Sometimes things just seem to pile up. Debt can be one of those things. Often, there’s not a clear event to point at as a cause. In other cases, there may be some specific financial calamity (the loss of a job, an uninsured medical expense) that wreaked financial havoc and caused debt to accumulate. Debt consolidation may be an option to get on the road to becoming debt free and moving forward financially.
What Is Debt Consolidation?
Debt consolidation is using a new debt (or debts) to consolidate other debts. The objectives of debt consolidation are to lower costs and make debt easier to manage. For example, using an installment loan to pay off credit card debts won’t only reduce the interest rate, but will also replace the variable credit card payments with a fixed payment for a set period of time.
The borrower knows how much they need to pay each month and for how long. Often, people with a lot of credit card debt don’t know how big their payment will be until they get the bill.
Debt consolidation simplifies your finances by taking several payments and replacing them with a single payment. There are a variety of ways to accomplish this.
Forms of Debt Consolidation
The most common — and generally the most desirable — form of debt consolidation is an installment loan. In cases where the debtor has paid their bills on time and maintained their credit, they can often get a lower rate than they have on their credit cards. They can lower their payment significantly and have a definite time when the debt is paid off.
In cases where the debtor has damaged their credit, care needs to be taken to determine if this strategy will work.
Replacing high interest debt with new high interest debt is rarely a good idea.
Another common method of debt consolidation is to replace existing debts using a low interest or zero interest offer on a credit card. There are limited times where this is a good idea.
In most cases, low or zero interest introductory offers are for a very short time, generally not more than six months. Then the rate typically goes to a market-based rate, perhaps not far from what the debtor has now. Unless you can pay off the debt within the introductory period, this method generally is just postponing the problem. It makes sense in some cases, but not often.
Home equity loans can also be an option. In some cases, a borrower may be able to get a lower rate of interest on a home equity loan than they could get on an unsecured installment loan.
Naturally, you need to own a home to have home equity, so this option isn’t available for everyone, nor is it always a good idea for those who own a home. It can be if there’s sufficient equity, if the borrower can clearly handle the payments, and the borrower doesn’t anticipate needing their equity in the near future.
For example, if you plan on moving in six months and using the equity to help you get a new place, this might not be a viable option. Using home equity introduces an additional form of risk: tying up your home as collateral for the loan.
One additional option that needs to be mentioned is the 401(k) loan. This is an option of last resort. When you take a loan against your retirement plan you are generally taking the borrowed assets out of the market and decreasing your potential to accumulate funds for your retirement.
The advantage of 401(k) loans is that they are not dependent on your credit, nor do they report to credit bureaus.
Using a 401(k) loan to pay off consumer debt also introduces additional risk. In most cases if you sever employment with your employer before the loan is paid back, you have little time to pay it back and avoid having it become a taxable event.
This can make a 401(k) loan a very expensive form of debt payoff. There are some cases where this is a good option, but those are rare cases.
Debt Consolidation and Your Credit
As with other debt, the most favorable terms are available to those with the best credit scores. Debt consolidation, however, can also be a means to improve your credit.
Applying for a debt consolidation loan will create a hard inquiry on your credit.
A hard inquiry stays on your credit for two years, but its effect is mostly in the first few months. For a few months after a hard inquiry, your credit will be adjusted downward by a few points.
Be careful not to apply to many lenders, as additional hard inquiries for consolidation loans will have additional negative effects on your credit.
Once you have paid off existing debts, especially credit card debts, your credit utilization improves, improving your credit score. You should consider keeping some revolving credit accounts open to help keep your utilization low.
The new debt consolidation loan will initially hurt the utilization portion of your credit score. Installment debt is considered in determining utilization, but to a lesser extent than revolving debt.
The net effect of consolidation on credit is usually positive within a few months. The utilization portion of your credit score improves, as does your ongoing payment history, and the minor impact of a hard inquiry quickly fades.
Avoiding Debt-Cycle Risk
Unfortunately, many people cycle through debt problems, cleaning them up, at least somewhat, before diving back in again. This is something you can avoid.
There are many reasons people go into debt, but the reason a specific individual has gone too far into debt is identifiable. There may have been a loss of a job, with debt accumulating during the time between jobs. There may have been large unforeseen expenses, such as uninsured medical expenses.
In most cases, the reason an individual goes into debt is overspending. In many cases, it is overspending plus some event that made it worse. The debtor had a lot of debt, lost their job, or had some other financial shock, and the debt situation got much worse.
It is essential to identify the cause of debt and take specific steps to prevent it from repeating, or it may happen again. That’s the cycle. Nothing changes if nothing changes. If you’re overspending and free up a little money, you’re still overspending. Unless you stop.
The Bottom Line
Debt consolidation can be a great way to get some relief from debt or a fresh start. It helps if you approach the problem before damage is done to your credit. Good credit provides more options, and more favorable options.
A great way to avoid the cycle of debt is to use a three-step process. Identify the cause of the debt and take steps to align spending with available resources.
Then consolidate existing debts to lower interest costs and have a more manageable fixed payment. Third, use the monthly savings from the debt consolidation to build an emergency fund, providing additional insulation against future unanticipated expenses.
Debt doesn’t need to be a life sentence. There is always a way out, there’s always the possibility of making a situation better going forward. Debt consolidation can be a tool to move forward for people who are ready to do the work toward building a solid financial future.