If you have several debts that you're struggling to keep track of, debt consolidation may be a good option for it. It allows you to combine multiple debts and make one monthly payment. You may also be able to lower your payment amount and/or interest rate. Two popular ways to consolidate your debt are a debt management plan or debt consolidation loan.
Written by Curtis Lee, JD.
Updated July 28, 2023
Debt consolidation is one of many forms of debt relief. It works by combining multiple debts into a single account. The goal is to save the borrower money and make their monthly payments easier to manage and pay. Because there are several types of debt consolidation, we’ve created the following article to explain what debt consolidation is and when to use it. We’ll also cover the most common types of debt consolidation available, including debt management plans and debt consolidation loans.
What Is Debt Consolidation?
Debt consolidation is a type of debt relief that involves taking two or more debts and combining them into a new loan. Instead of making multiple monthly payments for multiple debts, the borrower pays has one payment. This makes it easier to avoid a late or missed payment. It may also save you money if you can get a lower interest rate. Other times, you may not save any money in the long run, but you’ll have lower monthly payments. These are more manageable and decrease the likelihood of default.
Most debt consolidation will occur with either a debt consolidation loan or a debt management plan (DMP). A debt consolidation loan uses a large loan to pay off several smaller debts. A DMP is set up by a credit counselor at an accredited, nonprofit credit counseling agency. The counselor will negotiate with your creditors on your behalf.
If you choose to consolidate your debts with a loan, there are two main types to consider: secured and unsecured loans. There are several types of secured and unsecured debt consolidation loans available. Common unsecured debt consolidation loans include:
There are also several secured forms of debt consolidation, such as:
Cash-out mortgage refinances
Home equity lines of credit (HELOC)
But before you choose how you’re going to consolidate your debts, you need to determine if it’s a good idea for your situation.
When Is Debt Consolidation a Good Idea?
If you have good credit, you may want to consider debt consolidation. But if your credit score isn’t good enough to get better terms for a new loan, you can still work with a licensed credit counselor who can help you set up a DMP. They may suggest a DMP debt relief if you have a lot of outstanding debt.
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Which Type of Debt Consolidation Might Be Best for Me?
The right form of debt consolidation depends on your unique financial situation. There are three major forms of debt consolidation, including DMPs, unsecured debt consolidation loans, and secured debt consolidation loans.
Debt Management Plan
If you don’t have the best credit history, then visiting a credit counseling agency to set up a debt management plan (DMP) is likely your best option. A DMP allows you to take advantage of lower interest rates and a streamlined repayment plan without getting a loan.
A credit counselor will negotiate the terms of the DMP for you. They may be able to get your creditors to lower your interest rate or monthly payment. After reaching an agreement, you make one monthly payment to the credit counseling agency or DMP administrator. They then distribute that money to each participating creditor as required by the DMP.
When using a DMP to consolidate debt, there are several things to consider. First, unless you qualify for a waiver, the credit counseling agency will charge you a modest monthly fee. Second, if you can’t make your monthly payments, you could be removed from the program and subject to your original interest rates. Finally, your credit score could temporarily drop at the beginning of the DMP. This is because many creditors will close a credit account when it becomes part of a DMP.
Unsecured Debt Consolidation Loan
Unsecured loans often have higher interest rates than secured loans because they aren’t backed by collateral like a car or house. But they are also less complex and faster to get. And if you have a high enough credit score, you can still get an interest rate that makes the debt consolidation worth it financially. Three popular types of unsecured loans to use for debt consolidation are the personal loan, a credit card balance transfer, and a 401(k) loan.
For many borrowers, a personal loan is the best choice. You can consolidate any type of debt with it. Also, a personal loan will often provide the lowest possible interest rate for an unsecured loan as long as you have good credit. Another benefit of personal loans is that you can typically get a loan term of at least five years. It’s also a good choice if you want a loan for a reasonable interest rate where you don’t have to risk your retirement account or property as collateral in case of default.
Balance Transfer Credit Cards
If most of the debts you want to consolidate are credit card balances, using a balance transfer credit card is a good option. Usually available only with credit cards, a balance transfer works by moving one or more credit card balances from an old account to a new one. The new account will normally offer a low or 0% introductory interest rate for a set period. This introductory period will depend on the credit card issuer and balance transfer terms. It’s possible to get up to a one-year introductory period if you have a solid credit history.
The biggest catch with balance transfers is that you need to pay off the balance before the introductory interest rate ends. If you don’t, whatever balance is remaining will be subject to the normal credit card interest rate, which is often in the double digits. Then there are the balance transfer fees to consider. These are typically between 3%-5% of the total amount you transfer. Even if you pay off the entire balance during the introductory low or no-interest period, you’ll still have to pay that balance transfer fee.
This is why most debt consolidation balance transfers are used with credit card debts. Other types of debts, like auto loans, student loans, medical bills, and mortgages will have lower interest rates — often similar to the balance transfer fee. So using a balance transfer to consolidate these loans doesn’t make financial sense
401(k) loans aren’t the most well-known for consolidating debt, but they may be a good choice if you have income that fluctuates. Some 401(k) loans have flexible repayment options that can accommodate inconsistent income or seasonal income. And if you need a large amount of money to consolidate your debt, thanks to the CARES Act, you could be eligible for up to a $100,000 loan.
