Debt Consolidation Explained

When you’re in over your head with credit cards, student loan payments, and more, paying off your debt can seem nearly impossible. Debt consolidation offers a way to combine your debts into a single balance with one monthly payment (and possibly a lower interest rate).

There are several ways to consolidate debt, and it’s important to understand that consolidation isn’t a good fit for all borrowers. Here’s what you need to know about debt consolidation.

Key Takeaways

• Debt consolidation combines multiple debts into a single payment, which can simplify repayment and potentially reduce interest costs if you qualify for a lower rate.
• Common debt consolidation options include debt consolidation loans, personal loans, balance transfer credit cards, home equity loans/lines of credit, debt management plans, and debt settlement.
• Debt consolidation can be a good idea if you’re juggling too many payments, paying high interest rates, or need the structure of a defined repayment timeline.
• Consider your credit score when choosing a debt consolidation option. Those with good credit may qualify for low-rate loans or 0% balance transfer cards, while those with poor credit may need to look at secured loan options.
• Shop around and compare lenders, interest rates, fees, and loan terms to find the best debt consolidation solution for your situation.
• Debt consolidation alone may not resolve underlying financial issues such as overspending habits or low income. Combine it with budgeting, earning more income, and developing healthier financial habits.
• Before consolidating, ensure you’ll save money over the long-term compared to your current debts. Don’t consolidate if it will ultimately cost you more.

What Is Debt Consolidation?

Debt consolidation takes multiple debts and combines them into a single debt. Borrowers can switch to making one monthly payment, which is much easier to track. And if your consolidated debt has a lower interest rate than your existing debts, you could save money over time and get a lower monthly payment.

But debt consolidation can have some drawbacks. You’re simply shifting your existing debts from one place to another, so you aren’t removing or reducing your debt in any way. And if you can’t get a lower interest rate, you won’t see much value from debt consolidation.

How Does Debt Consolidation Work?

The most common types of debt consolidation involve taking on a new debt that combines your existing debts into a single balance. (We’ll get into a few alternatives later). Here are the steps you can take:

1. Assess your debt. Make a list of all your debts, including the amount you owe and the interest rate. Add them up to calculate your total debt amount.
2. Explore consolidation options. Evaluate the different types of debt consolidation you may be eligible for and determine which option is right for you.
3. Shop around for lenders. If you plan to get a loan or credit card to consolidate your debt, shop around for the best lender or creditor. Compare interest rates, terms, and fees from several lenders to find the best option.
4. Apply for a loan or credit. Gather the documents you need and submit your application to the lender or creditor who will be handling your debt consolidation.
5. Consolidate your debts. Depending on the debt consolidation option you choose, you may need to pay off or transfer your existing debts yourself, or the lender may handle this step for you.
6. Repay your consolidation loan. Always make your payments on time and work toward total debt repayment.

Different Types of Debt Consolidation Explained

There are many ways to consolidate your debt, each with its own set of pros and cons:

Debt Consolidation Loans

Debt consolidation loans roll multiple debts into a single loan. The lender will issue the funds to pay off your debts with the original creditors and set one fixed monthly payment. Debt consolidation loans cannot be used for secured debts that are tied to collateral, such as mortgages or car loans. Debt consolidation loans can be secured (where you provide collateral) or unsecured.

Pros:

• Simplifies your debts into a single payment.
• Potentially offers better interest rates and a lower monthly payment.
• Sets a fixed timeline to repay your debts.

Cons:

• Not as valuable if you can’t get a lower interest rate.
• Lifetime cost of your loan could be higher than existing debts.
• May include upfront fees.

Personal Loans

Consumers can take out personal loans (which can be used for almost any purpose) to pay off multiple debts themselves and then simply pay back the loan. This strategy could make sense if you can qualify for a lower interest rate.

Pros:

• Simplifies your debts into a single payment.
• Potentially offers better interest rates and a lower monthly payment.
• May include upfront fees.

Cons:

• Requires manual repayment of individual debts.
• Not as valuable if you can’t get a lower interest rate.
• Lifetime cost of your loan could be higher than existing debts.

Balance Transfer Credit Cards

Credit cards with low introductory APR offers can help borrowers pay off their high-interest credit card debts quicker. You simply open a card with a low introductory APR (some cards go as low as 0% for qualified borrowers) and transfer your existing credit card balances onto the new card. Ideally, you pay the balance off before the introductory rate expires, lowering the interest you’ll pay (or eliminating it entirely).

Pros:

• Low introductory APR for a limited period reduces the interest you pay.
• Combines your existing credit card balances onto a single card.
• Gives you a timeline to pay off your debt before the introductory APR expires.

Cons:

• The best interest rates are only available to borrowers with good credit scores.
• Many credit cards charge a balance transfer fee of 3% to 5% of the transfer amount.

