Debt consolidation is the process of paying off multiple existing debts with one new loan. Although there are special loans marketed as debt consolidation loans, personal and home equity loans can be used for debt consolidation.
You'll start the process of loan consolidation by securing your new loan—ideally at a lower interest rate than you're currently paying on your debt. You'll use the money you've borrowed from your new lender to repay some or all of your existing creditors. This process can simplify your life since you'll have one payment to make instead of many. And, depending on the terms of your new loan, consolidation can often reduce your interest rate and total repayment costs too.
Still, while debt consolidation has advantages, it's not right for everyone. Here's what you need to know to determine if consolidating existing loans is a good solution for you.
Reasons for Debt Consolidation
The first step to deciding if debt consolidation makes sense is to evaluate your goals. Borrowers may consolidate debt for a number of reasons, including:
- Lower total interest costs: If you qualify for a new loan at a lower rate and don't make your repayment timeline substantially longer, you could save money on repayment.
- Reduce monthly payments: Your monthly payment could be lower due to consolidation if you reduce your interest rate, make your repayment timeline longer, or both.
- Simplify repayment: When you pay off multiple existing debts with one new loan, you only have one payment to worry about instead of several. This may be easier to manage.
- Change loan servicers: If you don't like your current loan servicers, debt consolidation allows you to switch to a new lender who you'll deal with for all future payments.
All of these are valid reasons for consolidating debt. But it's important not to confuse consolidation with a plan for repayment. A debt consolidation loan simply moves your debt around and sometimes lowers the cost of paying it back—it won't erase your debt and it's not a substitute for a plan to become and stay debt-free.
Types of Debt to Consolidate
You can consolidate many types of debt including:
- Credit card bills
- Medical debt
- Personal loan debt
You can also consolidate both private and federal student loans but federal student loan consolidation is a more complex process than refinancing into a private student loan or applying for a personal loan.
However, if you want to retain the benefits of federal student loans including repayment flexibility and eligibility for loan forgiveness, you can do that only using a direct consolidation loan made by the Department of Education. Unlike other types of consolidation loans, this won't change your interest rate (your new rate will be a weighted average of your old ones).
Private student loans do not have special borrower benefits, and so can be consolidated with other private lenders without worrying about losing important protections. In this case, the process would be called student loan refinancing, even though it could have the effect of consolidating multiple educational debts into one.
Alternatives to Debt Consolidation Loans
Debt consolidation is not the only solution to changing the terms of your loans.
Renegotiate the Terms of Your Existing Loan
Some lenders will allow you to change the terms of your loan if you ask, especially if you have trouble making payments. The benefit of this is renegotiating may be possible even if you're not able to qualify for a debt consolidation loan due to a low credit score or delinquencies.
Refinancing is similar to consolidation in that you're taking out a new loan. But you don't have to consolidate multiple debts to refinance—you can secure a new loan to pay off a single old one. For example, many people refinance their mortgages, either to lower their rate and payment, or to tap into the equity of their home by taking a cash-out refinance loan.
If you have credit card debt, you could transfer the balance from one or more existing cards to a new balance transfer card offering a low promotional interest rate. This could lower your interest rate to as low as 0% APR for a limited time. But be careful, as your rate could rise substantially when the promotional period ends, and there is usually a fee of as much as 5% of the amount transferred that will be tacked on to the balance.
A Debt Management Plan
A debt management plan—which you get from a nonprofit credit counseling organization—involves closing your existing credit cards and having a credit counselor negotiate with your creditors on your behalf. They then work out a payment plan for all the debts owed, which may include lowered interest rates.
It's common to see advertisements for "debt consolidation companies" online. While some credit card debt consolidation companies are legitimate, these ads are often run by debt settlement firms, so be wary.
When Does Debt Consolidation Make Sense?
Debt consolidation may make sense for you if:
- You can qualify for a consolidation loan: You'll generally need good credit as well as proof of income. If you can't qualify based on your own financial profile, you may need a co-signer.
- You're able to reduce the interest rate on your current loans by consolidating: It generally makes little sense to take a consolidation loan at a higher rate than your current debt, as you'd make repayment more expensive over time because of higher interest payments.
- You can afford the new monthly payments on your consolidation loan: You don't want to borrow money if you'll struggle to make the monthly payments.
- You have a solid financial plan: If you don’t have one, consolidation could be risky if it simply makes you feel you've made progress on debt repayment when you've actually just moved your loan balance somewhere else. It's also dangerous if you don't have your spending under control and get deeper into debt once your consolidation loan frees up credit.
- You understand total repayment costs on your consolidation loan: Don't focus solely on lowering your monthly payment—you could make your loan cost more over time even with a lower payment if you extend your repayment timeline.
Some debt consolidation loans come with high fees or prepayment penalties. These should be avoided as they could make repayment costs higher.
If you're considering a home equity loan, home equity line of credit (HELOC), or cash-out refinance loan to consolidate debt, you need to be aware you could be turning unsecured debt (such as credit card or personal loan debt) into secured debt.
With secured debt, an asset—in this case, your house—acts as collateral and could be lost if you can't repay what you've borrowed. Unsecured debt, on the other hand, isn't guaranteed by any asset, so if you default, you aren't usually at risk of losing your house (though your credit will take a hit). Since you're putting your house in jeopardy by borrowing against your home to consolidate debt, make this choice after careful consideration.
- Debt consolidation can make repayment cheaper if you qualify for a lower interest rate than you're currently paying and don't extend your repayment timeline too much.
- You'll need good credit and proof of income to qualify for a debt consolidation loan at a competitive rate.
- You don't have to use a special debt consolidation loan to consolidate your debt—any personal loan should work.
- Be careful about converting unsecured debt, such as credit card debt, to secured debt such as a home equity loan because this means you’ll be putting an asset, like your house, at risk.