Good Debt vs. Bad Debt: What’s the Difference?
Americans are now deeper in debt than before the economic crisis starting in 2008, and the numbers are startling:
- Only about 26% of Americans say they carry “no debt,” according to Northwestern Mutual
- Total household debt is sitting at $14.64 trillion, according to the New York Fed
- Consumer debt totals up to over $4 trillion, according to the Federal Reserve
It’s no surprise that many are stressed about figuring out how to pay off debt. One tool available is a debt consolidation loan. They can help you get a handle on finances, make a plan, and get rid of debt once and for all. Here’s what you need to know.
In this article
- What is debt consolidation?
- How to use debt consolidation effectively
- Types of debt consolidation
- How much debt consolidation costs
- Is debt consolidation a good idea?
- Alternatives to debt consolidation
- Bottom line
What is debt consolidation?
At its most basic level, debt consolidation is the act of getting all your debts in one place. It’s a way to get your total debt into one package, your debt consolidation loan, so you’re only making one payment each month and so that debt is easier to manage.
It may also involve getting a low interest rate so you can save on interest charges compared to what you might be paying in credit card interest. Credit cards typically have variable interest rates, which can increase unexpectedly, whereas most debt consolidation loans charge a fixed-rate so you can better expect what you’ll pay in interest charges.
There are different types of debt consolidation, but today we’re looking at loans that can help borrowers with their debt.
How debt consolidation works
How debt consolidation works is that it allows you to get one big loan and use it to pay off your other loans so you’re not dealing with multiple interest rates and payments.
Let’s say you have the following debts:
- Credit card A: $5,000
- Credit card B: $3,000
- Car loan A: $10,000
- Car loan B: $4,000
- Bank loan: $3,500
- Payday loan: $2,500
With all of these loans, you’re paying different interest rates, and you have multiple due dates. Plus, the minimum payments can take up a lot of your monthly income. Rather than try to continue juggling all these payments — and watching a good chunk of each payment be taken up by interest — you could get one loan to pay it all off in a lump sum and then just pay that single loan.
With the example list of loans above, the total owed is $28,000. So, you could borrow a new loan of $28,000 and then use that loan amount to pay off the rest of your debts. Now, you only have one single payment and one interest rate. Depend on the loan terms you qualify for, you may also have a longer time to pay off your debt.
If you go through a lender that specializes in debt consolidation loans, there’s a good chance they won’t just give you the money. Instead, they’ll pay off the loans on your behalf, and then you start making your payment to the lender.
Other approaches to debt consolidation follow a similar pattern, although a loan might not be involved. No matter what approach you take, though, the idea is that you only make one payment each month, and hopefully get out of debt years sooner than if you’d kept making separate payments on each debt.
What kind of debts can be consolidated?
I’ve used debt consolidation to tackle credit card debt, and that’s fairly common. However, it’s also possible to include different types of debt in your debt consolidation efforts. Some of the debts you can consolidate with most loans and debt consolidation programs include:
- Credit cards
- Unsecured loans (like personal loans)
- Payday loans
- Some types of medical debt
- Some accounts sent to collections
Realize that student loans are a special case. You can consolidate federal student loans, but it needs to be done directly through the government. Private student loans can also be consolidated through refinancing. However, most debt consolidation loans won’t include student loans; those need to be consolidated separately.
Also, you might not be able to consolidate some of your secured debt, like auto loans and home loans. This is part of why it’s important to know the difference between secured vs. unsecured debt. But if you can get a big enough personal loan on your own to pay off an auto loan in addition to your unsecured debt, that’s one way to make it work. However, if you work with a debt consolidation program, they usually won’t allow you to include auto loans or mortgages in your consolidation plan.
How does debt consolidation affect your credit score?
Any type of debt is going to impact your credit score, and that includes a debt consolidation loan. However, the kind of impact you see depends on the type of debt consolidation you use.
If you decide to go with a debt consolidation loan, you might actually see an improvement in your credit score. Paying off your revolving lines of credit will result in a favorable credit utilization score. Additionally, if you make your payments on time, you’ll see a positive effect on your credit score. You might take a small hit to your credit score at the beginning when you apply for the loan but the benefits of a debt consolidation loan can be bigger once you pay off your smaller debts and keep up with your consolidation payments.
There can be some negative impacts, though. If you use debt consolidation that first requires you to stop making payments, you could end up seeing big drops to your credit score. Additionally, if you can’t handle your new debt consolidation loan payment and you start paying late or miss payments, your score will start to drop.
How long does debt consolidation stay on your record?
The length of time your debt consolidation remains on your credit report depends on the type of consolidation you get.
