When Is Debt Consolidation Loan A Good Idea

Debt consolidation combines your debts into a single monthly payment of the same amount each time. It may be a beneficial move for you if your debt load isn't excessive and your credit score is good. The strategy also works best when you have a plan to curb indebtedness.

Let's take a look at when a debt consolidation loan is a good idea.

How Does Debt Consolidation Work?

You take out a loan to pay off high-interest current debts such as credit card bills, which are rolled into one payment. But unless you can get a lower interest rate than the aggregate you're paying on existing debts, consolidation doesn't make sense. If you can get a lower rate, you can reduce your overall debt and reshuffle it so you can eliminate it more quickly.

Ways To Consolidate Debt

There are two main methods of consolidating debt, but they both call for good credit. The first one is getting a zero percent interest balance transfer credit card. You can transfer your debts onto this and pay off the balance during the promotional period.

The other method is to get a fixed-rate debt consolidation loan and use the funds to eliminate your debt, then repay the loan over a set term.

You can also take out a home equity or 401(K) loan, but these options are risky – you could lose your home if you default on payments. You could also lose your retirement fund.

When Debt Consolidation Makes Sense

Debt consolidation is a wise move if your total unsecured debt is under 40% of your gross income, and if your credit is sufficient to qualify for a 0% interest credit card or low-interest debt consolidation loan.

The strategy also works if your cash flow always covers debt payments, and you have a plan to avoid getting into new debt trouble.

For many people, consolidation can cast your debt woes in an optimistic light. If you have a loan that's due for repayment in three years, you know that in three years, unless you miss payments or spend too much, the loan will be paid.

On the other hand, if you're making minimum payments on credit cards, it could take years to pay those cards off. In the interim, you're accruing more interest than the initial principal.

Consolidation also makes sense when you can save money on interest.

Let's say "Bill" breaks his arm and doesn't have health insurance or the $5,000 to pay his hospital bill. To cover the expense, he takes a high-interest loan from the hospital.

Layer, realizing he could pay off his hospital debt and a high-interest credit card with a personal loan, Bill uses his good credit score to secure a consolidation loan with an interest rate 10% lower than what he was paying on the hospital loan and his plastic.

That's a good deal for Bill

When Debt Consolidation Isn't A Good Move

However, consolidation isn't a panacea. It doesn't address poor spending habits that helped create your debt. It also may not be good for you if you're up to your hips in debt and have no way of paying it off even with lower payments.

Additionally, if your debt load is so small you can erase it within six months to a year, and you'd save only a small amount by consolidating, pass on the strategy.

Ultimately, if your total debt exceeds half your income, you may be better off seeking debt relief. Now that you know when debt consolidation is a good idea, you can weigh the strategy against your personal situation, and do what's best for you.

(Disclaimer: Devdiscourse's journalists were not involved in the production of this article. The facts and opinions appearing in the article do not reflect the views of Devdiscourse and Devdiscourse does not claim any responsibility for the same.)