Should I consider consolidating my credit card debt?

Debt consolidation is when you pay off several loans or debts with a single loan—you consolidate all your debt into a single loan. It does not reduce the principal you owe, so that in sense it won’t help you—your total debt will remain the same but will be combined from three credit cards into a single loan. The most common—and beneficial—types of debt to use to consolidate credit card debt are mortgages or home equity lines of credit or loans, so that’s what we’ll discuss below.

If consolidation doesn’t reduce your debt, what are the advantages? There are several:

• Depending on the interest rate on your existing debt and also how payment is structured (e.g. the monthly minimums and how long a period of time you have to pay the debt off), you may be able to reduce your monthly payments. For example, one survey showed that in December 2009, average credit card interest rates were around 12 – 13%. The same organization found home equity lines of credit with average rates of around 6%. That means that the average American could chop 7% off their interest by replacing credit card debt with home equity debt. For you, with around $30k in debt, that’d save around $2,100 the first year.
• The consolidated debt may be tax deductible. Mortgages and home equity lines or loans are tax deductible, so you could deduct your interest payments (not including any portion of your monthly payment that is repayment of principal) from your gross income for purposes of reducing taxes. For most Americans, this equates to saving an amount equal to 1/5 to 1/3 of the interest.
• One payment may be easier to keep track of and less demoralizing than multiple payments.

However, there are downsides, too:

• Usually there are fees involved with new borrowing, so you may have to pay some application fees or points to take out the new loan. This can be several hundred to several thousand dollars.
• If you use a mortgage or home equity, you potentially put your home at risk if you can’t make payments.
• If you extend the total time you have to repay, even though your monthly payment may be smaller, you may have higher total payments.

So there’s no simple, one-size-fits-all answer—whether debt consolidation is right for you depends on your circumstances.

Your credit score is also known as your FICO score. It’s based on a great many factors, but the ones that most likely would affect you are: (1) the ratio of debt to available credit; (2) how long your different loans, debt, or sources of credit have been in existence; (3) your payment history; and (4) whether you’ve recently opened up new credit.

If you’ve maxed out or near maxed out on your credit cards, but consolidate them under a large home equity loan or line where you are only using part of available credit, that would help your score—a lower ratio of debt to credit. And if you can’t make your existing payments, but could make a consolidated one, that would also be good, since you won’t have (as much) negative payment history.

On the other hand, if you’ve had your credit cards for a long time, paying them off—if either you or the credit card companies then close them—would look bad for your score. And taking out new debt also may look bad.

So again, there’s no simple answer: sometimes consolidating helps your credit score, sometimes it doesn’t.

Overall, though, the most important thing is to be able to manage and live with your debt. If you can’t pay it as it stands, you’re wise to consider other options.