Is a Debt Consolidation Loan a Good Idea?

Exploring Strategies to Reduce Your Debt

A man looking at a sheet of paper considering if a debt consolidation loan is right for him.

If you have a lot of debt, debt consolidation can be a good way to help you reduce the amount of money you owe. But taking out a debt consolidation loan isn’t your only option when improving your financial health.

We’ll explore how you should begin the journey of managing your debt, strategies for reducing your debt burden without taking out any new loans, and when is a good time to consider taking out a debt consolidation loan. We’ll also cover different loans to help you decide what works for you.

Before you take out any loans, it’s best to address the underlying issues that have caused you to go into debt. Are you making too many purchases on your credit card? Can you reduce your monthly spending to live more within your means? Can you make a plan to manage your finances better? Let’s take a look.

Where to begin when paying off debt

Create a list of all your debts

The best way to start addressing your debt is to list all outstanding debts, loan balances, and interest rates. This gives you an idea of how much you own and a good starting place to reduce your financial burden. This might be intimidating, but you can’t move forward until you know where you stand.

Check Your Credit Score

Your credit score is a good barometer for your financial health. Checking where your score is now and monitoring where it goes as you pay down your debts helps you see if you’re going in the right direction. The higher the credit score, the better terms you will receive if you do take out a debt consolidation loan.

GNCU’s debt monitoring tool, My Credit Health, is available for members through the digital banking platform. Not only can it help you track your score, but you can see the balance of outstanding loans, get a sense of your financial health, and create goals to help you improve your score.

Create a Monthly Budget

Making a budget and sticking to it is the best way to get yourself out of debt, with or without a debt consolidation loan. You can explore many budgeting strategies, including the envelope budget, the 50/30/20 budget, or the zero-based budget.

Tracking your expenses and knowing your financial obligations can help you keep your spending under control and give you insights into how you can better optimize your finances.

Credit Counseling

If you are feeling lost, a debt and budget coach can help you make a plan to pay off your debt. They can look at your specific situation, analyze your spending patterns, and create a budget to manage your debt.

Take a look at these resources for financial coaching.

Debt Management Strategies

Now that you have a good idea of your financial situation, it’s time to start tackling your debt and paying it off.

When figuring out how to manage your debt, there are two common strategies: The avalanche method and the snowball method. Whatever method you decide, it’s important to continue making the minimum payments on all your debts while prioritizing which loans to pay off.

The Avalanche Method: Highest-Interest Debt

This strategy focuses on paying off your loans with the highest interest rate first and going down the list. As you pay off your higher-interest debts, you’ll have extra money to put toward your lower APR loans and eventually pay it all off.

The avalanche method is typically preferred because it helps you save money as you pay less interest in the long run by eliminating higher-rate loans.

The Snowball Method: Smallest Balance

This plan centers on paying off your debts with the smallest balances and building momentum as you pay off bigger loans. The snowball method is great if you want to simplify your life, as you will eliminate more loans quicker, giving you little wins as you pay off all your debt.

Both methods may prioritize the same loans. For example, mortgages have higher balances but lower interest rates than credit cards, which have higher APR but then have lower balances. Regardless, having a plan greatly increases your chances of getting out of debt.

What is a Debt Consolidation Loan?

Debt Consolidation works by taking out a bigger balanced loan and paying off high-interest loans. Many financial institutions offer loan products specifically for debt consolidation. This type of loan consolidates all your debts into one monthly payment, hopefully at a lower interest rate than your previous debts.

This can save you money and simplify your life by streamlining your debts into one payment, hopefully with lower interest. However, there may be origination fees for a new loan, and if you don’t have a good enough credit score, you might not be able to secure a loan with a better interest rate.  

When Should You Get a Debt Consolidation Loan?

You should get a debt consolidation loan if it helps save you money with a lower interest rate or lets you pay off your debts faster. Also, you should ensure you have the cash flow to cover the new monthly payments, as missing payments will further hurt your credit score.  Finally, you need to make sure you have addressed the reasons you have gone into debt in the first place.

However, if you can pay off all your debts in under a year, it’s probably not worth the fees, time, and credit check that goes into a debt consolidation loan.   

Benefits of a debt consolidation loan:

  • Simplify your payments into one loan
  • Save money by lowering your overall interest rate
  • Possibly pay off debt quicker
  • Improve your credit score

Risks of a debt consolidation loan:

  • Added fees and costs
  • You may pay more in interest overall
  • Put your assets at risk
  • Temptation to put more debt on paid-off credit cards
  • Doesn’t solve what got you into debt in the first place

Alternative To a Debt Consolidation Loan

A debt consolidation loan might not be your best option. There are a few alternative tools you can use in your journey to becoming debt-free.

Balance Transfer Credit Card

Many companies offer a balance transfer credit card to help you get out of debt. Look for a credit card with a 0% introductory APR (annual percentage rate) and a $0 annual fee.

Most balance transfer cards charge a one-time 3% to 5% fee on the debt you are transferring over. It may be difficult to find, but a $0 balance transfer fee would be ideal. Even with the small fee, this method can be much more affordable than typical credit card interest, which can be 20% APR or higher (at publication).   

The strategy is to apply for a balance transfer credit card, transfer all your debt to the new card, then pay it off before the 0% ARP introductory period ends. The common intro APR period is at least 18 billing cycles (about 28 to 31 days).

Home or Vehicle Equity Loan

If you’ve paid off all or a good chunk of your vehicle loan or mortgage, you could cash out the equity you’ve built in those assets to get money to pay off your debts. These loans can be a great option since their annual percentage rate (APR) can be in the single digits and much lower than credit card rates.

However, there is a lot of risk associated with these equity loans. You can get a good rate by putting up your home or vehicle as collateral, but you risk losing those if you can’t repay the loan. So, you must make sure you can pay off these equity loans before taking them out.

Click here to learn more about a Home Equity Line of Credit.

401(k) Loan

Depending on your employer, you may be able to borrow money from your 401(k) to pay off debt. However, borrowing from your 401(k) is risky and generally not recommended.

The positives of 401(k) loans are they’re usually cheaper than credit card debt, the interest you pay goes back into your account, and there is no credit check or impact on your credit.

On the negative side, the money you borrow isn’t making market gains, which can derail your retirement plan. Also, if you leave your job, you might be obligated to pay off the loan quickly. You could also risk tax complications and penalties. So, there are a lot of potential pitfalls when taking out a 401 (k) loan.

Takeaway: When is a Debt Consolidation Loan Worth It?

Overall, a debt consolidation loan is a good idea if it saves you money by merging higher-interest debt into a loan with a lower rate. However, a low credit score can prevent you from getting a better deal, and origination fees may eat into potential savings.

A debt consolidation loan isn’t just an easy fix for all your debt problems and might not be the best solution for your situation. Alternatively, planning a budget and reducing your expenses where you can be just as effective as taking out a new loan.