If you get a straight debt consolidation loan, it’s treated like any other debt. If you keep up with payments, that positive information will remain visible for several years — and that’s not a bad thing. You want to show that you can handle your payments.
However, missed payments or late payments can remain on your credit report for years. So, if you miss a payment on your debt consolidation loan, or if you have late or missed payments on other accounts that you pay off with your loan, they’ll stay on your report. The good news, though, is that as time passes and you have more positive actions, they will start to outweigh the negative.
When your debt consolidation comes as a result of debt settlement, you still end up with the information being reported for seven years. Your credit history will reflect that you settled the debt, instead of paying it off in full or as agreed. And that notation will remain for seven years after the settlement date. However, as with the missed payments, if you have more recent actions that are positive, those will have a greater impact as the months and years pass.
How to use debt consolidation effectively
There are some real benefits to using debt consolidation effectively. In fact, back in the day, I used debt consolidation to get a handle on some of my own loans. Here are some of the top benefits.
Get a lower interest rate
The most effective way to use consolidation loans is to make sure you’re getting a better interest rate. A low loan rate serves two purposes:
1. Save money on your debt. With a lower rate, less money is going to interest charges, so you save money, paying less overall on your debt.
2. Pay off the debt faster. When you’re paying higher interest rates, a larger portion of your payment goes toward interest — not reducing the principal. Once you get a lower rate, more of your money goes toward actually lowering what you owe, helping you get out of debt faster.
If you can combine high-interest debts with a debt consolidation loan that has a lower rate, you can come out ahead in the long run.
Set a payment you can better manage
In many cases, people feel overwhelmed by debt because they have multiple payments and it’s hard to keep track. Plus, if you add up all the minimum payments, there might not be much money afterward to cover other needs. In order to combat this reality, it makes sense to get a debt consolidation loan with a payment you can manage.
You can usually choose repayment terms of three, five, or seven years. On top of that, getting as much as possible under one “roof” can make a huge difference in your payments. For example, when I was consolidating my credit card debt, my monthly payments added up to more than $500. After I consolidated them all to a three-year loan, my monthly amount due was a more manageable single payment amount of $350 per month.
Look for ways to improve your monthly cash flow with the help of your debt consolidation loan so that you can get out of debt while still paying for the necessities of life.
Group types of debt together
If you can’t consolidate everything, do your best to group types of debt together. For example, we consolidated my then-husband’s five student loan payments into one, and my four credit card bills into one. Rather than making nine different debt payments each month, we were down to two, which helped us better manage the debt.
Sit down and look through your different loans, and see if there’s a way to group them together, based on different characteristics. Additionally, be realistic about the interest rates involved.
If you have a couple of credit cards with interest rates above 19% and a car title loan with a 36% interest rate, lumping them together with a loan at 13% APR (annual percentage rate) will save you money over the life of the loan. Then, if you can, take credit cards with rates of 15% and below, and see if you can consolidate them using a 0% APR balance transfer.
You’ll still have two separate payments, but it’s fewer payments than you had, and you were able to save much more overall. Grouping debts together and then tackling them that way can also help you create a long-term debt repayment plan when you can’t qualify for a big enough loan to pay everything off at once.
Types of debt consolidation
Debt consolidation loans aren’t the only route you can take. Additionally, there are different types of debt consolidation loans. In order to make an informed decision, it’s important to understand all of your potential debt consolidation options.
Here are some of the most common types of debt consolidation.
1. Work with a credit counselor
The best credit counseling companies can help you to create a debt repayment plan. They consolidate your monthly bills by making the payments to the creditors on your behalf. You send in one payment, and they divvy up the money as required by creditors.
In many cases, a credit counselor might be able to negotiate lower interest rates and better payment plans. You usually pay a monthly fee for the service, but it has the potential to save you money in the long run and get you out of debt faster.
How to get started
You can get started by researching credit counseling companies and by visiting NFCC.org to finding an accredited nonprofit counselor in your area. They can meet with you to help you consider your options and figure out a plan that works for your financial situation and budget.
2. Take out a personal loan
Another form of debt consolidation can be done with personal loans. When you use a personal loan for debt consolidation, you manage the debt on your own. You borrow money and once you receive the funds, you pay off your other loans. Now, you only have one payment to make.
In order to effectively use this option, you usually need good credit and adequate income.
How to get started
You can get started by comparing the best personal loans and debt consolidation loans or by visiting your bank or credit union. Do this before missed payments and high balances destroy your current credit score.
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3. Use a credit card to transfer your balance
Many credit cards offer a 0% APR balance transfer deal that can help you pay off debt. This is how a balance transfer works: You open one of these cards, and then transfer balances from other high-interest credit cards and even personal loans. With a 0% APR, every penny you pay goes toward debt reduction.
