When Is Debt Consolidation a Good Idea?

If you're in the process of becoming more financially responsible by paying down on existing debt or even getting close to completing payment of student loans, you're on the right track. One such approach you can take to merging your debt (and paying it off entirely) is debt consolidation.

In essence, debt consolidation is the process of paying off the higher interest rates (like borrowing with credit cards) by borrowing from a lower interest rate source. Theoretically, consolidation helps you to reduce your total debt and reorganize it so you can pay it off faster. This is especially true if you're dealing with a manageable amount of debt and just want to reorganize multiple bills with different interest rates, payments, and due dates. Conversely, making the minimum payment on your credit cards could mean months or even years before they're paid off, all while accruing more interest.

According to CNBC, 38 percent of people with debt have taken out a loan for debt consolidation. However, how do you know if debt consolidation is a sound strategy for you? We asked Stanley J. Kon, Ph.D. and chairman of Ripsaw LLC. "Lowering the cost of debt for the same amount of debt is always good," he says. "Consolidation that lowers overall debt at the same time depends on where the money is coming from and what the rate is compared to investment alternatives."

So, what are the downsides? Kon explains that this lower spending is more than likely a good thing, but foregoing investments may not be. For example, "if it prevents you from investing in a 401(k) retirement plan with a higher after-tax return than the cost of the debt, that would be bad," he adds. "That is why many people have a mortgage and substantial 401(k) or IRA plans. They are borrowing and investing at the same time, and it makes sense." At first, your credit score could drop if you chose to consolidate your debt; this is because you'd be opening up a new line of credit and transferring a large balance onto it. It's also worth noting that debt consolidation is not the same as debt settlement; with debt settlement, you enter into a negotiation agreement with your creditors to pay less than what you owe—typically, this is in the form of a single lump-sum payment. Consolidation loans can come with associated fees and those with secured debt oftentimes require collateral.

When it comes to any fiscal decision, always be monitoring your finances to determine if you're in the right place to consider consolation.