3 types of debt you can consolidate – and how to make them work for you
Debt consolidation involves combining several debts into one. Typically, when you use this strategy, you take out a new low-interest loan and use it to pay off balances on multiple high-interest accounts.
Consolidating expensive debt into one easy-to-manage account and payment can make sense for a number of reasons. The most obvious advantage of debt consolidation is that it has the potential to save you money. It can also help you get out of debt faster and could even have a positive impact on your credit scores.
Thinking of simplifying your debt and (hopefully) saving money? Here’s a breakdown of three of the most common types of debt you can consolidate, along with the benefits of doing so.
Credit card debt
Sound financial advice dictates that you should pay off your credit card balance in full each month. It’s the best way to avoid paying interest, reducing debt, and protecting your credit scores from damage.
Yet for many Americans, having a balance on their credit cards is part of normal life. According to Experian, the average credit card balance was $ 6,028 in the first quarter of 2019.
Of course, just because credit card debt is normal doesn’t mean you have to accept that it will be a reality for you. You can make a solid plan to get rid of credit card debt once and for all, and debt consolidation could help you reach your goal faster.
When you decide to consolidate your debt, it makes sense to start with the most expensive debt – and that’s probably your credit card accounts. Currently, the average credit card APR is 17.72%.
Using a low interest personal loan to pay off expensive credit card debt can save you a lot of money. For example, if your APR is 17.72% on your credit card and you consolidate $ 10,000 in debt with a new 24-month personal loan at 7.5%, you could save:
- Over $ 1,100 in interest charges
- Almost $ 50 per month
Plus, you could pay off the debt in two years. Financially speaking, it is a win-win situation.
Advantages of credit
When your credit reports show that you have unpaid balances on your credit cards, it is possible that it is lowering your credit rating. Balance itself is not that important from a scoring standpoint. Rather, scoring models like FICO are about the percentage of your credit limit used. This is known as use of credit, or your renewable usage rate.
When you use more of your card limit, your credit usage increases, which is not good for your credit scores. This is where a consolidation loan can help. Paying off your card balance to $ 0 with a new personal loan would reduce your credit card usage to 0%. Generally, the more usage drops, the better for your scores.
With a consolidation loan, the amount of debt would still be on your credit report, but it wouldn’t have the same impact on your scores. Indeed, personal loans are installment and non-renewable accounts. Installment loans, which are repaid monthly for a period of time, say two or five years, are treated differently by rating models. When you use an installment loan to pay off your credit card balances, your scores are likely to increase.
You can also use a balance transfer credit card to pay off your current credit card debt. If you have good credit, you may be able to qualify for a balance transfer offer with a low or 0% interest rate for six, 12, or even up to 24 months. However, since the new balance transfer card is still a revolving account, you probably won’t see as much benefit to your credit score if you go with this consolidation option.
Another type of debt that often makes sense to consolidate is student loans. Even if you only make one payment to a loan officer each month, you may have multiple student loan accounts on your credit reports.
Every time you received a new disbursement of funds while in college, a new loan was opened in your name. Many students take out a new loan every semester to cover tuition, fees, and other costs. In fact, it’s not uncommon to accumulate as many as eight or more student loans while earning a standard undergraduate degree.
If you don’t know how many student loans you owe, you can check your credit reports for the answers.
If you discover that you have more than one student loan to fill out your report, a consolidation loan might be worth considering. Here are some of the benefits:
It’s not obvious, but you may be able to get a lower interest rate on a student loan consolidation. If this happens, you could potentially save a lot. In fact, the more money you owe in student loans, the more money you’ll save by consolidating a new loan with a lower interest rate.
Student loan consolidation is not just potentially good for your wallet. It can also benefit your credit. In fact, a student loan consolidation can improve your credit in two different ways.
Advantages of credit
One of the factors scoring models pay attention to is the number of accounts with balances on your credit report. Granted, that’s not a huge scoring factor – certainly not as important as, say, your payment history or your credit usage. However, it does have some impact on your credit scores. By reducing the number of accounts with outstanding balances on your reports, you may be doing your credit scores a service. No, your scores probably won’t go up 100 points (or anywhere close to that), but sometimes even a few points can make a difference when working to improve your credit.
Consolidating your loans into one account also makes it easier to implement what is known as “credit defense”. Consider the following scenario. You get sick or hurt yourself and have to take time off work. Therefore, you cannot afford to pay your student loan officer. However, even if you only make one payment to a student loan organization, that payment is actually split between six accounts. Late payments don’t show up just once on your credit reports; late payments are reported on six different accounts. Now imagine you consolidated your student loans into one new account before you got sick and missed that payment. Instead of six overdue payments on your credit report, only one account would be reported as overdue. While a single late payment still wouldn’t be good for your credit rating, it would certainly be less damaging than six overdue accounts from a scoring standpoint.
High rate personal loans
Credit cards and student loans aren’t the only types of loans you might want to consolidate. Whether you’re trying to simplify your finances or get out of debt faster, consolidating high interest personal loans can also be a good idea.
If you’ve taken out personal loans in the past, you may be able to save money on interest by getting a new loan with a lower APR. Maybe your credit has improved, or interest rates are lower than they were when you took out your loan (s). If you can get a new loan at a better rate, the overall interest savings could be substantial.
Remember that it is best to compare rates before taking out any type of new financing. You can view personal loan rates through Bankrate, as well as your local bank and credit union, to find the best deal for your situation.
Advantages of credit
Since personal loans are installment and non-revolving accounts, consolidating these loans into a new personal loan will not reduce your credit utilization rate. (Personal loans don’t increase credit usage to begin with.) So you probably won’t see a significant increase in score when you reduce personal loan balances and replace them with a new one.
Your scores might benefit slightly if you reduce your number of accounts with balances. However, the credit check and having a new account on your report could offset this potential increase in score.
Nonetheless, if you can save money by consolidating expensive personal loans with a more affordable payment option, it probably makes sense to do so. Even though your credit scores are slightly affected by the new application and the new loan (and this is the worst case scenario), your scores may rebound over time as the account ages and you manage it properly.
Make debt consolidation work for you
You should not take out any type of financing, a consolidation loan or the like, without taking a moment to consider the potential drawbacks. With consolidation loans, a big mistake people often make is to keep accumulating more debt after using a new loan to combine their old balances. This mistake can eventually lead to financial disaster. Fortunately, this is a mistake you can avoid if you determine in advance that new credit card debt is prohibited.
Debt consolidation is not a magic wand. But, when used correctly, it is a powerful tool that you can use to potentially improve both your finances and your credit.
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