Alternative Loan Options

Some borrowers may turn to alternative options to pay off debt:

• 401(k) loans let you borrow money from your retirement savings account, but you will owe taxes and penalties if you don’t pay the loan back.
• A home equity loan lets you borrow a lump sum against the equity of your home. But you must use your home as collateral and repay any outstanding balance when you sell your home.
• A home equity line of credit (HELOC) lets you borrow a line of credit against the equity in your home, but you must use your home as collateral and repay any outstanding balance when you sell your home.

Because of the risks involved, these options should only be considered as a last resort.

Debt Management Plans

A credit counseling agency can negotiate with your creditors to create more favorable terms or repayment plans. The credit counseling agency will collect a single payment from you each month and pay your creditors directly.

Pros:

• Potential for lower interest rates and better loan terms.
• Expert guidance from financial counselors.
• Simplifies your debts into a single payment.

Cons:

• May require enrollment fees and ongoing management fees.

Debt Settlement

Debt settlement involves working with a company that attempts to negotiate a settlement with your creditors for less than the amount you owe. The company may advise you to stop making payments until an agreement is made and will charge you a percentage of your total debt. The company will not make any actual payments for you.

Pros:

• Potentially significant debt reduction.

Cons:

• Potentially high fees.
• No guarantee of successful agreement.
• Potential negative impact on your credit as you stop making payments.
• Potential for increased debt in the form of interest and fees as you stop making payments.
• You will owe taxes on canceled debt.

When Is Debt Consolidation a Good Idea?

There are a few scenarios where debt consolidation is a good idea:

• You’re juggling too many debts. If you can’t keep up with the number of monthly payments you have to make, debt consolidation can simplify things.
• You’re paying high interest rates. If you can qualify for a better interest rate with a debt consolidation option, you can save money.
• You need structure. Debt consolidation makes debt repayment manageable with a single payment and a clear repayment timeline.

Best Debt Consolidation Options for Different Situations

The best debt consolidation option depends on your situation:

• You have a good credit score. Balance transfer credit cards with 0% APR offers or fixed-rate debt consolidation loans with low interest rates are best when you have good credit.
• You have a subprime credit score. Look at secured debt consolidation loans (where you put up collateral) or bad credit loan options when you have subprime credit.
• Smaller debts. When you have smaller debts, a personal loan with flexible repayment terms or a balance transfer credit card might be your best bet.

Beyond Debt Consolidation: Additional Strategies

If you’re looking at debt consolidation, chances are you need some better debt management strategies. Here are some ways to manage your debt:

• Budgeting and expense tracking. Create a monthly budget that tracks all your income and expenses. Monitor your spending habits and look for ways to put extra funds toward debt.  
• Increasing income. Look for ways to generate additional income to pay down debt. You can pursue a promotion or raise at work, look for a better-paying job, or start a side hustle.
• Debt negotiation. Contact your creditors to negotiate better interest rates or friendlier repayment terms. They may cooperate if you explain your financial situation, especially when you have a long history of timely payments.

Warning Signs Debt Consolidation Isn’t Right for You

Here are some signs that debt consolidation isn’t right for you:

• Overspending habits. If you tend to overspend and you won’t change your habits, debt consolidation likely won’t help you in the long run.
• Underlying financial issues. If job insecurity, low income, or other financial problems are limiting your ability to handle your debts, you should work on addressing those issues first.
• Short-term debt. Consolidation might not be worth the effort if you have small, short-term debts that can be paid off quickly.

Choosing the Right Debt Consolidation Lender

Don’t just apply for a loan with the first debt consolidation lender that shows up on Google. Here’s how to find the right lender that meets your needs:

• Know how much you need. Add up your debts to find out how much you need for debt consolidation. There will be a limit to how much you can borrow.
• Pay attention to credit score requirements and debt-to-income ratio requirements. Lenders have requirements that you must meet to qualify.
• Compare interest rates and fees. Shop around for the best interest rate. If you can’t beat the interest rates on your existing debts, debt consolidation might not be worth it.
• Research the lender’s reputation. Check online reviews and ensure the lender is legitimate. Look for complaints on websites such as the Better Business Bureau and Trustpilot.
• Run the repayment math. Compare the cost of paying the debt consolidation loan with the cost of paying each account individually. Don’t consolidate if you would end up paying more in the long run.
• Look out for hidden costs. Read loan documents carefully to understand your repayment terms and any fees you may incur.

Bottom Line

Debt consolidation can offer a lifeline when you’re overwhelmed by multiple debts. Combining debts into a single account with one monthly payment and a lower interest rate is a great way to gain control of your finances and even save some money. But debt consolidation isn’t a one-size-fits-all solution.

At Credit & Debt, we understand the complexities of debt management and consolidation. Our experts can offer you custom advice that empowers you to manage your debt, and even help match you with the right financial products that meet your needs. Take control of your financial future with the assistance of Credit & Debt, your partner in debt resolution.