Should You Really Consolidate Your Debt? Essential Insights

Ravi thought he was making a smart move by consolidating his multiple loans into one. But months later, he realised his EMIs were lower, yet the total interest he was paying had nearly doubled. This is a common mistake many people make when consolidating debt.

Debt consolidation seems like an easy fix; it combines all your loans into a single payment, often with a lower interest rate. But is it always the best solution?

Let’s take an example: 

If you have ₹5 lakh in credit card debt at 36% interest, consolidating it into a personal loan at 14% seems excellent. However, if the tenure stretches from 2 to 5 years, you could pay more interest overall. 

According to Business Standard, interest on credit card dues in India ranges from 36–42%, while personal loans range from 10–31%. Therefore, while consolidating debt can lower your monthly EMIs, it's essential to consider the loan tenure and total interest payable.

Effect on Credit Scores with Debt Consolidation

Debt consolidation can affect your credit score differently, depending on how you manage your loans and payments.

While you might see a slight drop in your score initially, good financial habits can help improve your credit score over time. Let’s break down how it works:

1. Impact of a Hard Inquiry

When you apply for a loan (personal loan, home equity loan, or a balance transfer), the lender will run a hard inquiry on your credit report. This can reduce your score by a few points, but the impact is temporary.

Example:

Ravi had a credit score of 750. After applying for a consolidation loan, his score dropped to 742. But after six months of timely payments, his score went up to 765.

2. Reduction in Credit Utilisation Ratio

Your credit utilisation ratio is the percentage of your available credit limit that you are using. A high ratio (above 30%) can hurt your score.

Consolidating your debt with a personal loan changes your debt type from revolving credit (credit card debt) to installment credit, which doesn’t count 
against your credit utilisation ratio.

Read More – Is Your Credit Score Too Low for Debt Consolidation? Here’s What to Do

Consolidating your debt with a personal loan changes your debt type from revolving credit (credit card debt) to installment credit, which doesn’t count against your credit utilisation ratio.

Priya had three credit cards with a total limit of ₹2 lakh. She was using 50% of her limit, which hurt her credit score. After taking a personal loan to clear her debts, her credit utilisation dropped to 0%, boosting her score in just a few months.

3. How Your Credit Score May Fluctuate

Here’s a table showing how your credit score can change throughout the debt consolidation process:

Quick Tips to Boost Credit Scores After Consolidation

• Pay on time: Set up automatic payments to never miss a due date.
• Avoid closing old credit cards: Keep your old cards open to maintain a healthy credit utilisation ratio.
• Limit new loans: Too many hard enquiries can hurt your score.
• Track your credit: Use free credit score tracking tools.

Potential Risks of Closing Old Accounts

It might feel like a relief to finally close old credit accounts when you consolidate your debt. But wait! That’s where many people go wrong.

Two essential things affect your credit score:

1. Credit History Length: Lenders prefer to see a long history of good credit behaviour. The longer your credit history, the better your score.
2. Credit Age: Older accounts help maintain your average credit age. Closing these accounts shortens your credit history.

1. How Closing Accounts Hurts Your Score

If you close an old credit card after transferring its balance to a consolidation loan, your average credit age becomes shorter. This can reduce your score even if you’re paying your debts on time.

Example:

Imagine you have two credit cards:

• Card A: 10 years old
• Card B: 2 years old

If you close Card A after consolidating the debt, your credit history will now only show 2 years of history instead of 10. This shorter credit age could lead to a noticeable drop in your credit score.

What Should You Do Instead?

• Keep your old accounts open: If you’re not using the old credit card, leave it open.
  
  
• Use the card occasionally: Make small purchases, like groceries or fuel, and pay them off monthly.
  
  

This strategy keeps your credit age long and helps maintain a healthy credit score.

Ravi had a credit card for 12 years with a solid repayment history. After consolidating his debts, he thought closing the card would be a fresh start. 

Unfortunately, his credit score dropped by 30 points because he lost that long credit history. If he had kept the card open and used it occasionally, his score would have stayed high.

2. Debt-to-income ratio (DTI) and Future Loan Approvals

Even though debt consolidation can simplify your payments, lenders don’t just look at your credit score when offering new loans. They also consider your Debt-to-Income (DTI) ratio.

What Is the DTI Ratio?

The DTI ratio measures how much your monthly income goes toward paying debts. Lenders prefer a lower DTI because you have enough income to handle future payments.

Formula:

DTI = ( Gross Monthly Income/Total Monthly Debt Payments )×100

You reduce your monthly payments by consolidating multiple debts into a single loan with lower interest. This lowers your DTI and makes you more appealing to lenders.

Example:

Let’s say you earn ₹80,000 per month. Before consolidating:

• Total debts: ₹40,000/month
• DTI ratio: (40,000/80,000)×100=50%(40,000 / 80,000) \times 100 = 50\%(40,000/80,000)×100= 50%

A DTI of 50% is quite high, and banks might hesitate to offer new loans.

