Personal Finance Basics

Is debt consolidation a good idea?

August 4th, 2023 Aug 4, 2023 • Read time: 9 min


When you have debts from multiple sources, such as credit cards and loans, you may want to consider a debt consolidation loan. Debt consolidation combines all your existing loans and debts into one loan, which you would then make payments on monthly. There are things to consider when determining whether debt consolidation is a good idea. These include:

  • Should you consolidate your debt?
  • When debt consolidation is a good idea
  • When debt consolidation is a bad idea
  • How Sun Loan can help with debt consolidation

We’ll cover each topic to help you decide if debt consolidation is right for you.

Should you consolidate your debt?

As we mentioned, there are some things to consider if you’re thinking about consolidating your debt. These include simplifying your debt payments, determining whether you can afford a consolidated debt payment, and what your credit score is.

To simplify debt payments

When you have multiple debts or loans to pay off monthly, keeping track of it all can be a real challenge. Consolidating all your debts into one personal loan can make life a lot easier as you only pay a single bill rather than many.

If you can afford a consolidated debt payment

Debt consolidation combines all your remaining debts into one amount. The lender from whom you take out a debt consolidation loan pays off all of your debts, and the amount of your new debt consolidation loan will be whatever the lender paid to clear your debts, plus any added lender fees and interest. Before you sign off on your debt consolidation loan, find out whether any fees apply. And make sure you can afford your new monthly payment, which may be more than what you were paying for all your previous debts.

If your credit scores are good

It’s important to remember that any application for a new loan will cause a brief dip to your credit score. Debt consolidation, over the longer term however, can actually improve your credit by lowering the amount of the credit limits you’re using–particularly if you move your credit card balances to a loan. And if you make on-time payments on your new loan every month, that positive payment history may improve your credit score.

When is consolidating debt a good idea?

So, how do you know whether debt consolidation is right for you? There are several scenarios in which consolidating your debt can be a good idea.

Cut down on the number of debt payments

When it comes to organization and remembering to pay off your loan each month, debt consolidation really helps since you’re combining all of your previous debts into one easy loan payment. This makes life a little bit easier and more convenient.

Save money with a lower APR

One of the biggest reasons to consider consolidating debt is getting a loan that offers a lower APR or interest rate than your current loans and debts when comparing them on the same timeline or a shorter payoff timeline. With a lower APR, you’ll likely save money since the added interest and fees would likely be less than any of your existing loans with a higher APR. Be sure to shop around and research the best rates for debt consolidation loans–consolidating your debt makes the most sense when you can do so at a lower APR with a shorter payoff period.

Save money by paying off debt faster

By consolidating your debt into one loan, you might be able to pay off your loan faster. How? A debt consolidation loan might offer more room to put extra money toward the principal. If the loan you receive to consolidate your debts doesn’t have a prepayment penalty (a fee that  some lenders charge you if you pay off a loan early), it might make sense to take the same amount of money you would have paid for all your previous debts and put it all toward the new debt consolidation loan. And that can help you pay off the loan even quicker, which could save you money on interest.

Increase your credit score with on-time payments

Payment history is the most important factor in determining your credit score. When you make on-time monthly payments, you show lenders that you are a trustworthy borrower, resulting in a higher credit score. If you don’t make your payments on time each month, it’s the opposite effect–your credit score drops, which tells lenders that a loan might be risky. When you consolidate your debt, you only have one monthly loan payment, making it easier to pay on time and increase your credit score.

When is consolidating debt a bad idea?

As with many loan options, there may be some reasons that debt consolidation isn’t the best option for you. When you consider how to manage your debt, it’s important to know that there are other options besides debt consolidation, just in case this isn’t the best choice for your situation. Here are a few reasons why consolidating debt might not be right for you..

Options available for consolidation may not be ideal (consolidation terms may not be an improvement from current debt situation)

As we mentioned earlier, consolidating your debt really only makes sense if you can improve your financial situation. And a big part of that is by taking out a loan with a lower APR or interest rate than your current loans when looking at them over the same time period. Doing so may help you save money

Excessive additional charges

Whenever you take out a loan, there will be fees and charges. These can add up and cost you extra money you may not want to spend. Ask each potential lender about their fees, and then do the math to determine whether a debt consolidation loan is worth those charges–especially a prepayment penalty, which is what some lenders charge you for paying off a loan early (not Sun Loan, however…we never charge prepayment penalties!).

APR may increase (especially after the introductory period is over)

Some lenders may offer you a special or promotional APR for a certain amount of time to get you to do business with them. For example, a balance transfer credit card may offer you a 0% APR for a year–meaning you only pay off your principal each month for a year, without any extra fees or interest added on. But once that year is up, your monthly payments will likely change quite a bit once the APR kicks in. Another example is a variable rate loan, whose interest rates can change each month…for better or worse. If you prefer to have the same payment, look for a fixed rate loan with the lowest possible APR.

