How Does Debt Consolidation Work?

Debt consolidation is the process of combining two or more debts into a single account. It can streamline your monthly payments, which makes it easier to pay on time and avoid missing payments. And if you’re able to get better loan terms, it can save you money in the long run. There are several ways to consolidate your debt, including debt consolidation loans and debt management plans. Each works differently. Read on to learn more about how and when to use debt consolidation.

What Does Debt Consolidation Entail? 

Debt consolidation has several advantages. By streamlining multiple debt payments into one, you avoid having to keep track of several payments with different due dates and minimum payments. Debt consolidation loan payments are easier to manage. Also, you may save money by getting a lower interest rate. And since debt consolidation can lower your monthly payment, you’ll be less likely to be charged late fees or go into default.

If you consolidate your debt with a debt management plan (DMP), you’ll also benefit by having a credit counselor who will negotiate with your creditors on your behalf. A debt management plan may also lower your monthly payments. Paying off your debts may take longer with a DMP, but it makes repayment more affordable.

Before you contact your creditors, enroll in a debt management plan, or apply for a debt consolidation loan, there are a few things you need to do first.

Steps To Take Before Consolidating Your Debts 

Before you can consolidate your debts, you need to identify each debt and note the interest rate, balance, and any potential fees (like an early payment penalty).

Determine your weighted average interest rate.

Next, you want to determine your weighted average interest rate. This is your interest rate after you factor in the size of the debt. For example, imagine you have Loan A with a balance of $10,000 and an interest rate of 6%. You also have Loan B with a balance of $5,000 and an interest rate of 8%. Your average interest rate would be 7%. But your weighted average interest rate would be 6.67%. 

The weighted interest rate is lower because the 8% interest rate carries less weight. This is because Loan B is only $5,000, or one-third of your total debt. As a result, its interest rate only makes up one-third of your weighted interest rate. In contrast, Loan A consists of two-thirds of your total debt, so its 6% interest rate makes up two-thirds of the weighted interest rate.

Create a budget.

Now you can create a budget to determine what you can afford to pay for a new monthly payment. There are several ways to budget, but many people use a simple spreadsheet or a free app like Mint. If you’re not sure how to proceed, consider consulting with a nonprofit credit counselor. They can help you create a budget and determine the interest rate you need on your debt consolidation loan.

Look at your credit report and score.

If you haven’t already done so, pull your credit report and credit score from at least one of the major credit reporting bureaus (Experian, TransUnion, or Equifax). This will give you a better understanding of the kinds of terms you can expect when you consolidate your debt. If you credit history has improved in recent years, you may be more likely to get approved for a debt consolidation loan than if several negative items have been added to your credit report.

But take what you see with a grain of salt. There are broad market forces at work (like the Federal Reserve’s current monetary policy) that might have a stronger effect on the terms and availability of credit than your credit history does.

Get pre-qualified for a debt consolidation loan.

Finally, get pre-qualified for at least one debt consolidation loan. This gives you an idea of what interest rate you can expect. The pre-qualification process won’t hurt your credit score because it’s done with a soft inquiry. But keep in mind that if you want final approval for a debt consolidation loan, your lender will make a hard pull which could lower your credit score slightly for a short period of time. 

How Does Each Type of Debt Consolidation Work? 

If you decide to consolidate your debts, you’ll have three options: an unsecured debt consolidation loan, a secured debt consolidation loan, or a consolidation loan through a debt management plan. 

First, you can get an unsecured debt consolidation loan. These are simple but usually have higher interest rates than secured loans. That’s because the creditor faces a higher risk since the loan isn’t backed by collateral, like a car or home. So they’re not always the best option for debts that’ll take a long time to pay off.

Second, you can get a secured debt consolidation loan. They tend to have lower interest rates than unsecured loans because they pose less risk for creditors, but they are more complex. If you decide to get a secured debt consolidation loan, try to use real estate as collateral because it often increases in value over time. 

If you use real estate as collateral, the loan application process will be more involved. You may have to get your real estate appraised and take out title insurance. There will also be a loan closing before you get the loan. Using a car, boat, RV, or other property as collateral isn’t ideal because these items lose value over time. Because of this, creditors will impose higher interest rates even though you have to deal with the risk of losing your property in case of default.

Third, there’s the debt management plan. This may be your best option if you can’t get approved for a debt consolidation loan or the lender’s terms aren’t very favorable.

Debt Management Plans

In a debt management plan (DMP), a credit counselor will facilitate an agreement between you and your creditors so you can make one lump-sum payment to the DMP administrator or credit counseling agency. They’ll then distribute the money to each of your participating creditors. Not all debts are eligible for DMPs. Often, only credit card debts can be included. Medical bills, student loans, and tax debts aren’t usually eligible.

Each DMP is tailored to the borrower’s unique financial situation, but most will last 3-5 years. During that time you can’t apply for any new lines of credit. You also can’t miss a debt payment or you jeopardize your DMP. If you decide to take the DMP debt consolidation route, it’s best to work with an accredited, nonprofit credit counselor. You can use the National Foundation for Credit Counseling (NFCC) to find an accredited counselor. Attending a free credit counseling session is a good way to see if a DMP is the right option to help resolve your debt situation.

Unsecured Debt Consolidation Loans

There are three common types of unsecured debt consolidation loans. One of the most common is the personal loan. This is the best option if you have good credit and qualify for a lower interest rate and monthly payments that meet your budget. 

