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Debt Consolidation: What Is It & How Does It Work?

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In a Nutshell

Debt consolidation involves combining multiple debts into a single payment. If you can secure a lower interest rate and you can make the new single monthly payment, debt consolidation can be a great debt relief strategy. But there are also drawbacks to debt consolidation. In this article, we’ll help you understand how debt consolidation works so that you can decide whether it’s a good choice for you.

Written by Natasha Wiebusch, J.D.
Updated May 16, 2023

Debt consolidation involves combining multiple debts into a single payment. Debts you might combine include credit card debt, personal loans, or medical bills. If you can secure a lower interest rate and you can make the new single monthly payment, debt consolidation can be a great debt relief strategy. It can help you reorganize your debt and ultimately become debt-free.

But there are also drawbacks to debt consolidation. In this article, we’ll help you understand how debt consolidation works so that you can decide whether it’s a good choice for you.

What’s Debt Consolidation?

Debt consolidation is a common debt relief strategy you can use to reduce your overall debt. By combining multiple debts into one single monthly payment, debt consolidation makes it easier for you to keep track of your total balance and monthly payments. It’s also a way to lower your interest rates on your debt by consolidating multiple high-interest debts, such as credit card debts, into a single low-interest loan.

But as with all debt relief strategies, there are both advantages and disadvantages to consolidating debt. If you’re considering debt consolidation, seek professional advice from a debt counselor first. They can help you understand your debt and how strategies like debt consolidation may impact your credit report and credit score.

Beware of Scammers!

Unfortunately, many scammers will advertise debt relief advice to get personal information. If you’re looking for professional advice, be wary of these potential scammers. Make sure to verify their information first before you reveal any personal information, especially your Social Security number.

Factors To Consider Before Debt Consolidation  

If you’re deciding whether to consolidate your debt, there are a few factors you should consider before moving forward:

  • A lower interest rate is not guaranteed. Many borrowers consolidate their debts to lower the annual percentage interest rate on their debt. But a lower interest rate isn’t always a guarantee. If you have a poor credit history, the lender may not give you the interest rate you want, or they may offer you a variable annual percentage interest rate, which can increase over time.

  • Consolidation does not eliminate debt. Debt consolidation doesn’t eliminate your debt. Although it will lower your monthly payment, it will also often extend your repayment period.

  • You may lose certain benefits. Consolidating federal student loan debt with a private company will cause you to lose the benefits of having federal student loans. This includes income-driven repayment terms and the ability to ask for deferments and forbearances.

Even if you decide to apply for debt consolidation, remember that consolidation may only be possible if your credit score has improved since you applied for the original loan or credit card. Lenders will typically look for this because they don’t want to lend money to a borrower who is unlikely to pay them back.

When To Consolidate  

If you decide debt consolidation is right for you, then you’ll have to decide when the best time is to consolidate. Generally, you’ll benefit most from debt consolidation when you have the following:

  • A large debt pile: If you have lots of different sources of debt with different monthly payments, debt consolidation will make it easier to make your payments.

  • Healthy financial habits: Lenders will look at your credit history to determine what their loan offer will be, including what interest rate they’ll offer. It’s important to get in a good place with your payments and spending habits before you apply for a new consolidated loan so that you can get the lowest possible interest rate.

  • A good credit score to get a lower interest rate: Lenders will consider your credit score when deciding what interest rate to give you on your new consolidated loan. If you have a bad credit score, then it may not be worth consolidating because your interest rate will be too high and the total cost to pay back the loan may be too much.

  • Sufficient cash: Once you decide you’d like to consolidate your debt, make sure you have enough cash to make loan payments on your new loan. If you’re currently unemployed or if you don’t think you’ll be able to make the monthly payments, consider waiting.

Types of Debt That Can Be Consolidated

There are two broad categories of debt: unsecured debt and secured debt.

Unsecured debt is created when a lender loans money to a borrower without requiring that they put up something of value to get the money. All unsecured loans can be consolidated. This includes credit card accounts, department store cards, student loans, unsecured personal loans, payday loans, and medical bills, among others.

Secured debt, on the other hand, is debt that is “secured” by something of value called collateral. If you can’t pay back a secured debt, then the lender can take the collateral back. Common types of secured debt include mortgage loans, car loans, or other loans that were used to buy a specific item. Most secured debts can’t be consolidated. Mortgage loans and auto loans are common secured debts that can’t be consolidated.

Advantages of Debt Consolidation 

Debt consolidation can be very helpful for borrowers. If you’re trying to get out of debt, debt consolidation can help by lowering your monthly payments and creating a single payment so that you don’t have to keep track of multiple deadlines. Lower monthly payments free up more money so that you can pay for daily expenses like food and gas.

Also, many borrowers who find themselves with multiple debts end up paying more money in late fees for late payments. By reducing the number of payments you must make every month, debt consolidation will reduce the chances of getting a late fee. It will also help you focus on other responsibilities more without worrying about whether you’ve missed a payment.

Lastly, debt consolidation can also improve your credit score in the long run. It’ll reduce the amount of revolving debt you have, and you’ll be less likely to have missed payments reported to credit bureaus. Missing payments can really hurt your credit score.

Drawbacks of Debt Consolidation

Although there are advantages to debt consolidation, it’s not always the best solution. The risks and disadvantages of debt consolidation may outweigh the advantages. The biggest disadvantage of debt consolidation is that it can create additional costs through either higher interest rates, longer terms, or fees like origination or transfer fees. For example, if you consolidate your loan for a slightly lower interest rate, but you extend the payment period, you’ll pay more in the long run.

