioned above, debt consolidation is when you take multiple loans and combine them into one. That’s it. In the process of conducting debt consolidation there may be some benefits, such as lowering your overall interest rate.
One thing to keep in mind is that the overall debt burden is always the same, however if you can get a lower overall interest rate you may end up paying less overall by the end of the loan repayment period.
Debt Loan Consolidation Example: Jeff has 3 forms of debt. He has $5,000 on a credit card, $3,000 on a Home Equity Line of Credit (HELOC) and he owes $15,000 on a Car Loan. Below is a table of his debts with interest rates:
Jeff would like to consolidate his loans into one giant loan so that he only must make one payment per month. After shopping for loans with various creditors, his best offer is a $23,000 Consolidated Loan at 6%. Since his combined weighted average interest rate prior to consolidation was 6.86% he takes the loan with a small savings in interest paid every month and enjoys the simpler repayment schedule.
It should be noted in the example above that loan repayment term was not considered. This may play a role in your own calculation… after all the difference between paying back a large sum over 3 years can be dramatically different than a 10-year period.
Additionally, Jeff was lucky and received an interest rate below his combined weighted interest rate. This may not always happen. What rate you will receive is highly dependent on market conditions, the amount of debt you have, and most importantly your credit history.
Myth: Consolidation Will Lower the Amount you Owe
A major myth out there is that Debt Consolidation will lower the amount you owe. This is NOT true! Debt Consolidation will NEVER lower the amount of principal you owe. Do not confuse Debt Consolidation with Debt Settlement. Debt Settlement is a Completely Different Topic not covered in this article.
In addition to not lowering your principal, debt consolidation may end up costing more in interest if you are not careful. Using a debt consolidation loan calculator (link available down below) is an important tool to determine if the new interest rate you are paying is a bargain or scam.
Even if you find a consolidated loan that appears to beat the average interest rate you are paying, you still must consider any additional fees that you may have to pay up front. Some of these fees may outright negate any type of benefit the loan may give you.
Myth: Consolidation Will Hurt Your Credit Score
There is often a hesitation to consolidate loans due to a fear that it may damage one’s credit score. This is false.
Although it is true that to obtain a debt consolidation loan you will have to apply for credit which will, in effect, show an additional inquiry against your credit report, this is only temporary and will not seriously impact your score.
Additionally, the act of consolidating your debt will naturally close many open loans… and thus decrease your average account length… but once again this is not a major factor in your score and should not be a major consideration.
One positive that can occur, is that if your resulting monthly payment from consolidating your loan is less than the sum of the loans consolidated it will result in a lower debt utilization ratio. This ratio is incredibly important when determining credit worthiness when applying for a mortgage.
Thus, if you are in the market for a new home, consolidating your debt a year or two before you plan on making the purchase could be quite advantageous.
Myth: Consolidation Is a Scam
The myth that debt consolidation is a scam has a lot do with some of the marketing and seedier players in the industry. Consolidating loans is a routine and mundane activity, however, some smaller outfits with dubious motivations have targeted vulnerable people to turn a quick profit. This reputation among a limited number of participants has caused confusion for many.
Choosing a trustworthy lender is key. Before providing any type of personal information, always check the Better Business Bureau and Google Reviews to try to get a sense of how the business is received by its customers. If you can’t find anything then consolidating loans with that company is probably too risky.
It may be cliché but remember that if its too good to be true then it probably is. Consolidation is not a scam… but don’t make yourself an easy target either.
Fact: Consolidation Does Not Shrink Debt
Believe it or not, this fact confuses a lot of people. People often mistake Debt Loan Consolidation with another similar sounding term: Debt Settlement. Debt Settlement is where a 3rd party tries to negotiate down your loan balances for a fee because you can’t afford to pay the full amount. This is radically different from Debt Loan Consolidation.
Consolidating debts is literally taking different loans and smushing them together. If you hand a cashier 3 quarters, a nickel and 2 dimes and ask them to consolidate your coins, they’d give you a 1-dollar bill back. In debt consolidation, whatever goes into the consolidation comes out of the consolidation.
Fact: Consolidation MIGHT Save You Money
Didn’t I just say that Debt Consolidation doesn’t reduce the amount of debt you owe? Then how is it possible that it might save you money?
Debt Loan Consolidation can save you money by hopefully giving you a lower overall interest rate. If you can find a lender that can help you pay less interest over the life of the loan after you include fees, then you will be saving money over the disbursed original loans.
In other words: the principal remains the same, but the interest paid back can be lower (or higher).
If you have high interest credit card debt, then consolidating those debts may be a no brainer. However, if you have a low interest car payment and a few other low interest loans often found on debt backed by assets or guaranteed by the Government then you likely will not benefit from loan consolidation.
