By Karen Lynch | American Express Credit Intel Freelance Contributor
6 Min Read | January 17, 2020 in Money
Debt consolidation holds out an attractive promise: You can roll up several credit card balances, outstanding loans, and other debts into one, bigger loan with a single, lower monthly payment. Owing a lower amount every month makes it less of a stretch to pay off your restructured debt. Then going forward, having a single loan makes it easier to manage on-time bill payment. Say goodbye to juggling different interest rates, amounts owed, due dates, etc.; say hello to a single monthly payment.
The reality of how to consolidate debt, though, is more complicated. For one thing, you need to be in pretty good financial shape just to consider this option (even if paying your debts is a struggle). For another, restructuring your debt might actually mean higher total costs due to lengthier repayment terms. And to really make a difference, any debt restructuring should be accompanied by a fundamental reset of your overall spending.
Following the nine steps outlined below can help clarify how to consolidate debt—step by step.
You typically need to have an OK credit score (at least 660), and come in under 50% on your debt-to-income ratio (as in, all your monthly debt payments divided by your gross monthly income).1 Otherwise, banks usually charge higher interest rates, if they agree to lend to you at all.
If your debt is small and could be paid off in a year with a few extra payments, some lenders say that debt consolidation might not be worthwhile. And if your debt is overwhelmingly large, it might not work either—calling for a more rigorous option, such as a debt relief program or bankruptcy.2 In a U.S. News & World Report survey, most respondents who consolidated had debt of $5,000 to $20,000.3
Not all loans are good candidates for consolidation. Debt consolidation works mainly for unsecured debt. In the survey by U.S. News & World Report, respondents said they’d consolidated the following types of debt:
It’s not much use to mix in secured debt, such as home mortgages and auto loans, because their interest rates tend to be lower than personal loans.
And student debt often carries lower interest rates than you could get by consolidating it with other types of debt.4 That said, multiple student loans can be rolled into one. The U.S. Department of Education has an online federal student loan consolidation application and a calculator to show what your monthly bill would be.5
Several rules of thumb apply when analyzing how to consolidate debt.
Online calculators are available from lenders to crunch your specific numbers to estimate total costs.7
Comparing the alternatives could help determine your final choice. Here are the typical debt consolidation options:
Can you afford to pay your new monthly bill on time and in full every month? The calculators mentioned above can help you do the math. Some lenders say that consolidating debt with a personal loan could cut monthly interest costs nearly to half the rate on your credit cards and other outstanding balances.11
Ask yourself whether there’s more you can do to adjust your spending and pay off your current bills without a consolidation loan, says the Consumer Financial Protection Bureau (CFPB). And check with your creditors directly to see if you can negotiate lower interest payments or longer terms.12 You might also want to consult a nonprofit counselor on how to consolidate debt, the CFPB says.
And keep in mind that while debt consolidation can improve your credit score in the long term, the immediate impact might be negative. Improvement comes with a better mix of installment and revolving debt and a successful record of making your payments over time.13 The potential for a short-term fall includes the simple fact of opening a new account. Be sure your timing isn’t off, considering possible plans for other major steps such as home buying.
Experts warn against lapsing into a false sense of financial wellbeing, thinking that your debt is paid off. It’s not, it’s only restructured. This is the time to begin budgeting your future spending and making a concerted effort to stick to your plan. Otherwise, consolidation could land you in a worse position. You could end up with a big monthly consolidated loan payment plus a growing number of new bills as you continue spending on your credit cards, store cards, and other accounts.
Debt consolidation can help simplify your finances, reduce monthly payments, and pave a path out of debt. But it’s not for everyone. Determining where you fit in requires weighing different approaches, each of which has several providers that, in turn, offer a bewildering range of terms and conditions. The nine steps here outline how to consolidate debt, and provide a framework for finding what might be the best option for you. For more information, see our article, “What is Debt Consolidation and Why Should Millennials Care? ”
1 “Lower Your Debt-to-Income Ratio,” The Balance
2 “Debt Consolidation,” LendingTree
3 “Debt Consolidation Loans,” U.S. News & World Report
4 “Can I Consolidate My Student Loans and Other Debts Together?," Student Loan Hero
5 “Federal Student Aid,” U.S. Department of Education
6 “Debt Consolidation Loans,” U.S. News & World Report
7 “Loan Consolidation Calculator,” Interest.com
8 “Best Debt Consolidation Loans of 2020,” The Balance
9 “Consolidate High-interest Debt by Refinancing with a Low Mortgage Rate,” Quicken Loans
10 “Coping with Debt,” Federal Trade Commission
11 “Debt Consolidation,” LendingTree
12 “What Do I Need to Know If I’m Thinking About Consolidating my Credit Card Debt?” Consumer Financial Protection Bureau
13 “How Debt Consolidation Affects Your Credit Score,” MagnifyMoney