|Debt Consolidation Loans||Credit card balance transfers|
|The process||You borrow money with a new installment account to pay off existing debts. Thereafter, make a single monthly payment to the new account.||You borrow money with a revolving credit card to pay off existing debt. Then make a single monthly payment to the new account.|
|Costs||Your new lender may charge a set-up fee, application fee, or other fee that may increase the cost of financing.||Many credit card balance transfers include a balance transfer fee that can increase the cost of funding.|
|APR||Debt consolidation loans generally have fixed rates over a specified period of time.||Low introductory rates often expire after 6 to 18 months. Once the introductory rate expires, you will be charged the standard APR on the account. (Average credit card rates are currently around 17%.)|
|Qualification||Lenders look at your credit, income, and other factors to determine your eligibility and set your interest rate.||Lenders look at your credit, income, and other factors to determine your eligibility and set your interest rate.|
Debt Consolidation and Your Credit
There are two main questions people usually have when considering debt consolidation options:
- How much will it cost?
- What impact will this have on my credit?
The first question can only be answered with research and rate buying. Still, it’s a little easier to explain how debt consolidation can affect your credit.
Are Debt Consolidation Loans Harming Your Credit?
Debt consolidation loans can be good for your credit scores, depending on the information in your credit reports. Credit scoring models, like FICO and VantageScore, pay close attention to the debt-to-limit ratio (that is, the credit utilization ratio) on your credit card accounts. When your credit reports show that you are using a higher percentage of your credit limits, your scores can suffer.
Installment accounts, like consolidation loans, do not receive the same treatment when it comes to credit scores. Imagine you owe $ 30,000 on an installment loan and $ 3,000 on a credit card with a limit of $ 3,000. Since the credit card is 100% used, it would likely have a much bigger impact on your credit scores (and not in a good way) than the $ 30,000 installment account.
When you pay off revolving credit card debt with a debt consolidation loan, you can trigger a decrease in your credit utilization rate. This reduction in the use of credit could lead to an increase in the credit rating. Additionally, your credit scores can be affected by the number of accounts with balances on your credit report – the less the better. When you use a new loan to pay off multiple accounts at once, it could potentially give your credit scores a little boost.
Are balance transfers bad for your credit?
Opening a new credit card and using a balance transfer to pay off existing credit card debt can also lower your credit utilization rate. However, a balance transfer card is still a revolving account. A debt consolidation loan can reduce your utilization rate to 0% (if you have paid off all of your credit card balances). A balance transfer to a new credit card will not have the same effect.
So a credit card balance transfer could potentially improve your credit scores. But in general, paying off revolving credit cards with an installment account (i.e. a debt consolidation loan) has a chance to further improve your scores.
Is debt consolidation a good idea?
Here are some signs that consolidating your debt might be a smart financial move.
- Your monthly payments are manageable, but you can’t afford to pay off your high-interest debt in full in the next few months.
- You may be eligible for a lower interest rate than what you pay on your current credit obligations.
- You pay off your debts and believe that consolidation will help you clear outstanding balances faster.
- You have a stable income, are on a budget, and believe that you can avoid overspending in the future.
Only you can decide if debt consolidation is the right choice for your current financial situation. But considering some of the pros and cons of debt consolidation can make your decision a little easier.
Debt consolidation could reduce the amount of money you pay in interest. The average rate for a credit card with interest rate is 14.75%. Meanwhile, the average interest rate on a 24-month personal loan is 9.46%, according to the Federal Reserve.
Consolidating your debt could improve your credit. When you reduce your credit utilization rate and the number of accounts with balances on your credit reports, your credit scores can benefit.
All you have to do is make a monthly payment to your new lender. It’s easier to manage than multiple payments to different accounts.
Debt consolidation does not erase your debt. You’ll need to follow a budget and avoid overspending if you want your new consolidation loan (or balance transfer card) to permanently eliminate your debt.
If you have credit or income issues, you might have a hard time qualifying for a lower interest rate. There is usually no point in consolidating your debt if a new loan or balance transfer doesn’t save you money.
A debt consolidation loan has the potential to help you improve your financial life. But whether a debt consolidation loan helps or hurts you depends on how you handle the account and your finances as a whole.
Most importantly, avoid the temptation to charge new balances on your recently paid off credit cards. If you load new balances on the original accounts, you could be setting yourself up for financial disaster in the future.
How we choose the best debt consolidation loans
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