Fact: Consolidation There are Fees
In the original example way back at the top of this article we showed how to compare interest rates to get a sense if consolidating may make sense. Unfortunately, it is a little bit more complicated. You will also need to factor in any fees that may be involved with consolidation.
Look at the loan information closely. There should be an interest rate and an APR. APR stands for ‘Annual Percentage Rate.’ This is the amount of effective interest you will pay. It’s the amount that rolls your actual interest rate together with the fees that you will have to pay to instantiate the loan.
Therefore, when evaluating your options, consider only the APR. This is the full amount that you will pay in interest and fees given that you eventually pay the loan at the established monthly rate (as opposed to paying additional principal on top of the minimum payment).
Debt Consolidation Calculators
Below are several debt loan consolidation calculators from reputable sources. It is vitally important that you consider all aspects of the pre-consolidated loans and new consolidated loan to get a clear picture of what is going on.
It is highly possible for debt consolidation to be a net losing transaction if you are not careful.
NerdWallet Debt Consolidation Calculator: This is a solid debt consolidation calculator. It collects your individual interest rates and your monthly payments to give you a full accounting of the impact of the consolidation.
Bankrate Debt Consolidation Calculator: This excellent calculator allows you to see everything on one screen. You can toggle the various loan parameters and quickly press ‘calculate’ so you can see the results on the graph plotted below the input fields.
Finaid.org Debt Consolidation Calculator: I like this calculator because it is a private organization without any overt ties to banks or lending institutions. This calculator is good for double checking any calculator sponsored by a financial institution.
Does Debt Consolidation Make Sense for Me?
After using the above calculators, you should be able to get an idea of what type of interest rate and loan pay back term it would take for it to be ‘worthwhile’ to you. If you can find a reputable lender that doesn’t want you to put your home down as collateral and will give you an APR with all fees below the weighted average interest rate you are paying now then you have a slam dunk.
Likely, however, the answer isn’t so clear cut. To determine if debt loan consolidation is a viable option, figure out what your specific goal is. Here are a few examples of common goals:
- Pay off debt quicker
- Pay off debt easier
- Lower the amount of interest paid
- Lower monthly payment
Once you know your goal you will have a metric to determine ultimate success. If your goal is to pay off debt quicker but you can’t qualify for a lower interest rate, then debt consolidation just isn’t for you.
That said, if your goal is to lower your monthly payment due to a job loss or other income limiting situation, then a higher interest rate may work out better if calculations show that a lower monthly payment is achieved. Just be careful that you aren’t doing it for the wrong reasons. Lower monthly payments can be an easy trap to fall into.
If you are seeking to consolidate your debt because you have had a problem with credit cards, then consolidating your loans may spell more disaster later. Make sure you have the support system in your life to be successful prior to consolidating. You need the support of friends and family along with an effective toolset to ensure that you don’t end up in more debt after you consolidate.
How to do a Debt Consolidation
Conducting a debt loan consolidation in the modern age is incredibly simple. I would also say it’s too simple. Here is a listing of the steps involved with a debt consolidation:
- Determine which loans to consolidate
- Do a quick calculation of what your average interest rate is with current loans
- Ensure credit report is up to date and your credit score is preferably greater than 720.
- Contact a reputable bank or credit union to apply. There are websites out there that will allow you to shop around (e.g. LendingTree). Just make sure you are researching the bank you end up selecting and not the website that allowed you to shop the rate. It’s possible that non-reputable lenders may make it into some of the aggregate searching tools.
- Determine if the offers you have been presented meet your goals and/or beat your average interest rate.
Concluding Thoughts on Debt Consolidation
Debt consolidation can be a powerful tool to lower the amount of interest paid on a loan or even to just making the whole debt repayment process simpler. Years ago, I attempted to consolidate a series of low interest student loans. I had over 30 of loans in total. Unfortunately, I was unable to find a consolidated loan offer that beat my average interest rate and thus was unable to proceed. More unfortunately, I had to continue tracking 30 different student loans for several more years.
That said, if you can find a consolidation that makes sense for you… and you’ve thoroughly researched the lending institution and all the fees… jump on it! Just make sure that you aren’t consolidating so that you can find new ways to spend. If you make debt loan consolidation a tool to be used for a grander purpose of eventually getting out of debt and you will certainly be rewarded
Financial Warning and Disclaimer
I am passionate about personal finance; however, I still only write this blog for fun. Please do your own research and contact an expert before making any type of decision about your money. Debt, debt consolidation and other money matters can have far reaching consequences if they are approached from a position of ignorance. Make sure that you are informed by qualified experts that you trust.