What Is Debt Consolidation?
If you have substantial debt, juggling several monthly payments and seeing all the interest add up can become overwhelming. While it doesn’t erase what you owe, debt consolidation can make repaying your debts more manageable by eliminating multiple balances, leaving you with a single payment and possibly a better interest rate.
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.
Take a look at what debt consolidation is, the pros and cons to consider and how to choose an option that best fits your needs.
What does it mean to consolidate debt?
Consolidating debt means combining multiple debt balances into a single loan or line of credit. Some of the most popular methods to consolidate debt include debt consolidation loans, balance transfer credit cards and home equity lines of credit or loans.
Whichever one you use, they all involve the simplicity of one monthly debt payment and a single interest rate. Borrowers often seek debt consolidation when they want to simplify their bill payments, pay off the debt faster, get a lower monthly payment or stop paying a high interest rate.
How does debt consolidation work
To consolidate debt, you would usually request a new loan or credit line. The amount of credit offered must be high enough to pay off your other debt balances. Plus, the debt you want to pay off usually needs to be unsecured such as credit card debt or a payday loan.
Approval for debt consolidation requires applying and meeting the lender’s specific criteria. A low debt-to-income ratio and a good credit score will increase available options and lead to better interest rates. There are debt consolidation loans for those with bad credit, but they come with higher costs and may need collateral or a co-signer.
After approval, the process for paying off existing debts can vary. In some cases, the new creditor handles paying off the debts. Otherwise, you would get the money deposited into your bank account or have access to a credit line you can draw from to pay off creditors.
The lender will expect you to make your new monthly payment as agreed. Otherwise, you can experience fees, credit damage and potentially collateral loss (if your loan was secured by collateral).
The advantages of debt consolidation
Debt consolidation’s main advantages are having just one payment to manage and, sometimes, a lower interest rate than your existing debt. It can also provide a more efficient payoff plan that helps you escape debt sooner.
Paying a single payment
Having a single payment makes it easier to remember to pay the bill on time and avoid late fees and the ensuing negative impact on your credit score. You also will not have to track as many credit card and loan payments in your budget. The single payment simplifies interest since there will only be one rate.
Faster debt payoff
Debt consolidation can reduce the payoff time — especially if you get a lower interest rate. Choosing a set repayment period also helps you stay on track and gives you a clear finish line. Paying off debt faster can also help your credit score.
The disadvantages of debt consolidation
Debt consolidation can save you over time, but you’ll usually pay something upfront. Plus, your new interest rate may not always be competitive.
Upfront costs involved
Whether you choose a loan or credit card, the lender likely will charge a fee for originating the credit or transferring balances. Balance transfer credit cards charge anywhere between 3 to 5% of the debt to be transferred, and debt consolidation loans have varying origination fees. If you choose to consolidate your debt using home equity credit products, it’s important to remember that those have closing costs as well.
Interest rate could potentially be higher
Having a good credit profile and shopping around could land you a low interest rate, but there’s no guarantee. Rates vary by the loan or credit line type, along with your credit history and the specific terms selected. So, if you have blemishes on your credit report or struggle to qualify, you could end up paying a higher rate than you already do.
How to consolidate debt
The first thing you need to do is get a handle on your situation.
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
Loans for debt consolidation, home equity options and balance transfer credit cards all work for merging debt and ideally getting better terms. The payment amount, repayment length, interest rates, fees and application processes vary for each method. Learn more about these options to decide the best debt consolidation option for your situation.
Take out a debt consolidation loan
A debt consolidation loan gives the borrower a lump sum to pay off debts such as credit cards, medical bills and personal loans. It’s a personal installment loan available through many online and traditional lenders. In most cases, the loan doesn’t need collateral. You will also have a fixed monthly payment for easy budgeting and the funds could be in your bank account in one business day.
The loan amounts and repayment terms vary, so you can choose an arrangement that results in an affordable payment. Lenders usually let you borrow anywhere from $1,000 to $100,000 and give you between one to seven years to pay the loan back. You can pay the loan early to save on interest, but do note that the lender may charge a prepayment penalty. The lender may charge a one-time origination fee equal to a percentage of the debt consolidation loan amount.
Many lenders offer debt consolidation loan applications online where borrowers provide information about their income, desired loan terms and other debt obligations. The process involves a thorough credit check, and you may need to upload documents to verify income.
If you qualify, your financial profile and specific loan options will determine the interest rate offered and payment amount. You would then make monthly payments for the duration of your chosen term.
If this option sounds appealing, it’s essential to research the best debt consolidation loans. These will offer competitive rates, include minimal fees and have streamlined application processes.
Use a balance transfer credit card
A balance transfer involves moving other credit card balances to a single credit card. While an existing card may work, this option often involves getting a balance transfer card that provides a low or 0% APR introductory period. That way, you can avoid paying interest for several months and have payments fully applied to the principal owed. This saves you money and can speed up repayment.
