Debt consolidation is one of many possible options for debt relief. In simple terms, debt consolidation involves combining multiple debts into one obligation. However, there are risks and downsides associated with taking on this type of debt. This article describes how debt consolidation works, how it can be beneficial, and what pitfalls you may face.
Written by the Upsolve Team.
Updated July 22, 2020
Debt consolidation is one of many possible options for debt relief. In simple terms, debt consolidation involves combining multiple debts into one obligation. The monthly payment is typically lower than the combined payments on the separate debts, and terms may be more favorable. However, there are risks and downsides associated with taking on this type of debt. This article describes how debt consolidation works, how it can be beneficial, and what pitfalls you may face.
Debt Consolidation Loans
Unlike many other debt solutions, debt consolidation involves taking out a new loan. The debt consolidation loan will be used to pay off credit card debt, personal loans, and other high-interest debt. Consolidating these different types of debt allows you to stop juggling competing due dates and make a single monthly payment to the new lender. You will still owe the same total amount of money after you consolidate. But, your new monthly payment may be quite a bit lower than the combined monthly minimum payments you are making on credit card balances, personal loan payments, and other debts.
You can think of a debt consolidation loan as refinancing your existing debts. One of the simplest types of debt consolidation involves a credit card balance transfer. You can transfer balances from one or more cards to a new card with a lower interest rate. But, this can be risky--especially if you get overly optimistic. Low interest rates on balance transfers are typically time-limited, and if you can’t pay down the debt quickly, you could end up right back where you started.
Another approach is to take out a personal loan to pay off debts. Your new loan will ideally be at a lower interest rate than you are currently paying on your credit card balance and other unsecured debt. In most cases, the only added expense is a one-time loan origination fee. The origination fee is usually somewhere in the range of .99% to 5.99%. Depending on the total amount of your debt, this could mean paying thousands of dollars extra.
With more money going directly to reduce your loan balance, you could be debt-free sooner than if you continued making multiple payments at higher interest rates. But, don’t assume that will always be the case. Often, debt consolidation lenders lower your monthly payment by stretching out the loan term. So, you may be in debt longer and end up paying more interest over time, even with the better interest rate.
If you are considering alternative debt solutions such as debt settlement or debt consolidation, consider talking with a credit counselor before you make any decisions. While many debt relief organizations are for-profit companies that may steer you in the direction that is best for their own bottom lines, many reputable non-profit agencies provide credit counseling for free. Depending on your circumstances, these organizations may also be able to offer you a debt management plan that works much like a debt consolidation loan, but without taking out a new loan.
What Type of Loan is a Debt Consolidation Loan?
A debt consolidation loan may either be an unsecured personal loan or a secured loan. A secured loan requires that you provide some type of valuable property as collateral, and agree that the lender can take that piece of property if you don’t make your payments. It’s important to carefully consider your loan options, since some debt consolidation loans carry risks that others do not, and the loan term and origination fee can have a serious impact on the amount you end up paying. The Consumer Financial Protection Bureau provides additional information about the possible risks of debt consolidation.
One common type of consolidation involves taking out a home equity loan to pay off several smaller debts, get better repayment terms, lower monthly payments, and simplify payment schedules. While this is a workable option for some people, it can also be risky. When you refinance your mortgage or pay off personal loans and credit card debts with a home equity loan or home equity line of credit, you turn unsecured debt into secured debt. That means if you can’t keep up the payments, you could face foreclosure. Unsecured loans do not create this risk, but may be difficult to obtain one if you’re already carrying significant debt or have fallen behind on your payments.
What Debts Can be Included in Debt Consolidation?
Generally, debt consolidation loans are intended for unsecured debt such as medical bills, credit card debt, personal loans, and payday loans. Generally, private student loan debt can be included in a debt consolidation loan, but federally-guaranteed student loans can’t. Car loans and other secured debts are usually not managed through debt consolidation. However, under some circumstances you may be able to include auto loans or other secured debt in your debt consolidation loan.
When you’re deciding whether you can afford to make payments on a debt consolidation loan, don’t forget about secured debt payments that won’t be included in the loan and other monthly bills. While a lower interest rate or longer loan term may help improve your financial situation, it’s generally not wise to choose a solution without taking a hard look at the big picture--including your spending habits.
Will Debt Consolidation Affect My Credit Score?
The impact on your credit score will vary depending on your specific situation. But, many people see credit scores improve after debt consolidation. If you pay off credit card balances with a debt consolidation loan, you’ll instantly see a big drop in the percentage of available credit you’re using. That’s a key factor in calculating your credit score. And, if you’ve been juggling payments and falling behind, debt consolidation can put an end to late payments. Be careful, though. Continuing to use those credit cards and not pay them off monthly can put you even deeper in debt. And, your credit score will suffer as you use more of your available credit.
Some types of debt consolidation may temporarily lower your credit score. That’s because you may be required to close credit cards and other accounts included in the consolidation, especially if you’re in a debt management plan. Closing accounts will lower the average age of your credit accounts, and may increase the percentage of available credit you are using. Both of these items factor into your credit score.
However, many people who are considering debt relief options are carrying high balances and already have a history of late payments. So, you may already be fighting bad credit. Timely payments on your new loan will appear on your credit report, and will help you begin to build a stronger credit history right away.
How is Debt Consolidation Different from Debt Settlement?
Debt settlement is a completely different form of debt relief than debt consolidation. Debt consolidation typically involves a personal loan that gathers all or many of your existing debts into one larger loan. The goal of a debt consolidation is to pay off all of your debts and, if possible, to lower the interest rate compared to what you were paying before the consolidation. A debt settlement company collects funds from you to negotiate with your creditors. But, a debt settlement company typically works toward settling one debt at a time. That means that while you are making payments toward your debt settlement plan, your existing accounts are falling further and further behind. And, your credit history and credit scores will suffer. Debt settlement can be a good alternative for folks with limited debts and the ability to make some lump sum payments to creditors in exchange for forgiveness of the balance.
Upsolve is Here to Help
If you’re struggling with debt and searching for the best solution, we’re here to help. Upsolve is a non-profit organization dedicated to helping consumers conquer debt and move forward into better, more stable financial lives. We provide information about bankruptcy, including resources to help some people file Chapter 7 bankruptcy without an attorney. If you are interested in pursuing bankruptcy and don’t qualify for our free assistance, we can help you find a local bankruptcy lawyer. And, if you’d like to explore possible alternatives, we can help you connect with an accredited, non-profit credit counseling agency.