What Is Debt Consolidation?

Debt consolidation may help you pay your debt off faster, simplify your finances and improve your credit score. It can save you money if you approach it correctly. However, debt consolidation done wrong can leave you in a much worse financial position. This guide to successful debt consolidation can help you avoid the pitfalls and enjoy the rewards.

Debt Consolidation Meaning

Debt consolidation is when you use a new loan to pay off multiple smaller debts.  

Debt consolidation doesn’t eliminate or reduce any of your debts. It merely rearranges them into a more convenient form. If you owe $2,000 on one credit card and $3,000 on a line of credit and then consolidate them with a $5,000 debt consolidation loan, you still owe $5,000.  But you'll make one monthly payment instead of two.

How Can Debt Consolidation Help You?

Most people consolidate debt to achieve one or more of these benefits:

• To get a lower interest rate

• To get a lower monthly payment

• To simplify debt management

The best consolidation loans may achieve all three goals. Suppose the interest rates on your credit cards range from 17% to 27%. You pay them off with a 7% home equity loan. In that case, you could reduce your monthly expense, drop your interest rate, and combine several payments into one.

Optimize Your Loan Term

Getting a loan with a lower interest rate and a longer term could reduce your interest rate and lower your payment. However, too long a term could cost you more, even if the rate is lower. 

For instance, if you owe $5,000 on a credit card with a 17% interest rate, and your minimum payment is $100 per month, it will take 79 months to clear that debt and cost you $2,896 in interest. If you refinance it to a 15-year home equity loan at 10% interest, your payment drops to $53 a month. But it will cost you $4,671 in interest by the time you pay it off. 

Shorter loan terms have a higher payment, and lower the total interest you pay. Longer loan terms have a lower payment and increase the total interest you'll pay.

Optimize the term of your new loan to suit your needs. You want it to be short enough to pay off within a reasonable period. But you don’t want it to be so short that you’ll struggle to make your monthly payments. One solution is to take a loan with a payment you can make easily but then pay it down as fast as you can.

What Kinds of Debt Can You Consolidate?

You can consolidate all sorts of unsecured debt. Unsecured means the loan isn't guaranteed by something. Most credit cards and personal loans are unsecured.

In theory, you could consolidate secured debts. You could take a home equity loan and use it to pay off your car loan and credit card balances, and remodel your bathroom. But secured debts like car loans typically have low interest rates already. Consolidating won’t be worth it unless your debt consolidation loan has a lower rate than the debts you're consolidating.

Student loan debt is unsecured, but if you use a new private loan to pay off federal student loans, you lose valuable protections and options that only the government offers. Read Should I Consolidate Student Loan Debt? before tackling that.

Prepayment Penalties

A prepayment penalty is a fee for paying off your loan ahead of schedule. Check your loan agreements for any debts you plan to consolidate. Prepayment penalties are common with mortgages, but uncommon with credit cards.

Don’t automatically think you can’t consolidate an account because it has a prepayment penalty. Sometimes, these fees are very small. Call your lender and ask how much you’ll have to pay. Then decide whether it’s so much that it makes consolidation of that particular debt uneconomic.  

Also check for prepayment penalties on the new loan, so that you'll know whether you have the option to accelerate payoff without additional fees.

When Does Debt Consolidation Make Sense?

Debt consolidation could make sense when your credit standing is strong, you're current on your payments, and you have a plan for avoiding new debt after you consolidate.

Ideally, you'll qualify for a new loan that has better terms than your existing debts. It doesn't make sense to pay off a debt with a more expensive debt.

Also, consider the reasons you're in debt. If overspending contributed to your situation, there's a real risk when you consolidate. It's a common pitfall to pay off your credit cards with a new loan, and then run balances back up on those paid-off cards. If that happens, you could end up in even more debt and a worse situation.

Make Sure You Benefit

There’s no point in consolidating your debts unless you’re going to achieve one or more of these benefits:

• Reduce the interest rate on your debt

• Lower your monthly payments  

• Reduce the number of payments you have to make each month, a good safeguard against forgetting one

• Repay your debts faster

• Improve your credit standing. This could happen if you use an installment loan to pay off your credit cards, and then you avoid new credit card debt.

Address Overspending Before Debt Consolidation

Many who need debt consolidation have overspent. That's not always your fault. You may be facing medical bills or have experienced a period of unemployment, letting your credit cards or other borrowing take the strain. Others may have just never learned to budget.

Take a good look at your spending. Understand where your money’s going. Find areas to trim.

Make a budget. Set limits. Keep track. Make sure your payments fit your income.

Consider a debt management plan (DMP) if you have a good income but you need help getting your spending and debt under control. With a DMP, you’re usually required to close your credit cards and then make a single monthly payment into the plan. That payment is distributed to your creditors. Because your cards are closed, you can’t run your balances back up. And credit counselors can show you how to budget.

Does Debt Consolidation Hurt Your Credit Score?

Yes, your credit score will probably drop when you consolidate your debts. But it’s likely to be a minor hit that lasts a brief time. And, soon after, you might well see your score boosted, perhaps by a lot.

Lenders pull your credit report when you apply for a debt consolidation loan. And every inquiry could cause your score to drop a few points.

But if you zero out your credit cards, your score could rise. That’s because your credit utilization will fall, and credit utilization is a big factor in your score. This isn’t your total debt. It’s your credit card balances compared to their limits. A maxed out card is bad. A paid-off card is good.  

