If simplicity is the key to success, then debt consolidation, where you simplify your bills by combining multiple debts into one payment, can be the key to successfully managing your debt.
The strategy involves replacing your debt—whether it’s balances on multiple credit cards, a personal loan, or anything else you owe—with one new loan. Ideally, a debt consolidation loan will have a lower interest rate, which will help you save money or pay off your debt faster.
As with most financial instruments, taking out a new loan comes with risks. But if you’ve done your research and decided it’s the best move, here are six tips to help debt consolidation work for you.
1. Check your credit score
Before you start considering which debt consolidation option makes sense for you, it’s important to check your credit score and understand what that will mean for your search for loans.
“Getting things in order is important,” says Bruce McClary, senior vice president of membership and media relations for the National Foundation for Credit Counseling. “You should be well aware of your circumstances and how your credit score could potentially influence a lender’s decision.”
Because each lender has different requirements, there are no exact rules about what credit score you need to get approved for debt consolidation. But you’ll generally need at least a fair credit score. FICO scores are the most widely used credit scores, with a score of 580 to 669 considered fair, and a score of 670 to 739 considered good. The higher your score, the more likely you are to be approved for a debt consolidation loan—and you’ll get a lower interest rate.
If your score is not up to par, you can potentially improve your credit score by paying bills on time, keeping your credit utilization ratio low, and keeping old credit card accounts open.
2. Choose the debt consolidation loan that’s right for you.
There are four main debt consolidation loan options to consider: home equity lines of credit (HELOCs), home equity loans, balance transfer credit cards, and personal loans.
HELOCs and home equity lines of credit allow you to borrow against your home, receiving a lump sum of cash (with a home equity loan) or a line of credit that you can borrow as needed (with a HELOC). You can often get better interest rates on these products because your home is used as collateral, so they can be a good option for homeowners who have significant equity in their home and are willing to take on that risk.
Balance transfer credit cards have an introductory or advertised interest rate of 0%, allowing you to transfer high-interest credit card debt to a low-interest card. But after the promotional period, you’ll have to pay the standard annual percentage rate (APR), so it tends to make the most sense for borrowers with smaller balances who can pay the money back during the promotional period. You also need to be disciplined enough not to take on more debt on the new card.
Finally, personal loans are usually used for debt consolidation. Interest rates on these can vary widely, and typically you won’t get as good a rate as you would with something like a secured HELOC. But if you don’t have any home equity to tap, or don’t want to tap into your equity, and you have at least a fair credit score, it’s an option worth considering.
3. Make sure you fully understand the terms and conditions.
Even if the loan looks tempting, it’s important to read the fine print. Please review the documents carefully to make sure you understand how the terms apply to each possible scenario, including if you encounter problems.
“Often in situations where people get approval, they think about success,” McClary says. “It’s hard to imagine how you could run into circumstances where you run into financial difficulties that cause you to fall behind on those consolidated loans and lines of credit.”
Make sure you fully understand the penalties and interest for late loan agreements, as well as the options that may protect you in the event of unexpected financial difficulties. For a balance transfer credit card, pay attention to how high the APR could jump if you fail to pay off all of your debt during the promotional period.
4. Adjust your budget to accommodate your loan.
Once you are approved for a loan, your work is not over. It’s important to understand what this loan means for your budget overall so it doesn’t drain the rest of your finances.
For example, if you’re currently making higher monthly payments on your debt, you don’t want to fall behind on your mortgage, car payments, utility bills, daily expenses, or other obligations.
“You really need to have a good idea of what’s going to happen when you get a consolidation loan and how you’re going to achieve that goal,” McClary says. “It all has to fit within your budget.”
If you’re getting a significantly lower interest rate with a new loan—for example, an 8% APR on a home equity loan versus a 23% APR on a credit card—it might be tempting to make those smaller payments and relax. It might even be what you need if you’re consolidating to free up money for other accounts.
However, if you can do it, you’ll probably be better off continuing to pay the same monthly payment on your new loan as you did on your equity loan, says Mike Miller, a financial advisor at Integra Shield Financial Group.
“If you have the cash flow to make large credit card payments and you can continue to do that with a HELOC, you’ll pay off the HELOC faster,” says Miller.
The main thing is to be clear about your plan. to you take out a debt consolidation loan. Do you have the flexibility in your budget to maintain or even increase your monthly consolidation loan payments? Or do you need to use the extra money freed up from lower debt payments to pay other bills? Establishing a clear plan of action at the start will help you avoid making impulsive decisions later on.
5. Weigh Other Options
Debt consolidation can be an important step in debt management. This helps to simplify the routine job of paying monthly bills and thereby avoid late payments. Plus, you can often get a lower interest rate, which can make it easier for you to pay off your loans faster, which will save you money in the long run.
But this is not a panacea for your debt. If you were really struggling to pay your debt bills before consolidation, then chances are you’ll still be struggling afterward. If this is your situation, you may have better success by choosing a different path. You may want to consider a debt management plan, in which you work with a credit counseling agency to consolidate multiple debt payments into a single payment plan. You pay the agency, and the agency pays the creditors you owe. Another option is debt relief, which often involves working with a debt settlement company that can help you renegotiate the agreement you have with your creditors, ideally reducing your debt.
6. Avoid new debt
The final step to successfully using debt consolidation to your advantage may be the most important: To set yourself up for long-term success, you should avoid new forms of expensive debt. It may be tempting to top up your credit card balance once you’ve dealt with your existing debt, but this will only put you back where you started.
The more debt you take on, the more interest you’ll pay and the longer it will take to pay it off.
More money:
How to Use Your Home Equity to Pay Off Debt
A Four-Step Guide to Resolving Credit Card Debt
Debt Snowball or Debt Avalanche: Which Payoff Strategy is Right for You?