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Debt Consolidation: Everything You Need to Know

When you’re in over your head with student loan payments, credit cards, and more, paying off debt can seem nearly impossible.

Debt consolidation might be an option for you if you need help digging yourself out of a hole. Keep reading to learn more.

What is debt consolidation?

Debt consolidation is the process of taking out a new loan to pay off other debts you owe. This option ideally offers a better payoff deal than your old debts original terms, such as lower interest rates and monthly payments. 

It’s a great way to pay back overwhelming credit card debt, student loans, and other liabilities.

How does debt consolidation work?

The first step to starting debt consolidation is to visit your bank, credit union, credit card company, or online personal loan provider to apply for a consolidation loan. If you have a good history with the institution you’re applying at, it should be easier to get the loan. If you aren’t approved, you could try private lenders or mortgage companies. 

Once you have the loan, it will enable you to pay off all your debts through that single loan. Many creditors are willing to do this because it increases their chances of actually collecting the debts. 

Your new loan will be refinanced with an extended repayment period, so keep in mind you will likely be in debt for a longer period of time. Plus, a lower interest isn’t’ always guaranteed, so be sure to read the fine print with your financial institution. 

To sum up the debt consolidation process: 

Step 1: Apply for a loan with a trusted lender 

Step 2: Take out the loan with the lowest rates and best terms

Step 3: Use your loan to pay off your existing debts. 

Different types of debt consolidation explained: how to consolidate debt

There are different kinds of debt consolidation loans and each have their own set of pros and cons. Learn which could be right for you.

1. Debt Management Plans

Debt management plans are a solution for anyone struggling to pay their bills every month. They work by combining all of your unsecured debts into one monthly payment that you can pay off in three to five years. The interest rates, monthly payments, and late fees are lower and you pay a credit counseling agency, who will then pay the creditors the agreed-upon amount.

Learn more about Debt Management Plans>

2. Debt Settlement

Debt settlement is very different from debt consolidation. Like we said, consolidation is a loan that lumps all your unsecured debts into one single payment. Settlement, however, is when you work with a company to negotiate a lump-sum settlement payment with your creditors for less than the original amount you owe. These companies charge a fee for their service, and oftentimes it’s between 15-20% of your total debt. They do not make any actual payments to your credit institutions, they only try to negotiate your current debts.

Learn more about Debt Settlement >

3. Debt Consolidation Loans

If you’re having trouble managing all of your outstanding debts, a debt consolidation loan may be an option. Banks and private lenders offer these in two different forms: secured and unsecured. A secured loan is backed by one of your assets, like a car or house, to act as collateral. An unsecured loan is not backed by any assets and is more difficult to obtain. They also have higher interest rates and lower qualifying amounts, although the interest rate is still typically lower than what is charged by credit card companies and financial institutions.

Personal loans

Personal loans can be used for just about anything, including paying off your debt! The lender may ask you what you’re planning to do with the money, but most will just want to know you’ll be able to pay it back. 

They aren’t secured by collateral and can be relatively inexpensive compared to other loans.

Learn more about personal loans >

Other types of loans

We recommend exploring the options above before tapping into retirement funds and your home value. That said, it’s important to understand all of the options below. 

401(k) loans

A 401(k) loan is when you borrow money from your retirement savings account. Every employer’s plan is different, but it’s typically a fast and convenient way to get the money you need. You’ll have to pay back the borrowed money with interest within five years of taking the loan, depending on your employers terms. 

Home equity lines of credit (HELOCs)

A home equity line of credit (HELOC) is a second mortgage that allows you to access cash based on your home’s value. Similar to a credit card, they’re pretty flexible in that you can borrow as much as you need up to your home’s equity. These also have flexible interest rates. 

To get one, you need a credit score of 620 or higher, a home value that’s at least 15% more than what you owe, and a debt-to-income ratio that’s 40% or less.

Home equity loans

A home equity loan is when you borrow money using your home as the collateral. The money comes as a lump-sum payment and you repay the loan with a fixed-rate interest during a predetermined amount of time. 

