What Is Debt Consolidation and How Does It Work?
Debt consolidation is an umbrella term for combining various debts into a single one. This can be done through a loan, using a balance transfer credit card, or through a specialized agency, among other options. The goal is to make the "new debt" more manageable by having one lender, one monthly payment and one interest rate.
How does debt consolidation work?
Debt consolidation gathers debt balances from multiple sources and puts it in one place, simplifying your payoff strategy. You can develop a debt consolidation plan on your own, through a financial institution, a credit counseling agency, or a debt relief company.
Regardless of the solution you choose, the goal is for the ‘new’ debt to have a lower interest rate than the ones you originally had, and one monthly payment that is smaller than your old bills combined.
To know which debt consolidation strategy is the best, you need to evaluate the debt you’re working with and the terms you’re willing to agree to. Here are some steps to guide you through:
Take inventory of the debts that need consolidating
First, make a list of the debts you want to consolidate along with their remaining balance. Some debts, like credit cards, are easier to bundle up, while others, like personal loans, require a more complex strategy.
Check your credit score
Many debt consolidation strategies involve getting a new loan or credit line to combine your debts, so a good credit score and credit history are ideal. Knowing your credit score will allow you to determine whether it’s the right time to consolidate, or if you should work on improving your credit first, to get the best loan terms and rates possible. You can also request a free credit report from websites such as AnnualCreditReport.com, which allow you to see your report from all three major credit bureaus (Experian, TransUnion, and Equifax.)
Know the interest rate you’re shooting for
You’ll want a low interest rate that’s better than your weighted average. To calculate what your weighted average interest rate is, add up your debt balances. Then add up the interest paid in dollars on each of these accounts. Then, divide the total debt by the total interest paid and multiply that number by 100 to get that percentage.
Determine how much you’re willing to pay every month
Run the numbers and come up with a monthly payment that’s reasonable based on your current financial situation. Make sure this loan payment also accounts for any repayment fees required.
Different ways to consolidate your debt
Your options to roll debts together into a consolidated solution depends not only on your eligibility for credit but on the kinds of debt you hold.
Secured debt is debt that, like a mortgage or car loan, is backed by collateral like a house or a car. Such debts require special care when it comes to debt consolidation.
Unsecured debt has no such asset tied to it (think: credit cards, student loans, or medical bills) and is typically the best candidate for debt consolidation. There are many consolidation options:
- Debt consolidation loan - just as its name suggests, this is a single loan designed to pay off multiple unsecured debts. You can get this at any financial institution or credit union depending on your credit score. Instead of paying multiple creditors, you can have a single monthly payment.
- Personal loan - a personal loan is similar to a debt consolidation loan, in terms of the qualification requirements and issuers. The only difference is that they aren’t strictly tied to one purpose.
- Debt management program - this is an ideal option for those who have a less-than-stellar credit score as they don’t require you to apply for a loan. They feature direct credit counselors, are usually offered by nonprofit credit counseling agencies, and last three to five years.
- Credit card balance transfer - if you’re just looking to consolidate credit card debt, this is probably your best option. With a balance transfer credit card, you can transfer multiple balances from different credit cards to another card with a lower APR. Just make sure to consider balance transfer fees, late fees and always at least make the monthly minimum payment.
- Direct consolidation loan - this option is only for those looking to consolidate federal student loans. You can apply for it via the U.S. Department of Education.
- Home equity loan - many lenders that offer consolidation loans also offer home equity loans. Home equity loans offer lower interest rates compared to other options, since your house acts as collateral — but this is also their biggest disadvantage — as you could lose your home if you default on the loan.
- 401(k) loan - using your 401(k) is a tempting option as you don’t have to worry about passing a credit check. However, taking a loan against your retirement savings could result in tax penalties if not paid back in a timely manner.
- Debt settlement - this should be one of your last resorts, as it can have long-lasting effects on your credit score. Debt settlement usually involves hiring a debt relief company to negotiate with your creditors to pay less than what you owe.
- Bankruptcy - many don’t consider bankruptcy as a form of debt consolidation, but it can actually serve as one, particularly Chapter 13, which is a restructuring bankruptcy.
