Takeaways
- Debt consolidation rolls many loans into a larger loan with a new interest rate.
- Debt consolidations can be attractive if you can secure a low-interest rate.
- Debt consolidation declutters debt management into one seamless monthly payment.
- Debt consolidation loans are usually fixed-rate loans issued by financial institutions.
- Debt consolidation is not a one-size-fits-all approach and does not fix underlying debt, budgeting, or spending issues.
What Is Debt Consolidation?
Debt consolidation is a financial strategy in which you combine multiple debts into a single loan or payment plan.[1]
Many opt for this debt management strategy because it can lower your overall interest rate and make your monthly payments more manageable.
Consolidating your debt does not erase the original debts but consolidates them into a single loan with potentially more favorable payment terms. By consolidating multiple credit cards or loans into a lower-interest debt consolidation loan, you could lower monthly payments by reducing the overall interest rate.
Most debt consolidation takes place with a debt consolidation loan. Banks and other financial institutions typically offer these loans, which can be secured or unsecured. Secured loans, much like home equity loans, require collateral and typically offer a lower interest rate. Unsecured loans do not require collateral but usually have higher interest rates due to the lender's increased risk.
Debt consolidation can streamline your personal finances by simplifying your debt repayment plan. The reality is that debt consolidation is not for everyone, and you should carefully consider whether it makes sense for your financial situation.
Your debt consolidation opportunities largely depend on your credit score, credit history, and ability to secure your loan. As you analyze the opportunity to consolidate your debt, consider your finances, the terms of the new consolidation loan, the interest rate, and the impacts on your credit score.
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How Debt Consolidation Works
Debt consolidation works by heaping multiple debts into one larger loan. This includes credit cards, medical bills, personal loans, and student debt. These debts are then combined into a single loan or payment plan. Here's a breakdown of how it typically works:
1. Assessment of Your Debt
You should start by listing all your current debts and their interest rates to determine the total amount you owe and the average interest rate across your debts.
2. Securing a Consolidation Loan
You must research various consolidation loan options and how much debt they will consolidate. It makes the most sense to get a consolidation loan when the new loan offers a lower average interest rate than your existing debts. Banks, credit unions, and online lenders often offer consolidation loans.
3. Paying Off Existing Debts
The funds from your consolidation loan are used to pay off your smaller debts. Instead of multiple payments, you have just one monthly payment on your consolidation loan and a fixed term.
4. Repayment
The next step is to begin monthly payments on your new (single) loan. Typically, this means you've accepted more favorable terms, such as a lower interest rate or a more extended repayment period. Both options can help reduce your monthly financial burden.
Example of Debt Consolidation
Let’s look at a real work scenario to help you understand how debt consolidation works. Imagine you have three different debts:
- $10,000 in credit cards with an 18% interest rate
- $5,000 in personal loans with a 9% interest rate
- $30,000 in student loans with a 6% interest rate
Currently, each of these debts requires its own monthly payment, and you have found that managing them separately has become challenging and costly due to the high interest rates, especially on the credit card.
You decide to apply for a debt consolidation loan and are approved for a loan for $45,000.
Debt Consolidation Loan: $45,000 loan with a 7% interest rate
This new loan has an interest rate of 7%. Since your previous average interest rate was 9%, this new interest rate will be advantageous.
You then use this $45,000 loan to repay your original debts (student loan, credit card, and personal loan). Now, you have one monthly payment to keep track of. This simplifies your financial management and reduces the interest you will pay, saving you money over time.
Types of Debt Consolidation Loans
Debt consolidation loans cover a broad category of secured and unsecured loans. Secured and unsecured loans have distinct features best suited for unique financial situations. Here are the differences:
- Secured Debt Consolidation Loans: Secured loans require collateral. This can come from your home or vehicle, and the lender has the right to seize your property if you default on the loan.
Having collateral back your loan generally allows for lower interest rates due to the reduced risk to your lender. If you have something to offer as collateral, this type of loan may be beneficial for you trying to secure a reduced interest rate.
