Debt consolidation refers to taking out a new loan or credit card to pay off another existing loan or credit card. By consolidating multiple loans into a single, larger loan, you may be able to get more favorable payment terms, such as a lower interest rate, lower monthly payments, or both. Here's how to decide if you should consolidate debt and if you do, how to go about it.
KEY TAKEAWAYS
- Debt consolidation is the act of taking out a single loan or credit card to pay off multiple debts.
- The benefits of debt consolidation include a potentially lower interest rate and lower monthly payments.
- You can consolidate your debt using a personal loan, home equity loan, or balance-transfer credit card.
- Debt consolidation also has some potential drawbacks.
What is debt consolidation and when is it a good idea?
How Debt Consolidation Works
You can convert old debt into new debt in a number of ways, such as a new personal loan, a new credit card with a substantially higher credit limit, or a home equity loan. Then, you pay off your small loan with a new one. If you use a new credit card to consolidate other credit card debt, for example, you can transfer balances from your old card to your new one. Some balance transfer credit cards even offer incentives, such as 0% interest on your balance for a certain period of time.
In addition to lower interest rates and the possibility of smaller monthly payments, debt consolidation can be a way to simplify your financial life, with fewer bills to pay each month and fewer due dates to worry about.
Creditors are often willing to work with you on debt consolidation to increase your chances of paying what they owe.
An example of debt consolidation
Let's say you have three credit cards and owe a total of $20,000 on them with an average annual interest rate of 22.99%. You'll pay about $1,047 per month for 24 months to bring the balance down to zero, and you'll pay about $5,137 in interest over that period.
If you consolidate those credit cards into a low-interest card or 11% APR loan, you'll pay about $932 a month for the same 24 months to erase the debt, and your interest charges will total $2,372.
Debt consolidation risk
There are some downsides to considering debt consolidation. For one, when you take out a new loan, your credit score may take a slight hit, which may affect whether you qualify for another new loan.
Depending on how you consolidate your loans, you may risk paying more in total interest. For example, if you take out a new loan with a lower monthly payment but a longer repayment term, you may end up paying more in total interest over time.
Types of Debt Consolidation Loans
You can consolidate debt using different types of loans or credit cards. Which one is best for you will depend on the terms and type of your current loan 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, such as your home, which acts as collateral for the loan.
On the other hand, unsecured loans are not backed by assets and can be more difficult to obtain. They tend to have higher interest rates and lower qualifying amounts. With both types of loans, the interest rate is still lower than the rate charged on a credit card. And in most cases, the rates are fixed, so they won't increase during the repayment period.
With any type of debt, you'll want to prioritize which of your debts to pay off first. This often means starting with the highest interest loan and working your way down the list.
Here are a few more details about the most common ways to consolidate your debt.
Personal loan
A personal loan is an unsecured loan from a bank or credit union that provides a lump sum that you can use for any purpose. You repay the loan with regular monthly payments for a fixed period of time and with a fixed interest rate.
Personal loans typically have lower interest rates than credit cards, so they can be ideal for consolidating credit card debt.
Credit card
A new card can help you reduce your credit card debt burden if it offers a lower interest rate.
As mentioned earlier, some credit cards offer an introductory period with 0% APR when you transfer your existing balance to them. These promotional periods often last from six to 21 months, after which interest rates can climb to double digits. So it is better to pay off your balance as soon as possible or as much as possible.
Note that these cards may charge an initial fee, often equal to 3% to 5% of the amount you're transferring.
Home equity loan
If you're a homeowner who has built up equity over the years, a home equity loan or home equity line of credit (HELOC) can be an effective way to consolidate debt. These secured loans use your equity as collateral and typically offer interest rates slightly above average mortgage rates, which are typically lower than credit card interest rates.
Student loans
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 a weighted average of previous loans. Consolidating your federal student loans can extend the repayment period to 30 years to lower monthly payments. However, it may also mean paying more in total interest in the long run.
Private loans are not eligible for this program, although you may be able to combine them with other private loans.
Debt consolidation and your credit score
A consolidation loan can help your credit score in the long run. By lowering your monthly payments, you'll be able to pay off debt sooner and lower your credit utilization ratio (the amount you owe at any given time compared to the total amount of credit you have access to). This, in turn, can help raise your credit score, making you more likely to be approved by creditors and get a better rate.
However, taking out existing loans brand new can have a negative impact on your credit score to begin with. This is because credit scores favor older loans with longer, more consistent payment histories.
Eligibility for debt consolidation
Borrowers must meet the lender's income and creditworthiness standards to qualify for a new loan. For example, for a debt consolidation loan, you'll need to provide a letter of employment, two months' worth of statements for each credit card or debt you want to pay off, and letters from the creditor or paying agency.
Does debt consolidation hurt your credit score?
Debt consolidation can negatively affect your credit score temporarily due to credit inquiries, but in the long run it can help your credit score if you use it correctly. Most people who make their new payments on time see a significant increase in their credit score because they avoid missing payments and reduce their credit utilization ratio.
What are the risks of debt consolidation?
Debt consolidation can lead to you paying more in the long run, especially if you consolidate credit card debt but then continue to use the cards you've paid off. There may also be a small, short-term ding in your credit score.
What is the best way to consolidate debt?
The best way to consolidate your debt will depend on the amount you owe, your ability to repay it, and whether you qualify for a relatively cheap loan or credit card. Fortunately, you have many options.
What is debt settlement?
Not to be confused with debt consolidation, debt settlement aims to reduce a consumer's financial obligations rather than the number of their creditors. Consumers can work with debt-relief agencies or credit counseling services to settle their debts. These agencies do not make actual loans but try to renegotiate with lenders for the borrower's current debt.
Bottom line
Debt consolidation can be a useful strategy to pay off debt faster and lower your overall interest costs. You can consolidate debt in several ways, such as through a personal loan, a new credit card, or a home equity loan.
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