Debt consolidation vs. debt settlement
| Debt consolidation | Debt settlement | |
| What it is | Combines multiple debt balances into a single one | Negotiates your current debt balances for a lower amount |
| How it is done | You can do this yourself by applying for a loan to consolidate your debts, or using a balance transfer credit card. | You can either negotiate this directly with your creditors, or hire a for-profit debt settlement company to work on your behalf |
| Impact on credit | It may drop by a few points at first, but as long as you stick to the plan, it will bounce back within a few months | It will leave a negative mark on your credit report for up to seven years |
| Who it may be right for | Anyone who’s having issues managing multiple accounts and want to save money on interest | For those close to bankruptcy whose debts may be unmanageable otherwise |
| Pros | 1. No negative long-term impact on your credit, as long as you pay on time 2. Lower monthly payments 3. Save money on interest 4. Increases your cash flow over time 5.Can help you improve your credit score | 1. You may end up paying as much as 50% less than what you owe 2. Can help you avoid bankruptcy 3. It may take less time than with a consolidation plan |
| Cons | 1.You may have to pay additional fees 2.Takes a lot of discipline to succeed 3.It may take you a while to pay it all off | 1.There is no guarantee creditors will negotiate with debt settlement agency, and you can end up in a worse position 2.It can affect your credit for years and hinder your ability to apply for new credit 3.There may be tax penalties on the discharged amount |
How do you choose the right debt consolidation loan?
Debt consolidation loans are not one-size-fits-all. When deciding which is the right one for you, it’s important to consider two things: your credit score and the type of debt you want to pay off.
If most of your debts are secured, such as an auto loan or a mortgage. Then, the best course of action is to look for a refinance loan. If you’re looking to consolidate unsecured debts, like personal loans, student loans or medical bills, then the best route is to take out a consolidation loan.
And obviously you’re going to be looking for an interest rate lower than the ones you are currently paying. If the new interest rate isn't fixed, be sure to talk to the lender about the possibility that it might increase down the line and budget accordingly. And no matter what, read the fine print. Every last tiny line of it.
How do you choose the right debt consolidation company?
There are plenty of companies that exist just to take advantage of people struggling with debt — you want to avoid these companies at all costs.
For a loan or a balance transfer credit card, use a licensed financial institution and a name you trust. If you decide a debt management plan or a debt settlement is right for you, vet the debt relief company or agency in question through the Better Business Bureau to see if any complaints have been made against them.
Lastly, you’ll want to choose a company that can give you the right solution that adjusts to your monthly budgeting and to the timeframe you’ve established to pay off your debts.
Debt consolidation FAQs
What is debt consolidation?
Debt consolidation is a personal finance strategy that consists of taking multiple high interest debt balances from different sources and combining them into a single account, to ease debt repayment.
How does debt consolidation work?
There are multiple ways to consolidate your debt. You can take out a personal or a debt consolidation loan to pay off your balances, transfer your credit card balances using a balance transfer card, or by designing a debt management program with the help of a credit counseling agency.
How do I get a debt consolidation loan?
When getting a debt consolidation loan, the first thing you need to do is take note of how much you owe on each of the accounts you want to pay off or consolidate. That way, you’ll know the exact loan amount you’ll need to borrow. Once you do that, it’s time to shop for lenders to ensure you get the best terms and rates possible. If you don’t know where to start, prospective borrowers can use a rate comparison website, like Credible or LendingTree.
How does debt consolidation affect your credit score?
Debt consolidation may cause your credit score to drop by a few points. This is because when you take out a loan to consolidate your debts or transfer the balances to a new credit card, both of those accounts are new and don’t have a payment history, which is one of the biggest factors taken into account to calculate your FICO score.
What is the best debt consolidation company to use?
When looking for a debt consolidation company, whether it's a financial institution or a credit counseling agency, the most important thing is to look for a company that has been around for a long time and has a good track record with its customers. You’ll also want to choose a company that can offer you a repayment strategy that’s tailored to your budget and financial goals.
Summary of Money’s guide to debt consolidation
- Debt consolidation consists of taking multiple debt balances and rolling them into a single account, to simplify your pay-off strategy and repayment terms.
- You can consolidate your debts using different types of loans, a balance transfer credit card, or by enrolling in a debt management program from a nonprofit organization, just to name a few.
- The right consolidation strategy will depend on factors such as your credit score and the types of debt you have.
- Besides making debt more manageable, debt consolidation allows you to save money on interest, free cash flow through a lower monthly payment and can help boost your credit score.
- When choosing a debt consolidation company, go for a well-known institution with a good reputation and that can offer you the right plan that fits your financial circumstances.