What Is Debt Consolidation? Benefits, Risks, and Example

Debt consolidation refers to the act of taking out a new loan to pay off other liabilities and consumer debts. Multiple debts are combined into a single, larger debt usually with more favorable payoff terms such as a lower interest rate, lower monthly payment, or both.

Learn how debt consolidation can be used as a tool to deal with student loan debt, credit card debt, and other liabilities.

Key Takeaways

  • Debt consolidation is the act of taking out a single loan to pay off multiple debts.
  • You can use a secured or unsecured loan for a debt consolidation.
  • New loans can include debt consolidation loans, lower-interest credit cards, and home equity loans.
  • Benefits of debt consolidation include a potentially lower interest rate and lower monthly payment.

How Debt Consolidation Works

Debt consolidation is the process of using new financing to pay off other debts. If you are saddled with different kinds of debt, you can apply for a loan to consolidate those debts into a single liability and pay them off as one loan. Payments are then made on the new debt until it is paid off in full.

Debt consolidate can provide a lower interest rate, which can lower the cost of your overall debt. It can also lower your monthly payment amount to make paying your bills easier. Finally, some people consolidate debt so that they can pay only one lender instead of multiple lenders to simplify their bills. And as long as you don't take out any additional debt, you can likely get rid of your debt faster.

You can roll old debt into new debt in several different ways, such as by using a new personal loan, credit card, or home equity loan. Then, you pay off your smaller loans with the new one. If you are using a new credit card to consolidate other credit card debt, for example, you can make a credit card balance transfer from your original cards to your new one.

Creditors are often willing to work with you on debt consolidation to increase the likelihood that you will repay debt.

Example of Debt Consolidation

For example, if you have three credit cards and owe a total of $20,000 with a 22.99% annual rate compounded monthly. You would need to pay $1,047.37 a month for 24 months to bring the balances down to zero. You will pay $5,136.88 paid in interest over time.

If you consolidated those credit cards into a lower-interest loan at an 11% annual rate compounded monthly, you would need to pay $932.16 a month for the same 24 months to pay off the debt and you would pay a total of $2,371.84 in interest. Your monthly savings would be $115.21, and your total savings would be $2,765.04.

Consolidating three credit cards with an average interest rate of 22.99%
Loan Details Credit Cards (3) Consolidation Loan
Principal $20,000 $20,000
Interest % 22.99% 11%
Payments $1,047.37 $932.16
Term 24 months 24 months
Bills Paid/Month 3 1
Total Interest $5,136.88 $2,371.84

Risks of Debt Consolidation

Debt consolidation can provide several financial advantages, but it also has downsides to consider. For one, when you take out a new loan, your credit score could take a minor hit, which could impact how you qualify for other new loans.

Depending on how you consolidate your loans, you could also risk paying more in total interest. For example, if you take out a new loan with lower monthly payments but a longer repayment term and a higher interest rate, you will likely pay more in total interest.

Make sure that the consolidation process saves you money, and that upfront costs by debt consolidation services do not affect your ability to make timely payments.

Debt consolidation services often charge hefty initial and monthly fees. Consider consolidating debt on your own with a personal loan from a bank or a low-interest credit card.

Types of Debt Consolidation

You can consolidate debt by using different types of loans. The type of debt consolidation that will be best for you will depend on the terms and types of your current loans and your current financial situation.

There are two broad types of debt consolidation loans: secured and unsecured loans. Secured loans are backed by an asset like your house, which works as collateral for the loan.

Unsecured loans, on the other hand, are not backed by assets and can be more difficult to get. They also tend to have higher interest rates and lower qualifying amounts. With either type of loan, interest rates are still typically lower than the rates charged on credit cards. And in most cases, the rates are fixed, so they do not vary over the repayment period.

Here are some common ways to consolidate debt.

Personal Loan

A personal loan is an unsecured loan from a bank or credit union that provides a lump sum payment to use for any purpose. Then, you repay the loan with regular monthly payments for a set period of time and with a set interest rate.