If the low interest rate for your new consolidated debt is only temporary, you may end up paying higher interest rates if you can’t pay the debt off by the end of the low interest rate period. Take balance transfer credit cards, for example. They can be used to consolidate debt, but they usually have a 0% interest rate only for the first year. After that, the credit card lender can raise the interest rate.

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How To Consolidate Debt

To get the best debt consolidation deal, take your time choosing your lender. Each debt consolidation option has its own pros and cons. Shop around and gather as much information as possible about each lender. You might be surprised at how different each lender’s offers are.

While you’re shopping around, keep in mind that your options may be limited depending on your credit score, the type of debt you have, and the real estate assets you own. For example, if you’re renting, you won’t be able to use a line of equity to consolidate debt because you’d need to own real estate to qualify.

Here are seven different methods of debt consolidation you might consider:

1. Debt Consolidation Loan  

Usually, lenders offer debt consolidation loans, which are personal loans specifically designed to pay off debt. Debt consolidation loan terms typically include a fixed repayment period or fixed interest rate.

2. Credit Card Balance Transfer  

In a credit card balance transfer, you move debts from several credit cards to a new card called a balance transfer credit card. This allows you to save money on interest. Transfer balance cards typically have interest rates as low as 0% for a limited time. To best take advantage of this, you’d need to pay off all or most of your debt by the end of the low-interest period.

If you’re considering using a balance transfer credit card, make sure to look at what the rate would be and how long the low interest rate will last. Unlike a debt consolidation loan, balance transfer payments can change after the first year. You’ll also want to consider the maximum credit card balance limit.

3. Debt Management Plan

Another way to consolidate debt is to establish a debt management plan (DMP), also called a debt consolidation program. This type of repayment plan is created by a credit counseling agency, which negotiates new payment terms and schedules. Through these new terms, borrowers are better able to pay off their debt more affordably and quickly. DMPs typically only cover unsecured debt. So, even though this can be a great debt consolidation method for credit card debt, it would not work for secured debt like an auto loan.

4.  Student Loan Consolidation 

If you have student loans, you’ve probably received offers to consolidate them for a lower interest rate. These offers are common. With student loan consolidation, you can combine several student loans into one loan with a single monthly debt payment. Student loan consolidation is available for both federal and private student loans. Although this type of debt consolidation is common, it’s important to consider what benefits you’ll lose if you consolidate federal student loans

5.  Home Equity Loans & Lines of Credit

Home equity loans (HELOANs) and home equity lines of credit (HELOCs) are loans taken out against a piece of real estate you own. These types of loans generally allow you to borrow up to 85% of the equity in a given piece of real estate. For example, if you own a home worth $200,000 and you owe $100,000 on the mortgage, then you have $100,000 in equity. If you can borrow up to 85% of that equity, you’d be eligible for an $85,000 loan.

Under this option, you would need to borrow a predetermined amount of money and repay that amount over a specified repayment period at a fixed rate. To take HELOC out, you may be required to pay fees. Even though this method is popular, it has its drawbacks. One of the biggest drawbacks is that if you can’t make the payments, you can lose your home through foreclosure.

6.  Cash-Out Mortgage Refinance

A cash-out mortgage refinance is similar to a HELOC and HELOAN in that it also uses real estate to secure the debt. Instead of creating a separate debt obligation though, a cash-out mortgage refinance replaces the current mortgage with a larger mortgage loan amount. The new mortgage is used to pay off the old mortgage, and the borrower receives the difference in the form of a "cash-out." This amount can be used to pay off the existing debt.

7.  Retirement Accounts

Depending on the borrower’s debt load and personal circumstances, it may be possible to use retirement accounts, like 401(k) and Roth IRA accounts, as a debt consolidation option.

Alternatives to Debt Consolidation

If you decide that debt consolidation isn't the right option to deal with your debt, you still have other options. Possible alternatives include using the debt snowball method, the debt avalanche method, or debt relief programs.

Debt Snowball

The debt snowball method involves prioritizing paying off your smallest debts first, regardless of their interest rates. While you make larger payments on your smallest debt, you’ll still have to make minimum payments on all your other debts. Once you finish paying off your smallest balance, you begin to focus payments on your next smallest debt.

Debt Avalanche

The debt avalanche method involves prioritizing debts with the highest interest rate first, regardless of the total balance. While you make larger payments on your high-interest debt, you’ll continue to make minimum payments on your other debts. Once you pay off the debt you’re focused on, you can move on to the next balance.

Debt Relief Programs

Debt relief programs, which are usually offered by for-profit companies, can help you with debt consolidation, debt negotiation, or debt settlement. Although these programs can be helpful, they will charge fees. If you’re considering a debt relief company, be sure to research whether they’re legitimate and verify their reputation.

Credit Counseling

You can also talk to a credit counselor. Credit counselors usually work for nonprofit agencies, and they can help you create a plan to pay off your debt. They can help you consider your options, like whether a debt consolidation loan, a debt settlement, or a method like the snowball method is best for you.

Let's Summarize...

Debt consolidation has its benefits, but it also has some drawbacks. Whether it’s the right approach for you and what kind of debt consolidation is best will depend on your particular circumstances. Most importantly, remember that even if debt consolidation isn’t right for you, you still have other options.

If you’re overwhelmed by credit card bills or if you have too much secured debt, you might want to consider bankruptcy. With Upsolve, you can get a free bankruptcy evaluation.

Written By:

Natasha Wiebusch, J.D.


Natasha started her career as a lawyer representing labor unions and other investors in multi-state class action lawsuits. Passionate about the civil rights elements of her cases, she moved into practicing employment law to represent employees against discrimination of various ki... read more about Natasha Wiebusch, J.D.

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