>>Check out Freedom Debt Relief reviews on YouTube

How Do You Consolidate Debt?

There are many ways to consolidate your debts. Here’s a list of common ones. 

• Credit card balance transfers

• Personal loans for debt consolidation

• Cash-out mortgage refinance

• Home equity loan or home equity line of credit (HELOC)

• 401(k) loans

• Debt management plans from credit counseling firms

Here’s what you need to know about each.

Credit card balance transfers

You’ve probably received mailings about these. You transfer balances from existing cards onto a new one that offers an introductory interest-free period, typically six months to 21 months.

A 0% annual percentage rate (APR) is unbeatable. So what's the catch? Watch out for these potential drawbacks:

• You must have good or excellent credit. These are for creditworthy borrowers.

• Compare balance transfer fees, which typically run approximately 5% of your transfer amount.

• Remember, the reason for taking a balance transfer card is to take what you’d otherwise pay in interest and put it toward paying off your debt faster. 

• Avoid carrying credit card balances in the future.

Personal loans for debt consolidation

This is the first choice for many, especially those who aren’t homeowners. You apply to your bank or an online lender for a personal loan, and you use the money to pay down your other debts. 

The interest rate you’re offered will mainly depend on two things:

1. Your credit report and score

2. Your choice of lender

That second one is important. Some lenders offer the same borrower a much better interest rate than others, so do your research. In addition, many personal loans come with fees. Compare loan fees and interest rates before applying. The annual percentage rate, which lenders have to disclose by law, incorporates both the interest rate and the costs to obtain a loan so you can compare offers more easily.

Don’t apply to multiple lenders, or you risk damaging your credit score. Each application could knock a few points off your scores. Most personal loan providers allow you to prequalify without a hard inquiry. Do this with a few before choosing your lender and applying.

Cash-out refinances and home equity loans

These are available to homeowners with sufficient equity. Equity is the difference between your home's market value and the amount you still owe on the mortgage. If you have a $300,000 home and you owe $150,000 on your mortgage, you have $150,000 in home equity. You could look for a lender that lets you borrow a portion of it.

If you’re eligible, home equity financing comes with some of the lowest interest rates available. And monthly payments are smaller because loan terms are longer than those of most personal loans.

Even so, there are downsides:

1. Loan fees

2. Longer loan terms mean more interest overall

3. If you can't repay the loan, you could lose your home

401(k) loans

If your employer allows you to borrow against your 401(k), it might make sense to do so. 

• No credit check

• The law allows you to borrow up to 50% of your account balance or $50,000, whichever is less.

• Repayment comes out of your paycheck, so you’ll never be late.

There are significant disadvantages, which is why many financial advisors don’t recommend this course of action:

• As long as you have a loan against your account, you can’t contribute to it. If your company matches contributions, you lose that benefit.

• If you leave the company, voluntarily or involuntarily, you have to pay off the loan. If you can't, it becomes a distribution for tax purposes. If you’re not eligible to withdraw from your account, you’ll face a 10% penalty in addition to income taxes on the unpaid loan balance.

Debt management plans from credit counseling agencies

Like other forms of debt consolidation, debt management plans don’t make your debts disappear. But they may give you an opportunity to conquer your debt and create a financial plan that helps you avoid debt in the future.

You’ll work with a certified credit counselor who will review your financial situation. You’ll get a customized repayment plan, and your counselor may be able to negotiate lower interest rates (“concession rates”) with your creditors. 

You make one payment each month into the plan, and it’s distributed among your creditors. The payment includes a fee that goes to the counseling firm. DMPs can work if you can afford the payment. The payment could be high if you're used to making minimum payments. A DMP is designed to fully repay your debts in three to five years. If you miss payments, your creditors could back out and revoke the concession rate.

However, the Federal Trade Commission says, “The traditional Debt Management Plan (DMP) supported by creditors is not sufficient to help many consumers…these inflexible full principal programs will work for only about 25 percent of consumers who seek credit counseling assistance because they require a payment beyond a consumer’s ability to manage over the life of a program.”

Debt Consolidation Mistakes

Debt consolidation could help you pay off debt faster if you do it correctly. However, some mistakes can put you in a much worse financial position. Don’t undertake debt consolidation lightly, and avoid these common errors.

1. Wrong method: The right program or loan should provide a real benefit and help you achieve your goal better than other methods.

2. Unaffordable plan: Falling behind with your debt consolidation loan could be financially disastrous. So be realistic about the monthly payments you can comfortably afford.

3. Unrealistic expectations: Debt consolidation doesn't wipe out debt. You’ve simply rearranged your financial deck chairs. Your task is to make sure those deckchairs aren’t on the deck of your own personal SS Titanic.

4. Old habits: It’s tough, but don’t build up more debt while you’re paying down your consolidation loan. Learn to live frugally, at least until you’re clear of unsecured debt.

Arguably, the biggest mistake is waiting too long to act. If you’re in financial trouble, there’s a good chance your credit score is falling. And that’s going to badly affect the interest rate you’ll pay when you finally get around to consolidating. If you're struggling with debt, you have options beyond consolidation, including bankruptcy, debt settlement, and other forms of debt relief. Talk to a debt expert and learn more today.