Personal loans generally have lower interest rates than credit cards so they can be ideal for consolidating credit card debt. However, if you use a personal loan to pay off credit cards, ensure you do not continue spending more on your credit cards or you will only magnify your debt problem with a consolidation.

A debt consolidation loan is a personal loan specifically for consolidating debt. They are designed to help people who are struggling with multiple high-interest loans.

Credit Card

A new card can help you reduce your credit card debt burden if it offers a lower interest rate and if you stop spending on your original cards.

Some credit cards offer an introductory period with 0% APR that can help significantly reduce the total interest you pay in credit card debt if you use it correctly for balance transfers. Be aware of what the credit card's interest rate will be once the introductory period ends, and ensure you will not end up paying more in interest if you cannot pay off the balance before then.

Home Equity Loan

If you are a homeowner who has equity, a home equity loan or home equity line of credit (HELOC) can be a useful way to consolidate debt. These secured loans use your equity as collateral and typically offer interest rates slightly above the average mortgage rates, which is generally well below credit card interest rates.

Student Loan Program

The federal government offers several consolidation options for people with student loans, including direct consolidation loans through the Federal Direct Loan Program. The new interest rate is the weighted average of the previous loans. Private loans don't qualify for this program, however.

Debt Settlement vs. Debt Consolidation

Keep in mind that debt consolidation loans don’t erase the original debt. Instead, they simply transfer a consumer's loans to a different lender or type of loan. For actual debt relief or for those who don't qualify for loans, it may be best to look into a debt settlement rather than, or in conjunction with, a debt consolidation loan.

Debt settlement aims to reduce a consumer's obligations rather than the number of creditors. Consumers can work with debt-relief organizations or credit counseling services. These organizations do not make actual loans but try to renegotiate the borrower’s current debts with creditors.

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Consolidating Debt

Debt Consolidation and Credit Scores

A consolidation loan may help your credit score in the long term. Paying off the loan's principal portion sooner can keep interest payments low. This, in turn, can help boost your credit score, making you more likely to get approved by creditors for better rates.

However, rolling over existing loans into a brand new one may initially have a negative impact on your credit score. That's because credit scores favor longer-standing debts with longer, more-consistent payment histories.

If you consolidate your credit card debt but continue to use the credit cards you paid off, you risk increasing your overall debt load, which can negatively impact your credit score.

Requirements for Debt Consolidation

Borrowers must meet the lender's income and creditworthiness standards to qualify for a new loan. Although the kind of documentation you'll need often depends on your credit history. For example for a debt consolidation loan, you may need to provide a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.

Once you get your debt consolidation loan, consider which loans you'll pay off first. In some cases, your lender may choose the order in which creditors are repaid. If not, consider paying off your highest-interest debt first.

Does Debt Consolidation Hurt Your Credit Score?

Debt consolidation could temporarily affect your credit score negatively because of a credit inquiry, but in the long-term it can help your credit score if you use it correctly. Most people who make their new payments on time find their credit score increases significantly as they avoid missing payments and decrease their percentage of utilization.

What Are the Risks of Debt Consolidation?

Consolidating debt could potentially lead to you paying more in the long run, such as if you consolidate credit card debt but then continue to use the cards you paid off. Make sure that the consolidation process saves you money, and that upfront costs by debt consolidation services do not affect your ability to make timely payments.

What Is the Best Way to Consolidate and Pay Off Debt?

The best way to consolidate and pay off debt will depend on the amount needed to pay off, your ability to repay it, your credit score and other aspects of your personal financial situation. It is important that you consolidate in a way that you will be able to make the new monthly payments so that you can save either on monthly payments or overall interest.

The Bottom Line

Debt consolidation can be a useful strategy for paying down debt more quickly and reducing your overall costs in interest. You can consolidate debt in many different ways, such as through a personal loan, new credit card, or home equity loan. Consider consulting with a professional financial advisor for guidance on the options that may best fit your personal situation.

Article Sources
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