Which Loans Should I Pay Off First?
One thing to keep in mind, however, is you’ll likely pay a balance transfer fee of 3% to 5%, whichever is greater, so make sure your interest savings are bigger than the fee. Additionally, realize that most of these balance transfer credit card offers are limited in length. So it’s a good idea to have a plan to pay off the debt before the regular interest rate kicks in, usually between six and 18 months after you get the card.
How to get started
You can get started by comparing the best balance transfer cards to see which you qualify for. In general, you need fairly good credit to meet the criteria for the best options.
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4. Borrow money from a retirement account
Many 401(k) plans allow you to borrow money for five years. You have to repay the loan with interest, but the interest you pay goes into your retirement plan — so you’re basically paying the interest to yourself. However, that won’t make up for time in the market, so consider the opportunity cost of raiding your retirement. Plus, if you don’t repay the loan on schedule, you end up with penalties from the IRS so taking out a 401(k) loan to pay debt is risky.
How to get started
Start by talking to your human resources manager about how to get a 401(k) loan, and what information you need to provide to the custodian. Understand, too, that if you leave your job before the loan is paid off, the whole balance becomes due.
5. Borrow against your home or vehicle
If you have a valuable asset, like a home or vehicle, you can borrow against it in order to consolidate debt. You might not be able to get a personal loan, or some other type of loan, but if you have a valuable asset that has equity, you can borrow against it. In some cases, you can get a lower interest rate by getting a secured debt consolidation loan.
A home equity loan and a home equity line of credit (HELOC) are two different financial products that allow you to borrow against the value of your home. Before you choose either of these strategies, you’ll want to understand the primary advantages and disadvantages of a home equity loan vs. a HELOC.
The downside is that now you’ve taken what is probably unsecured debt and then secured it with something valuable. If you can’t make your debt consolidation loan payments, your home or vehicle could be repossessed.
How to get started
You can get started by talking to a lender about what your asset is worth, and how much you can borrow against it. You might need to meet credit and income criteria to qualify.
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How much debt consolidation costs
The cost of debt consolidation depends on the type of loan you use. Many personal loans and secured loans don’t come with origination fees, so you can avoid those. With a credit card balance transfer, it’s common to pay a fee of between 3% to 5% of what you borrow. So, if you get a card for $10,000, you might pay between $300 and $500 as an initial fee.
However, even if you aren’t paying origination fees, there will be costs related to interest. The good news is that the cost of a debt consolidation loan interest is usually lower than what you’re already paying.
If you use a nonprofit credit counseling program, you shouldn’t need to pay upfront costs. Instead, you’re likely to pay a monthly fee of $25 or $30 a month for the time you’re in the program. Because you might end up getting out of debt faster, or benefiting from negotiations made on your behalf, paying the fee might be cost-effective.
Carefully weigh the costs against what you’re saving and how quickly you’ll be out of debt in order to get an idea if this is the right move for you.
Is debt consolidation a good idea?
If you’re struggling to stay on top of your debt, consolidation can help you create a plan and manage your payments in a way that can save you money over time. However, in order for it to be effective, you need to be realistic about your plan and committed to staying out of debt once you get rid of it. Whether debt consolidation is a good idea depends on your financial situation.
When debt consolidation is a bad idea
Debt consolidation loans aren’t a good idea if you can’t keep up with payments or if you’re in a situation where you’re not sure you’ll be able to stick to the plan. Additionally, debt consolidation can free up space on your credit cards which can sometimes feel like you have permission to keep making purchases if you’re not in control of your spending habits.
In order to know if debt consolidation loans are worth it for you, it’s vital to address the source of your problem. Figure out why you keep debt spending, and look for solutions so you aren’t living beyond your means. Until you stop the habits that led to the debt, consolidation won’t be a big help.
Alternatives to debt consolidation
Debt consolidation isn’t your only option when you’re drowning in debt. Here are some alternatives to consider, and what you need to know about each of these debt relief programs:
What it is: A debt management plan is a specific repayment schedule based on what you owe and how much you can afford. A debt management or credit counseling agency negotiates with your lenders to reduce your interest rate, monthly payments, fees, and total balance due.
Pros: After you and your lenders reach an agreement, you’ll make one monthly payment to the credit counselors.
Cons: Often the initial consultation or review session is free, but enrolling in a debt management plan typically has a cost.
When to consider it: Before enrolling in a plan, credit counseling agencies will review your debt, income, and other assets to see if you’re a viable candidate for a debt management plan.
- What it is: Rather than paying off your debt, you agree to a settlement with your creditors. You agree to pay a smaller amount and your remaining debt is written off.