After consolidating:

• New payment: ₹25,000/month
• New DTI: (25,000/80,000)×100=31%(25,000 / 80,000) \times 100 = 31\% (25,000 / 80,000) ×100= 31%

Lenders with a lower DTI of 31% are more likely to offer you loans at better interest rates.

3. Accumulating New Debts

Here’s the mistake many people make after consolidating:

• They clear their credit cards with a consolidation loan.
• Then, they start using the cards again and build up new debts.

Now, they have two problems:

1. A consolidation loan to repay.
2. New debts piling up on credit cards.

This situation can hurt your credit score and make it harder to get future loans.

Priya consolidated her debts and lowered her DTI. Excited about her financial progress, she started using her credit cards again. Within a year, she had both the consolidation loan and ₹1.5 lakh in new credit card debt. Her credit score dropped, and banks rejected her home loan application.

Alternatives to Debt Consolidation

When considering debt relief options, consolidation isn't the only path. Let's explore alternatives that might align better with your financial goals and situations.

• Debt Snowball Method
  
  

This strategy involves paying off debts from the smallest to the most significant balance, regardless of interest rates. It's designed to motivate you by quickly ticking off smaller debts, creating psychological wins. 

For instance, if you have debts of ₹10,000, ₹20,000, and ₹30,000, you start with the ₹10,000 debt, paying as much as possible on it while maintaining minimum payments on others.

• Debt Avalanche Method

Contrary to the snowball, the avalanche method focuses on paying off debts with the highest interest rates first, which can save you more money over time on interest charges. 

Using the previous example but focusing on interest rates, if your ₹30,000 debt has a 20% interest rate while others have 15% and 10%, you would tackle the ₹30,000 debt first.

• Credit Counseling and Debt Management Plans

Credit counselling agencies can offer guidance on managing your money and debts, help you develop a budget, and typically offer free educational materials and workshops. 

A debt management plan (DMP) is a structured repayment plan through a counselling service, where you make a single payment to the agency, and they pay your creditors, often at reduced interest rates.

• Bankruptcy

Bankruptcy should be considered a last resort due to its long-term negative impact on your credit score. However, in extreme cases where other debt-relief options are not viable and debts are entirely unmanageable, filing for bankruptcy could provide a fresh start. 

It’s essential to consult with a bankruptcy attorney to understand the challenges and the process involved.

How to Choose the Right Debt Consolidation Strategy

Choosing the proper method for consolidating debt involves understanding various factors that could impact your financial health.

Factors to Consider

• Interest Rates: Always compare the interest rates of your existing debts with the consolidation loan offers to ensure you are saving money.
• Fees: Look out for hidden fees in consolidation loans or balance transfer cards, such as transfer or loan origination fees.
• Loan Terms: Longer loan terms might reduce your monthly payments but increase the total interest paid over the life of the loan.

Avoiding Pitfalls and Scams

1. Research Thoroughly

Before you choose a company for debt consolidation, research is essential. Many companies offer attractive deals but might be scams or charge hidden fees. Always check:

• Company reviews online.
• Whether the company is registered with financial authorities (like the Reserve Bank of India).
• Their history of customer complaints.

Sunil, a 35-year-old from Mumbai, found an online company that promised to “clear all debts quickly.” But after paying a hefty upfront fee, the company disappeared. A little research beforehand could have saved him from this scam.

Also Read - Debt Consolidation or Settlement – What’s Best for You?

2. Read the Fine Print Carefully

Even trusted financial institutions can have hidden terms. Always read the loan agreement carefully before signing.

Look for:

• Hidden fees (processing fees, prepayment charges).
• Interest rate hikes after a specific period.
• Early repayment penalties.

Anita took a loan with a low 10% interest rate. But after two years, the rate increased to 16% due to a clause she didn’t notice in the contract.

3. Seek Expert Advice

Consult a financial advisor if you are unsure. They can help you:

• Understand the risks and benefits.
• Choose the best consolidation loan option.
• Plan your repayments based on your financial goals.

Final Thoughts

If you have multiple high-interest debts and struggle with managing payments, consolidation could help. But, if your spending habits don’t improve, you could have even more debt. Always have a clear repayment plan before consolidating.

Ready to face your debt?

Start by consulting a financial advisor or using an online debt calculator. Ensure your decision leads to genuine financial freedom, not just temporary relief.

FAQs

1: What is debt consolidation? 

Debt consolidation involves combining multiple debts into a single loan or payment plan, often with a lower overall interest rate.

2: Is debt consolidation worth it? 

It can be beneficial if it reduces your interest rates and helps manage payments better, but it's important to assess your personal financial situation.

3: What are the risks of debt consolidation? 

Potential risks include longer payment terms, accruing more debt, and the need for collateral in some cases.

4: Can debt consolidation improve my credit score? 

Consolidation can improve your credit score over time if it helps you make timely payments and reduce your total debt burden.