You might also consider a 401(k) loan if you want the benefit of a lower interest rate without having to risk any collateral or you don’t have a good enough credit score to get a personal loan with good terms. The risk of using a 401(k) loan is that if you can’t pay back the loan in time, you could face early distribution and tax penalties. Another consideration is that your 401(k) may not allow these types of loans.
Secured Debt Consolidation Loan
If you’re using a secured loan for debt consolidation, your home is most likely your best source of collateral. Real estate values can fluctuate, but they generally increase over time. This increase in value means it’s easier to get more favorable loan terms when real estate is used as collateral.
Property such as cars, boats, or RVs can also serve as collateral. But because their values tend to decrease over time, they don’t provide the same level of security that real estate does. As a result, lenders will often adjust the terms of the loan to reduce their risk. They might raise the interest rate or reduce the amount of money they’re willing to loan.
Given the benefits offered through real estate collateral, if you’re going to get a debt consolidation loan, you should strongly consider using your home or other real property to do so. There are three main types of secured debt consolidation loans secured by real property: a cash-out mortgage refinance, second mortgage, and home equity line of credit (HELOC).
Cash-Out Mortgage Refinance
In a cash-out mortgage refinance, you replace your first mortgage with a new one. This new mortgage is for a higher balance and hopefully better terms than the first mortgage. Then you use the extra cash to consolidate your debts. Cash-out mortgage refinancing is beneficial for lower monthly payments, which can help your cash flow. But these lower payments mean it’ll take longer to pay off the loan. In the long run, this debt consolidation option may not be the cheapest.
A second mortgage is a mortgage where you use the equity in your home as collateral. The first mortgage you used to purchase the home is still in place, but the home and land it sits on serves as collateral for the second mortgage. This is a good option if you have equity built up in your home and want to consolidate your debts in a way that allows you to have a set loan term and payment schedule. The terms, or length of time, of most second mortgages are shorter than the first mortgage.
The primary drawback of a second mortgage is that it puts your home at risk if you default. There are also loan costs to pay, such as an origination fee and closing costs.
Home Equity Line of Credit (HELOC)
HELOCs are similar to second mortgages in that a bank lets you borrow money based on the equity you have in your home. HELOCs often have variable interest rates, which could potentially lead to higher payments later on. So before using a HELOC to consolidate your debts, you need to be confident that the interest rates will stay within an acceptable level or that you can pay everything off before the interest rate gets too high.
What if Debt Consolidation Isn't Right for Me?
Debt consolidation has its advantages, but it’s not an ideal form of debt relief for everyone. If debt consolidation doesn’t make sense for you, or you can’t get repayment terms that make it worth your while, there are at least three alternatives to consider: credit counseling, debt settlement, and bankruptcy.
First, there’s credit counseling. While it’s not a form of debt relief, credit counseling can help you better understand your financial situation and what debt relief options you should consider. Whether you decide to consolidate your debts or use another form of debt management, it’s still a good idea to use credit counseling.
Talking to a credit counselor can complement any other debt relief or management strategy you’re using. Nonprofit, accredited credit counseling agencies offer free consultations. During this consultation, the credit counselor can help you with:
Understanding the types of debt relief available
Identifying which debt solution is best for your unique set of circumstances
Second, there’s debt settlement. This allows you to settle your debts for less than what you owe. Either you or a debt settlement company will negotiate with creditors to reach a debt settlement agreement. If one is reached, you’ll usually need to make a large, single payment or just a few payments over a short period of time.
Debt settlement is an ideal solution if the following two conditions exist:
You currently have a lot of cash on hand or you can readily obtain a large amount of cash in a short period of time. This might occur if you have a tax refund or inheritance coming soon.
You lack enough stable income to make regular debt payments. This is common for borrowers who just lost their jobs.
Third, you may want to consider filing bankruptcy. Bankruptcy is a legal process of obtaining debt relief through the discharge and/or restructuring of debt. Most individuals with unmanageable debt file either Chapter 7 or Chapter 13 bankruptcy.
Chapter 7 makes it possible to discharge, or wipe out, many types of unsecured debt. But only borrowers who meet the financial requirements are eligible for this type of bankruptcy. Borrowers who don’t qualify for Chapter 7 bankruptcy can often file for Chapter 13.
Chapter 13 reorganizes a borrower’s debts so they’re easier to pay back. With a Chapter 13 bankruptcy, the court will create a repayment plan where you make payments to your creditors for 3-5 years. At the end of this repayment plan, if any debt balances remain, they get discharged.
If you decide to file bankruptcy, you can do it yourself, although having a bankruptcy attorney is recommended for complex cases. Either way, you should at least consult with a lawyer that handles bankruptcies. This can give you a better understanding of your financial situation and what you can expect during the bankruptcy process.
Debt consolidation is a form of debt relief that allows borrowers to roll multiple debts into a single monthly payment. In addition to the streamlined payment process, borrowers may also enjoy low interest rates or smaller monthly payments. The two primary ways to consolidate debt are with a debt management plan or a debt consolidation loan. Debt consolidation loans that are secured with collateral will have a lower interest rate, while unsecured loans will have a higher interest rate. Consulting with a credit counselor can help you understand your options and what’s going to work best for you.