Debt consolidation is using one loan or credit card to pay off multiple loans or credit cards so you can simplify your debt repayment. With one balance instead of many, it should be easier to pay off your debt and, in some cases, secure a lower interest rate from the lender. Although there are multiple benefits to debt consolidation, there are some drawbacks, too.
What Is Debt Consolidation?
Debt consolidation is combining multiple debts into a single monthly payment by paying them off with a credit card or another type of loan.
How Debt Consolidation Works
Let’s say you have multiple credit card balances and small loans with different interest rates and monthly payments:
- Credit card A: $3,500, 24.90% APR
- Credit card B: $2,500, 18.90% APR
- Credit card C: $1,500, 12.00% APR
Rather than paying these balances individually, you can consolidate all three balances with a single loan that requires one payment instead of three. For example, if you consolidate these balances into a $7,500 loan with 7.00% APR and pay off the loan in four years, you’d pay $1,120.80 in interest. By comparison, if you made a 4% monthly minimum payment on each card, it would take more than $5,440 in interest payments and 12 years to completely pay off the debt.
Your credit score is a factor in qualifying for a low interest rate. If your credit score is higher now than when you applied for your credit cards, you may be able to get a lower rate than what you currently have on your credit card(s).
Types of Debt Consolidation
There are a few methods you can use to consolidate your debt. Your options may be limited, depending on the type of debt, your credit standing, and any real estate assets you have.
Credit Card Balance Transfer
A credit card with a high credit limit and a promotional interest rate on balance transfers is a good candidate for consolidating other high interest rate credit card balances onto a single credit card. Combining your balances under an interest rate that’s lower than the average rate of your existing balances allows you to save money on interest and pay toward one credit card instead of several.
Balance transfers don’t usually count toward any introductory cash, points, or miles bonuses a card offers.
Debt Consolidation Loan
Lenders often offer “debt consolidation” loans which tend to be unsecured personal loans specifically designed for paying off debts. Debt consolidation loans usually have a fixed interest rate and repayment period for more stable repayment terms.
Debt Consolidation Programs
A debt consolidation program, or debt management plan (DMP), is a repayment plan arranged through a credit counseling agency that establishes a new payment schedule and terms that can help you pay down your debt faster and more affordably. It's typically offered to borrowers whom a credit counselor has deemed otherwise unable to repay their loans based on a review of their finances.
Student Loan Consolidation
These loans are specifically for consolidating multiple student loan balances into a single loan with a single monthly payment. This arrangement can be beneficial if you have multiple student loans with different servicers. Student loan consolidation is available for private and federal loans.
Home Equity Loans and Lines of Credit
Home equity loans and lines of credit typically allow you to borrow up to 80% to 85% of your home’s equity. The loan option allows you to take out a certain amount of money that you repay via fixed repayments over a set term. A home equity line of credit (HELOC) is similar to a credit card in that you have access to the money whenever you need it and only pay interest on the money you actually borrow. Be careful, though: you may have to pay a series of fees to finalize your HELOC. You’ll then take the money from your loan or line of credit and pay off your existing debts, whether credit cards, personal loans, or other borrowed money.
Home equity loans and lines of credit require you to use your home as collateral. If you don’t pay your loan or line of credit back, you could lose your home through foreclosure.
Cash-Out Mortgage Refinance
Cash-out refinancing is a type of mortgage refinance in which you get a new mortgage that’s more than you owe on your first mortgage. The new mortgage pays off the old one and you get to pocket the difference through a “cash out.” You can use this money to pay off your existing debts, assuming what you’re approved for covers your credit card and loan balances. As a reminder, cash-out refinances typically come with closing costs.
Does It Cost Money to Consolidate Your Debt?
You may have to pay additional fees, depending on the debt consolidation method you choose. Some typical fees include:
- Balance transfer fees for credit cards (usually 3% to 5%)
- Origination fees for personal loans used for debt consolidation
- Closing costs for mortgage-related loans and lines of credit
The best way to find the loan or line of credit with the lowest rates is to get quotes from multiple lenders and compare the fees. You’ll find that some lenders that offer personal loans for debt consolidation, for example, don’t charge any fees at all while others charge late fees and origination fees.
Pros and Cons of Debt Consolidation
Debt consolidation has both benefits and drawbacks to consider before you make a final decision.
Easier to manage your expenses by combining multiple debts into a single monthly payment.
Possible lower interest rate
Could lower your overall monthly debt payment
May not qualify for an interest rate that's lower than your existing balances
Lengthened repayment term could cost more in interest even with a lower rate
Some loans require you to put your home up as collateral
Consolidating your debt doesn’t decrease the amount you owe. It simply restructures your debt into (ideally) a more affordable monthly payment. The trade-off might be a longer repayment period or more interest paid compared to not consolidating.
Alternatives to Debt Consolidation
After reviewing your options, you may decide that debt consolidation isn’t the best way to tackle your debt. Two popular payoff methods that don’t require consolidation are the "debt snowball" and "debt avalanche strategies." Both focus on paying off your debts one at a time. The debt snowball focuses on paying off your smallest balances first and moving on to bigger balances, while the debt avalanche strategy tackles the balances with the highest interest rates first.
If your situation is more complex, you should consider seeking assistance from a debt relief program. Pursuing debt settlement is a last resort, because it involves stopping payments and working with a firm that holds that money in escrow while negotiating with your creditors to reach a settlement, which can take up to four years. Withholding payments from your creditors can seriously damage your credit score.
- Debt consolidation, or debt management, allows you to combine multiple debts into a single balance with a single monthly payment.
- You may be able to save money on interest or cut down on your repayment time by consolidating your debts.
- A debt consolidation loan, home equity loan, or credit card balance transfer are a few methods to consider.
- Debt consolidation isn’t always the right choice. Alternatives include the debt snowball or avalanche methods, as well as credit counseling.