The amount of money you can borrow is usually determined by your income, market value of your home, and your credit history. A bank, credit union, mortgage company, and mortgage broker are all options to consider taking a loan from.

4. Balance Transfer Credit Cards

If you don’t want to take out a loan, you might consider consolidating all of your credit card payments onto a new credit card. This could be a good idea if the new card charges little to no interest or if there is a $0 annual fee and $0 transfer fee.

When is debt consolidation a good option?

When considering whether debt consolidation is a good idea for you or not, think about your current situation. If you’re juggling multiple bills with different payment amounts, interest rates, and due dates, consolidating everything into one lump-sum payment might be a good idea. Especially if you can get a lower interest rate than what you already have.

“What type of debt consolidation option is best for me?”

The two most common (and least risky) ways of consolidating debt both involve lumping all your current debt payments into one monthly bill. 

The first is to move all your debts to a 0% interest balance-transfer credit card and be sure to pay it in full each month. You’ll most likely need a credit score of 690 or higher to qualify. 

The next option is to apply for a fixed-rate debt consolidation loan at your financial bureau. Then, use that money to pay off your debt while paying off that loan in set installments. These loans don’t require an excellent credit score, but the higher the score, the lower your interest rate will probably be.

Risky debt consolidation options you should avoid:

Debt consolidation isn’t a perfect solution for overwhelmed debt and doesn’t always work. Here are two loans to be wary of because they put two very important things at risk–your home and your retirement.

401(k) loans

A 401(k) loan allows you to borrow money against your retirement savings account, so it should be used as a last resort when you need to pay off debt. 

This option is appealing because of it’s low-interest, but it could totally derail your retirement savings. The amount of money you borrow won’t be growing compound interest that could benefit you in the future. There could also be potential tax consequences and penalties for this type of loan if it’s not paid back. Plus, you’ll still have to pay back the balance of the loan if you leave the job.

Home equity lines of credit (HELOCs) & home equity loans

Using home equity lines of credit (HELOCs) or home equity loans relies on your home as collateral, so it can be a risky option to consider. 

Let’s start with HELOCs — like we said, these are structured similar to credit cards in that you can access cash based on your home’s value. They have a low, variable rate but because you can take out different amounts at different times, they’re harder to budget for. 

Adjustable rates also mean that your payments could increase, leading to deeper debt in the long run.

A home equity loan can be a good idea depending on your financial situation, but nonetheless, you should proceed with extreme caution. With this loan you’ll have a fixed rate and a set payment schedule, so it’s easier to budget for. 

But, if you miss a payment or are late, it could put you in danger of losing your home. And if you decide to sell while the loan is still in place, you’ll have to pay the entire balance at once.

FAQs

Does debt consolidation hurt my credit?

If you make your loan payments on time every month and pay more than is due, it could help improve your credit score. 

But if you continue unhealthy spending habits like spending more than your line of credit, or you’re late with your payments or completely miss them, this will hurt your score.

Can I consolidate my debt before applying for a mortgage?

Yes, but patience is key. Consolidate your debt well in advance of buying a home so you’ll be more likely to be approved for a mortgage. 

If you pay off your consolidation loan on time and in the full amount, your credit score will increase, which looks great to mortgage companies. It shows you will be a responsible borrower.

Can I refinance my mortgage to consolidate debt?

You can refinance a mortgage to pay off debt, but you’ll want to make sure you have enough equity. A good rule of thumb is if you’ll end up owing more than 80% of your home’s value after you refinance, hold off because you’ll have to buy mortgage insurance. You need 20% equity in your home to avoid mortgage insurance.

Can I file bankruptcy on debt consolidation?

They are two different things! Bankruptcy is a legal process overseen by the federal courts and designed to protect individuals and businesses overwhelmed by debt. It does major damage to your credit score, so another viable option is debt consolidation. 

You’ll only want to file for bankruptcy if you cannot consolidate your debt. Speak with a debt coach or a lawyer before going down this path.

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