- Pros: You don’t have to pay the total amount you owe, so you can save money on your debt. Additionally, you can often be done with the debt and move on quicker than using debt consolidation.
- Cons: Debt settlement requires you to skip payments, so it can damage your credit score. Another downside is that any debt you’ve received forgiveness for might show up as income and be taxed.
- When to consider it: If your credit is already damaged and you’re having trouble keeping up, a debt settlement company can help you manage your payments and reduce what you owe. This should only be used if your credit is already a problem, and if you’ve accounted for the potential taxes.
- What it is: You have your debts reduced or wiped out by a court. You might be able to avoid paying anything (Chapter 7), but the more likely bankruptcy scenario is that you set up a reduced payment plan for your creditors (Chapter 13).
- Pros: There is the potential for a “clean slate” that allows you a fresh start. Additionally, if you’re successful, you might not need to pay fees, saving you money.
- Cons: Bankruptcy takes a tough toll on your credit, and remains on your report for up to 10 years, affecting your score and making it hard to get other loans. Additionally, it can be difficult to get bankruptcy, and some types of debts, like students loans, are practically impossible to have dismissed.
- When to consider it: When you’re truly out of options, bankruptcy can help you just get rid of the debt and move on. If you can’t handle your debt any other way because it’s too overwhelming for your income situation, this is the option to choose.
- What it is: Based on your paycheck, you receive short-term funds. You repay the loan when your next paycheck comes or extend the loan.
- Pros: You can usually get cash quickly, allowing you to move fast. Additionally, many payday lenders don’t run a credit check, so you can get the loan based on your next paycheck.
- Cons: There are extremely high interest rates. In fact, you’ll probably pay more than your original debts. It’s easy to extend a loan if you can’t pay, but that just lets the fees and interest pile up, getting you stuck in a cycle of payday loans.
- When to consider it: Payday loans should almost never be considered as an alternative to debt consolidation. You’re more likely to be in a worse position when using payday loans.
What’s the difference between debt consolidation and credit card refinancing?
Technically, credit card refinancing can be a type of debt consolidation, if you use it to pay off your other credit card debts with a lower rate.
For the most part, though, debt consolidation is about getting all debts in one place and paying them off, while choosing to refinance credit card debt focuses more on getting a lower interest rate by using a balance transfer with a 0% APR.
Can I consolidate debt without taking out a loan?
Yes, you can. This is usually done through a credit counselor who can help you work out a plan.
Rather than taking a loan, your credit counselor accepts your payment and then makes payments to your creditors. They manage your debt on your behalf so it’s consolidated and you don’t have to worry about multiple payments.
Can I qualify for a consolidation loan with bad credit?
There are some lenders that will let you get a loan with bad credit, including debt consolidation loans. But you’ll probably have to pay a higher interest rate. If you have poor credit, a different program might make more sense for you.
Can debt consolidation loans be taxed?
In most cases, debt consolidation loans won’t be taxed, since you’re borrowing money. However, if you use a debt consolidation or debt settlement arrangement that includes a portion of your debt being forgiven, you might be taxed on that amount.
Can I use my credit card after debt consolidation?
As long as you didn’t close your credit card as part of your debt consolidation plan, you should be able to use it. However, be extremely cautious about racking up more debt.
Will debt consolidation work if I’m on a limited income?
If you’re on a limited income, it’s best to look for a debt consolidation expert that can help you work out a plan that fits your budget. It can work as long as your payments are affordable on your current income.
Are there special loan consolidation options for veterans?
If you’re a veteran, there is a possibility of debt consolidation for VA loans. If you’re on active duty, your interest rates on mortgages and credit card accounts must be capped at 6% APR. This can give you breathing room.
Can medical debt be consolidated?
In many cases, your medical bills aren’t actually considered debt until they go to a debt collector, or if you used a line of credit to pay. If your medical bill debt is in collections, you might be able to consolidate it. For the most part, though, if you want to consolidate your medical debt, you should consider getting a personal loan and paying it off along with your other obligations.
Debt consolidation isn’t a solution for everyone, but it might help some people on their journey to become debt-free. If you decide that it won’t work for you, it’s possible to use other strategies to tackle your debt. You can create a debt paydown plan that allows you to tackle your obligations in order, or you can look for ways to earn additional income.
Additionally, there are other courses of action to take, including looking into debt settlement, bankruptcy, and credit counseling. Carefully consider your options, and consider talking to a professional, to determine your best course of action.
But if you are currently behind on your bills, getting slapped with late fees, and not sure how to change your personal finances, then handling your debt in some way will be key. If you’re ready to try debt consolidation, then check out our list of the best debt consolidation companies.
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