5 Myths About Debt Consolidation
by Kimberly Rotter | Updated Aug. 13, 2021 - First published on July 1, 2021
Consolidating your debt can be a good way to lower costs and reach your financial goals
If you're trying to get out of debt, a debt consolidation loan is one strategy to consider.
Debt consolidation is when you combine more than one debt into a single debt. In addition to a debt consolidation loan, some other popular ways to consolidate debt include:
There are a lot of pros and cons to consolidating debt as well as a whole lot of myths surrounding the subject. Before you go forward, we'll bust a few of those myths that might affect your decision.
Myth No. 1: Debt consolidation allows you to pay back less money
Debt consolidation isn't a debt settlement. In a debt settlement, the consumer negotiates an agreement to pay back less than they owe. If it sounds too good to be true, that's because it usually is. Debt settlement can take a long time. It may hurt your credit score severely and cost you extra money in taxes and fees. Also, there is no guarantee that you will ultimately pay less than you would have paid without the settlement.
Debt consolidation does not change the amount of your balances. You are simply taking one bigger loan to pay off multiple smaller debts.
Myth No. 2: Debt consolidation hurts your credit score
Any time you apply for credit, your credit score can lose a few points. When you apply for a debt consolidation loan, there is no rate-shopping window. Every application will create a new inquiry on your credit report, and each one has the potential to lower your score a little bit.
That said, the debt consolidation loan itself doesn't hurt your credit score. Here's why.
Your credit score is based on:
- Your payment history
- Your credit utilization ratio -- how much you owe on your credit cards compared to the limits
- Your credit mix -- the different types of credit you may have (credit cards, installment loans, mortgage, etc.)
- The age of your credit accounts
- The number of times you've applied for new credit recently (inquiries)
In some cases, a debt consolidation loan can actually make your credit score go up. That's a common result for people who use this type of installment loan to pay off credit card debt. When you pay off your cards, your utilization rate goes down because it's calculated on your revolving debt, not your installment loan debt. Utilization is a big factor in your credit score, so paying off your cards could cause your score to rise considerably.
Also, if you didn't have an installment loan on your credit report before, your credit mix will improve when you get the debt consolidation loan. That could also cause your credit score to go up.
Myth No. 3: Debt consolidation takes a long time
Debt consolidation is not a lengthy process. If you qualify for a debt consolidation loan, you can consolidate your debts in the span of a few days. The factors that affect the timeline include:
- Time to research loan options
- Whether you qualify now or need to improve your credit score first
- How quickly the lender processes and approves your application
- How long it takes to receive the funds (typically same-day or a few days after approval)
Myth No. 4: Debt consolidation costs a lot of money
Debt consolidation is not free. Most lenders charge an origination fee or a lender fee. Those that don't usually charge a higher interest rate.
Even so, many people lower their overall cost when they consolidate their debt. That's because the interest rate for a personal loan can be lower than the average interest rate on the debts you want to combine. This is particularly common if you currently have credit card debt.
As long as you research consolidation loans and their fees carefully before you choose one, debt consolidation can be a smart solution to paying down your debt.
Myth No. 5: Debt consolidation results in more debt
One of the most dangerous pitfalls of debt consolidation is increasing your overall debt load. This can happen when you use a loan to pay off your credit cards and then you charge the credit cards back up again.
Only you can bust this myth.
Yes, if you pay off your credit cards with a new loan, you will have the opportunity to rack up even more debt. But if you have a solid financial plan, adding to your debt load is far from inevitable.
One great solution is to close your credit card accounts as soon as you pay them off. Don't worry about this hurting your credit score. For one thing, getting out of debt is more valuable than protecting your credit score in the short term. For another, the damage is likely to be minimal. You could lose a few points if your account age goes down, but you'll gain points when your utilization ratio goes down.
The pros of getting out of debt far outweigh the cons of temporary fluctuations in your credit score.
Before you apply for a debt consolidation loan, take a step back and evaluate the reasons you're in debt in the first place. For a lot of people, debt is the result of a financial situation that was not in their control. But debt can sometimes be the result of overspending or not having the right budgeting method in place. No matter which category you're in, you'll get the greatest benefit from debt consolidation if you pair it with a plan to manage your personal finances.
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