Credit Card Balance Transfer

For many borrowers, the easiest type of unsecured debt consolidation loan is the balance transfer. These are only available from credit card companies and have several appealing characteristics. For one, they often come with low or 0% introductory interest rates. And second, you can often transfer various types of debts onto the balance transfer credit card, like student loans, personal loans, and auto loans.

Credit card balance transfers have disadvantages, though. The low or 0% introductory interest rate period can be short. When the introductory period ends, you’ll have to pay the regular high credit card interest rate. There’s also a transfer fee. These vary by card issuer but usually range from 3%-5% of the total amount being transferred.

Using a balance transfer to consolidate debt is great if you can pay off the balance before the introductory interest rate period ends. It’s also easy to do and may only require one telephone call and 30 minutes to complete.

401(k) Debt Consolidation Loan

Less common is the 401(k) debt consolidation loan. Because of the early withdrawal penalties and taxes involved with taking money out of a 401(k) early, this should be one of the last options you consider. If you’re confident that you can fully repay the consolidated loan to avoid early distribution penalties, this could be a good option. Some of the benefits include:

• No application is needed to apply.

• You can consolidate as much as $100,000 due to new limits provided by the CARES Act.

• You get up to five years to pay back the loan.

• You may have flexible repayment options. Depending on the terms of your 401(k), you could make quarterly instead of monthly loan payments.

Potential drawbacks to using a 401(k) loan to consolidate your debts include:

• Because you’re taking money out of an account that could be earning investment income or capital gains, tax-free, you may have less money for retirement.

• If you can’t repay the loan on time, the money you withdrew from your 401(k) will be treated as an early distribution. This means you’ll have to pay income taxes on the money, and if you’re younger than 59 1/2, you’ll face another 10% tax penalty on top of that.

• Not all 401(k) plans allow loans.

Secured Debt Consolidation Loans

As mentioned before, it’s best to use real estate as collateral to secure a debt consolidation loan. For most people, the only significant piece of real estate they own is their home. So below are three common methods of using your home to get a secured debt consolidation loan.

Mortgage Cash-Out Refinance

With a mortgage cash-out refinance, you refinance your home for more than the amount necessary to pay off the original mortgage. Then, you use the excess money for debt consolidation.

Depending on the length of your mortgage term, a mortgage cash-out refinance could result in a repayment term of up to 30 years. This means you’ll pay more money over time than if you just paid off each loan individually. But it may also give you lower monthly payments, which could help if you’re struggling with cash flow. Mortgage cash-out refinance loans usually have low interest rates, so they are popular when consolidating loans that include a car loan. 

Second Mortgage

If you like the terms of your mortgage, you may not want to refinance. In this case, to take advantage of the equity in your home, you can take out a second mortgage to use for debt consolidation. A second mortgage uses the equity in your home as collateral and offers borrowers a lump sum that’s paid back over time with interest at a variable or fixed rate. But unlike with a first mortgage, the length of the loan for a second mortgage is often shorter. This means you can save money in the long run. But the trade-off will be higher monthly loan payments.

If you default on the second mortgage, the lender with the first mortgage gets priority to proceeds from the home. This creates additional risk for the second mortgage lender and is why the interest rates for second mortgages are higher than interest rates for first mortgages. As with mortgage refinance cash-outs, the interest rate with a second mortgage is often less than interest rates for auto loans. This is why some people use second mortgages to pay off their car loans.

The biggest risk with a second mortgage is that if you can’t make payments, you risk losing your home. Second mortgages aren’t as popular as they used to be, now that home equity lines of credit are more easily accessible. But second mortgages have the advantage of sometimes offering lower interest rates.

Home Equity Line of Credit (HELOC)

Home equity lines of credit (HELOCs) are similar to second mortgages in that you’re borrowing money against the equity in your home. But unlike second mortgages, HELOCs offer you a revolving line of credit that you can borrow as little or as much as you like, up to your approved credit limit and for the set draw period. A draw period is the amount of time you can use your HELOC. For most borrowers, this is 10 years. And most HELOCs give borrowers 20 years to pay back off the funds.

HELOCs are good for situations where you don’t know exactly how much money you’ll need. This is why it’s often not the best option for debt consolidation because you’ll know before applying for a HELOC how much money you need to consolidate your debts. The interest rates for a HELOC are usually variable and can be slightly higher than with a second mortgage. But they’ll still be lower than high-interest debt, like credit cards.

Some of the risks associated with a HELOC include losing your home if you can’t make payments and having your HELOC frozen by your lender if your home loses significant value. One of the biggest drawbacks with a HELOC is that the more money you take out, the higher your HELOC repayments will be. And like second mortgages, HELOCs will often require you to pay origination fees and closing costs.

Let’s Summarize…

Debt consolidation works by rolling two or more existing debts into new debt. You might do this to lower your monthly payments, save money with a lower interest rate, or make it easier to manage and pay your debts. 

There are a variety of ways to consolidate debt, including two popular options: a debt management plan or a debt consolidation loan. Each has its pros and cons. If using a loan, you can choose between securing it with collateral or keeping it unsecured. Unsecured loans are often simpler to get but have higher interest rates. If you aren’t sure what the best option is for your circumstances, you can contact a credit counselor to learn more.