Longer payment term leads to more payments

Longer payment terms can be good in one way–they stretch out your payments so your monthly bill is more affordable. However, doing this extends the time you’re actually paying off your debt. And that’s not always ideal for people looking to get rid of their debt. Also, remember that the more months you need to pay off your loan, the more interest you’ll pay over the life of the loan. And that may end up costing you more than your previous debts.

Credit scores may be impacted

Debt consolidation loans can hurt your credit score for a short period of time. There are a couple of reasons for this. First, as we mentioned, the lender will run a credit check when you apply for a debt consolidation loan, resulting in a hard inquiry that can drop your credit score by double digits. That generally only lasts for a year, however.

Your credit score could also suffer if you close your credit cards or accounts that were paid off by consolidating your debt. That’s because the average age of your credit accounts makes up 15 percent of your credit score. When you open a new account or close an older one, the average age of your credit history decreases, which can also lower your credit score. We recommend keeping your old credit cards and accounts open, even if you don’t plan on using them.

How can you consolidate debt?

A debt consolidation loan isn’t the only way to combine your debts into one reasonable amount to pay off. In fact, there are quite a few options to consider when you want to consolidate your debt.

Personal loan

One option to consolidate or pay off your debt is to take out a personal loan. What’s the difference between a personal loan and a debt consolidation loan? You may use a personal loan for many expenses, including debt consolidation. If you take out a personal loan, you could use a portion of it to consolidate your debt by paying off all your credit cards and other debts and then use the rest for another expense.

Debt consolidation loan

A debt consolidation loan, on the other hand, is a personal loan that is usually used only to consolidate two or more debts. Lenders may not allow you to use this type of loan for anything else, like you could for a personal loan. As we’ve covered, with a debt consolidation loan, the lender pays off your existing debts, and then you pay off the new loan.

Balance transfer credit cards

We briefly discussed balance transfer credit cards as an option for consolidating your debt. A balance transfer credit card allows you to move unpaid debts like credit card balances and various types of loans from one or more accounts to a new or different credit card. It’s a popular choice because many credit card lenders offer a low or even a 0% introductory APR that allows you to pay off your debt with little to no interest for a period. Just make sure you can afford the payments once the introductory rate ends. Like a debt consolidation loan, a balance transfer credit card streamlines your debts into one monthly payment.

Debt management plan (DMP)

Another possibility is a debt management plan (DMP). A DMP combines multiple debts into one monthly payment, and creditors reduce your interest rate. In return, you agree to a payment plan between three and five years. While there are benefits to a DMP, especially with interest rates, there are a few things to keep in mind. First, you can generally only use a DMP to pay off credit card debts. Most agencies will not allow you to use a DMP for other debts, like student loans, taxes, or medical expenses. Also, during those three to five years, you likely won’t be able to use credit cards or open another form of credit. Finally, missing a payment is never a good idea. Especially not while using a DMP. One missed payment may cause the agency to end your low interest rates.

Borrow from retirement accounts

Taking money out of your 401(k) or IRA retirement account is generally not a good idea and should only be used as a last resort if no other options are available. Why? Because, for one, you’re taking money away from your own retirement, which you will need once you stop working. But just as–if not more–important, it will cost you a lot depending on when you take the money out.

Withdrawing from your retirement account before you turn 59-½ years old is considered an early withdrawal. And that usually comes with penalties–a 10% early withdrawal penalty plus income tax. Investopedia offers an example of what this could cost you:

Suppose you take $45,000 from your 401(k) to pay off debt. First, you will owe a 10% ($4,500) early withdrawal penalty. On top of that, you must also pay income tax on the $45,000. For example, if you’re single, and your other taxable income is $100,000, your $45,000 withdrawal will be taxed at 24%, or $10,800. In total, your $45,000 withdrawal will cost you $15,300 and leave you with $29,700 to apply to your debts.

If you wait until after age 59-½, you do not have to pay the 10% early withdrawal fee, but you will still have to pay income tax on the withdrawal. Unless your debts have high interest rates, it costs too much to use your retirement funds to consolidate debt. But it is an option.

H2: Sun Loan can help with debt consolidation

Sun Loan is ready to help with your debt consolidation! Through a personal installment loan, you can simplify your monthly bills and take back control of your finances. We offer loans up to $10,000 to help you pay off your debts through an affordable monthly payment that–when paid on time–can help you build up your credit score. With a single personal installment loan from Sun Loan, you only have one payment to deal with each month. And you can lock in a fixed interest rate so your monthly payment is never a surprise. Apply online today or visit us at one of our many convenient branches. If you’d like to speak to a loan expert, call us at (800) SUN-LOAN.

Author – Amy Sines

Amy Sines is Vice President of Operations Support at Brundage Management Company, the management holding company for Sun Loan. She brings two and a half decades of experience in the consumer loan indu... Read more »

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