Debt Consolidation 101: Should You Consolidate Your Debt?

Debt is a fact of life for most Americans. Consider that the average individual has $38,000 in personal debt, not including mortgage debt. What's more—a scant 23% of U.S. residents report that they carry no debt, a figure that's been decreasing over the past few years.

However, while debt may be common, it doesn't have to be stressful or all-consuming. For many, debt consolidation provides a way to simplify multiple payments, while reducing your interest rate. It can make the path toward paying down your debt more apparent and ensure you stay the course.

Learn more about what consolidating debt entails—and the pitfalls to avoid—you may just discover that it's exactly what you need.

What is Debt Consolidation?

The concept of debt consolidation means that you roll all of your debt payments into one loan. You end up with one payment and one interest rate. It sounds simple—and it can be. But there is more than one way to handle this consolidation, from taking out a 401k loan to leveraging a balance transfer credit card. Each has its pros and cons, which we'll touch on momentarily.

The overall goal should be to roll high-interest debt into a lower interest rate, which will save you money over the long term and ideally reduce your monthly payments. However, in some cases, in order to achieve a monthly payment that's doable, people end up extending the terms of their loan.

Do the math for your situation and determine what's most important to you. If you've been missing payments and impacting your credit score, then you may simply want a single payment you can afford—and be willing to take a bit longer to pay it down to achieve that. It may be that paying the reduced interest rate even with a longer-term is still less than paying down your debt under your current terms.

Your Debt Consolidation Toolbox

As mentioned, you've got a couple of options for consolidating your debt. Here are four of the most common:

A personal loan. In this case, you take a loan from your bank or perhaps a debt consolidation company to pay down your debts. You're looking for an unsecured loan with a low-interest rate so that your monthly payment isn't overly burdensome. Those with the best credit have a better chance of getting a lower rate. However, be sure to shop around. Do be wary of online lenders, as they can sometimes charge a fee to originate the loan. Do your homework to make sure you don't end up paying more to pay less.

A home equity loan or line of credit. If you own a home, this can be a good option. With a HELOC or line of credit, you essentially borrow money against the value of your home. The interest rates tend to be lower than a personal loan, and the terms for paying the money back can range from five to 20 years.

A balance transfer card. This is a credit card designed for debt consolidation. If you have excellent credit, then you may be eligible for an introductory period of 0%—usually for about 18 months. You can transfer your debt (usually for a fee), pay it down rapidly and sidestep paying interest altogether. However, if you extend out of that introductory window, the interest rate kicks back in and it's often close to regular credit cards.

A 401k loan. Conventional wisdom suggests that you should never touch your retirement savings. However, if your debt is preventing you from saving and putting you in financial peril, then you may need to reconsider. A 401k loan will likely offer a lower interest rate than your bank and doesn't show up on your credit report. But you must pay it off within five years or you'll face steep penalties. Additionally, if you leave your employer, the loan will come due within 60 days.

Does Debt Consolidation Make Sense for You?

Everyone's debt situation is different. To evaluate whether consolidating your debt makes sense, you need to first understand the debt you have. Write out all of your payments, the interest rates, the term, and the amount owed. Then ask:

• Am I paying exceedingly high interest on some or most of this debt?
• Can I find a loan with an interest rate that's less than average of interest rates that I'm currently paying?
• Can my consolidated monthly payment be smaller than the combination of payments I'm making now?
• Would consolidating my debt help me pay my debt down faster and/or ensure I don't miss monthly payments?
• Am I committed to not taking on any new debt in the process?

If you answer yes to one or more of these questions, then debt consolidation is worth is investigating. Look for a loan product that fits with your needs, credit score, and financial plan. Dig into the payment terms of your new loan so that you understand what's required. And put yourself on a path toward less debt and less stress.