- Unsecured Debt Consolidation: Unsecured loans do not require collateral, which means there is no risk of losing personal property if you default on the loan. However, the tradeoff involves higher interest rates and stricter credit requirements because your lender is exposed to an increased risk.
If you do not have collateral to offer the lender or want to avoid risking your assets, this loan type would be more suitable for your debt consolidation.
- Bad Credit Debt Consolidation Loans: Bad credit loans are usually unsecured loans designed for individuals with lower credit scores (read about rebuilding your credit). They offer an opportunity to consolidate debt even with bad credit.
Bad credit loans usually have higher interest rates and require stricter repayment terms. This may be an option if you need to consolidate debt but need a better credit history
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Advantages of Debt Consolidation
Being smart about your money decisions can leave you paying less interest over time. Given your phenotype and financial situation, consolidating your debt could make perfect sense. Here are some advantages of doing so:
- Lower Interest Rates: Debt consolidation can lower your overall interest rates. Lowering your interest rates will save you money in the long term.
- Single Monthly Payments: Consolidating multiple debts into one single payment simplifies your finances and makes it easier to manage payments and budget effectively.
- Fixed Terms: Debt consolidation loans usually have a set payment term, varying from one to seven years. This allows you to calibrate when you will become debt-free. It also allows you to reduce debt faster, improve your credit score by lowering your credit utilization, and maintain consistent on-time payments.
Disadvantages of Debt Consolidation
Debt consolidation will not cure bad spending patterns or a lack of budgeting. If you are considering consolidating your debt, analyze the downsides, too. Here are several disadvantages to consider:
- Equivalent Interest Rates: Debt consolidation may sometimes lead to lower interest rates. Thisis especially true if you have poor credit, which makes it more likely that consolidating your loan will be costlier in the long run. (Read about how to increase your credit score quickly.)
- Upfront Fees: There are also upfront fees and the risk of falling deeper into debt due to those newly freed-up credit lines.
- Collateral At Risk: Securing debts against assets like a home can lead to financial stress if you feel like you can’t make payments. Failing to meet repayments might result in losing your home or vehicle.
- Term Extension: Debt consolidators can be flexible if you have trouble meeting your debt obligations. One of the solutions could be to extend the term of your loan, which means you might end up paying more interest overall despite having a lower monthly payment.
Other Ways to Consolidate Debt
Debt consolidation doesn’t necessarily have to occur through a debt consolidation loan. There are many other ways to consolidate debt, including:
- 0% interest balance-transfer credit cards
- Home equity loans
- Debt management plans
Each of these has its own set of terms and conditions. You need to understand and consider the costs (like origination or transfer fees) and the potential impact this may have on your credit score from new credit inquiries or changes to your credit utilization.
Debt consolidation aims to make payments more accessible and reduce the overall cost of your debts over time. No matter the consolidation route, it is vital to budget for your debt payments, reduce your spending, and carefully manage your finances so that your consolidation leads to financial improvement rather than just lumping your debts into a loan you can’t keep pace with.
Smart Summary
Debt consolidation can be an excellent tool to get your debt management back on track. By securing a loan with a lower interest rate and short-term, you can completely turn an annoying debt management system into a streamlined process. The decision to get a debt consolidation loan should only be made after extensively researching the best loans available and ensuring you have exhausted the other tools in your toolkit, like trying to pay off your credit cards quickly.
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Frequently Asked Questions
If you have multiple credit cards or loans with very high interest rates that you can’t pay off within a year, consolidating your debts could be a smart move.
There are two main debt repayment strategies: the snowball method and the avalanche method. Each method takes a unique approach to weighing the tradeoff between debt balances and interest rates.
When you apply for a debt consolidation loan, the lender will conduct a hard pull on your credit report, which can affect your credit score. However, your credit score will improve if you can pay off your debts quickly with a consolidated loan.
(1) Consumer Financial Protection Bureau. What is the difference between credit counseling and debt settlement, debt consolidation, or credit repair? Last Accessed January 16, 2025.