To apply for a card, visit the creditor’s website to find the application option for the one you want. You’ll answer basic questions about your income, housing situation, employment and possibly your bank balances. The creditor may also ask about balance transfers, including specific account information. After you read through the card’s terms and submit the application, the creditor usually shows an instant decision.
If you don’t request a balance transfer when you apply, the cardmember portal should have a form to supply the account information, or you can call the number on the back of your card. Once the creditor receives the request, it pays off the listed debts. This process can take up to six weeks. Once the transfer finishes, your card balance gets updated with the transferred amount, and you set out to pay off your credit card.
Note that most of these cards charge a balance transfer fee, typically between 3% and 5% of the transferred amount. After the promotional period, the regular interest rate will apply and usually be higher than debt consolidation loan options. So, it’s important to pay off the card before then or shop around for a competitive rate. It’s also important to note that a balance transfer credit card may not provide a large enough credit line to transfer high debt amounts.
Tap into your home's equity
Owning a home can give you more debt consolidation options, provided you have enough equity in your home. A home equity loan or home equity line of credit (HELOC) can work if you’ve paid off enough of your mortgage or had your property’s value increase so that you have 15% or more equity in it. While lenders usually don’t allow borrowers to take out credit for the entire equity amount, borrowing against 80% is common.
Home equity loans and HELOCs both come with the risks involved with using your home as collateral — in other words, if you default on your loan, you could lose your home.
They both usually involve closing costs as well that can make up as much as 5% of the borrowed amount. However, home equity loans and HELOCs work differently when it comes to the repayment process, interest rates and how you can use the funds.
A home equity loan provides all the money in a lump sum and comes with a fixed interest rate. The loan term can be up to 30 years, and the monthly payment stays the same throughout. HELOCs, on the other hand, provide a line of credit to access as needed during a draw period. The interest is usually a variable rate, and you would only make interest-only payments until the full repayment period begins.
This debt consolidation option has the lengthiest and most involved application process. You can start the process through your current mortgage lender or seek another with the best terms. As with a mortgage, you must verify your income, assets and other debts when applying for a home equity loan or HELOC. You will likely need to supply supporting documents like bank statements and tax returns. Also, the lender may ask for a professional home appraisal to verify the current value.
Approval can take anywhere from a few weeks to a couple of months. You will have a closing meeting with the lender to sign papers and pay closing costs. You will then get the lump sum or access to the line of credit to pay off your debts.
Alternative debt consolidation options
There are other alternatives worth looking into as well. Two options include signing up for a debt management plan or settling current debts with creditors.
Debt management plan
A debt management plan through a credit counseling agency would also streamline multiple debt payments into one. The agency reviews your whole financial picture, collects information about your debts and creates a repayment plan that fits your budget. The result is a single monthly payment made to the agency, which then sends the agreed payments to the creditors owed.
Since it doesn’t require taking out a new credit line or loan, this option is a good choice for those who may not meet the credit or income requirements for traditional loans or credit. It can also help you save on interest and fees and reduce collection calls since the credit counselor will often negotiate with debt collectors. Sticking to the plan and paying on time can ultimately eliminate the debt, but you’ll need to follow the agency’s rules to avoid being removed from the program.
This debt consolidation alternative comes with some costs and limitations. First, the agency can charge a one-time setup fee and a monthly fee for as long as the plan is active. Also, the plan excludes certain debts, such as secured loans, and may forbid you from using credit cards while enrolled.
Debt settlement involves working alone or with a debt settlement company (also called “debt relief” or “debt adjusting”) to persuade creditors to accept less than the full balance owed. This option works best if your account has already been delinquent for at least a few months and if you can afford an agreed lump-sum payment.
The do-it-yourself approach to debt settlement involves contacting creditors to explain the financial issues preventing you from paying the full amount. After explaining your case, you’ll present the reduced amount you could pay. If the creditor agrees, get proof in writing, make note of any terms and make the payment as soon as possible.
Working with a debt settlement company makes the process easier since the company negotiates on your behalf. But this option is usually costly. A settlement company may still not have luck settling all your debts. There are also risks that a contacted creditor will try to sue and that the company will ask you to stop paying bills and take other actions that result in negative items on your credit report.
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.
Is consolidating your outstanding debt the best move to make?
If you have high debt balances with high interest rates, it may be best to consolidate debt as long as you can save on interest and afford your single monthly payment. This will require getting approved though so, if you have a poor credit score, you may need to first look into ways to improve your credit score. If you have smaller debt balances or manageable interest rates, the upfront cost of consolidation may not be worth it. Instead, debt snowball and debt avalanche do-it-yourself strategies may work better for you.
What is debt consolidation?
How does debt consolidation work?
How do I get a debt consolidation loan?
How does debt consolidation affect your credit score?
What is the best debt consolidation company to use?
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.