What Is Debt Consolidation?

Debt consolidation is a very helpful financial tactic that can both organize your debts and make them more affordable. But what does this entail - what is debt consolidation?

This article will answer your questions about debt consolidation so you can decide whether it’s right for you. 

Topics covered include:

• What is debt consolidation?

• What is debt consolidation good for?

• How does debt consolidation work?

• What can be used as a debt consolidation loan?

• Debt management plans

• What is debt consolidation: FAQs

Debt consolidation means combining several debts into one. 

Over time, a typical consumer may acquire a variety of debts. There might be two or three credit card balances outstanding. A personal loan used to pay off a medical expense may still have a couple years left on it. Wedding loans, vacation loans, or student loans may also be part of the mix.

Having debt spread among multiple sources is often not the most efficient way to handle it. Trading all those debts in for just one source of debt can help you make better decisions about it.

The next section of this article will explain what you can accomplish by using debt consolidation to manage your debts. It will also highlight the types of debt that are the best candidates for debt consolidation.

What Is Debt Consolidation Good For?

Taking multiple debts and combining them into one doesn’t instantly reduce the total amount you owe. However, debt consolidation can accomplish a variety of financial goals, if you know what to look for when consolidating your debts. 

Financial goals of debt consolidation

The following table lists some financial goals and how debt consolidation can help you achieve them.

Identifying which goals are most important to you will help determine how your debt consolidation program should be structured.

Best types of debt to consolidate

You may have several kinds of debt, but some types are better candidates for debt consolidation than others. 

Generally speaking unsecured debt is the best type of debt to consolidate. Unsecured debt is debt that is not backed by any collateral. Because of this, it tends to have higher interest rates. Those high rates may give you an opportunity to save money through debt consolidation. 

Secured debt typically has much lower interest rates than unsecured debt. Common examples of secured debt are mortgages and car loans. It’s tough for debt consolidation to lower your interest rate on secured debt unless you can get a secured debt consolidation loan. 

Because of this, the prime candidates for debt consolidation are the following:

Credit card balances

This is one of the most expensive types of debt around. Credit cards charge higher rates than most personal loans, and certainly more than mortgages. That makes credit card balances a great candidate for debt consolidation because of the potential to lower your interest rate.

Also, people often have more than one (and sometimes several) credit cards. Debt consolidation can organize all those monthly payments into one. 

Finally, another problem with credit card debt is that it has an indefinite repayment period, so your debt can drag on and on. A debt consolidation loan can give you a clear timetable for getting rid of that debt.

Personal loans

Though their interest rates are not typically as high as credit cards, unsecured personal loans do generally charge fairly high rates of interest. Because of that, you may be able to lower your interest rate through debt consolidation.

Personal loans also often have fairly short repayment periods, resulting in high monthly payments. Debt consolidation can restructure that to pay the money off over a longer period of time with lower monthly payments. 

While that may negate some of the benefit of lowering your interest rates, it may be a necessary step if you can’t afford your current payments. 

How Does Debt Consolidation Work?

You can consolidate debts simply by borrowing money from one source to pay off what you owe to some of all of your existing creditors.

Before you do this though, it’s important to review the goals you want to accomplish. For example, if you’re trying to reduce your interest rate, you’d borrow just enough to pay off those existing debts with higher rates than your debt consolidation loan. 

Besides choosing which type of loan to get and which debts to pay off according to your consolidation goals, another key to making this approach work is to make it part of a broader program to reduce debt over time.

For example, if you lower your monthly payments and then just use the extra money to spend more, you could end up worse off than when you started. The idea is to end those old debts, not to allow them to build back up.

So, as you plan your debt consolidation, create a budget as part of it. This budget should detail  how you’ll pay off your consolidation loan, and how you’ll borrow less in the future. 

What Can Be Used as a Debt Consolidation Loan?

A key to making all this work is to find the right type of debt consolidation loan. It should have characteristics that are preferable to your current debt, and that meet your debt consolidation goals. 

Here are some possibilities for debt consolidation loans:

• Balance transfer credit cards. These often offer an introductory 0% interest rate, though only for a limited time. That means you can save money by consolidating other debt into one of these cards, as long as you can pay off the debt during the 0% period. Also make sure that any balance transfer fees don’t negate the effect of your interest savings. 

• Personal loans. Since personal loans generally have lower rates than credit card debt, they can save you interest as a consolidation loan. You might also be able to lower the rate of existing personal loans, especially if rates have dropped since you got those loans or your credit score has improved. 

• Home equity loans. If you own a home and have built up equity, the relatively low interest rate on a home equity loan could be used to consolidate higher interest debt. When using any form of mortgage as a consolidation loan, a sound repayment plan is especially important because your home may depend on it. 

• Home equity lines of credit (HELOCs). A HELOC can work similarly to a home equity loan, except give you more flexibility about when and how much you borrow. This can be good for debt consolidation if you have current debts but also expect to have to borrow for upcoming expenses. A HELOC would allow you to consolidate both your existing debts and those upcoming ones. 

• Cash out mortgage refinance loans. If interest rates have dropped since you got your home mortgage, you might be able to save money by refinancing. With a cash-out refinance loan you could also consolidate other debts. Again, having a realistic repayment plan is essential with any mortgage because the loan is secured by your home.

Debt Management Plans

You may be able to figure out how to consolidate debt on your own. If you need help, a debt management plan (DMP) might be an approach to debt consolidation that works better for you. 

With a DMP a debt consolidation company helps you figure out which debts to consolidate and whether you can save money with a debt consolidation loan. 

Even if you can’t get a consolidation loan that would save you money, a debt consolidation company might help by organizing your debts and making your monthly payments for you. That way, you’d only need to keep track of making one payment a month to the debt consolidation company.

On top of that, as part of a DMP a debt counselor might be able to negotiate changes in your repayment terms to ease your monthly expense. 

There would be a fee for this, which would reduce some of the benefit of debt consolidation. You must also remember that even when they’re being handled in a DMP, your debts remain your responsibility. However, if you lack the time, inclination or ability to manage a debt consolidation plan by yourself, this little extra help could make a difference.