How Does Debt Consolidation Work?

What is debt consolidation, and how does debt consolidation work? 

Debt consolidation means replacing two or more debts with a single new debt. Essentially, you borrow money and use it to pay off multiple debts. The money you borrow is often a debt consolidation loan, though it may be a credit card balance rather than a loan.

The debts you pay off could include credit cards, medical debt, auto loans, student loans, or a mix of different types of debt. In place of those debts, after you've consolidated you just have one monthly repayment to keep track of.

Debt consolidation could simplify payments to make them more manageable. In some cases, debt consolidation could also lower the interest rate and reduce your monthly payments. 

This guide will walk you through some possible debt consolidation solutions and explore how debt consolidation works.

How Does Bill Consolidation (Debt Consolidation) Work?

Debt consolidation works by using one loan to pay off multiple other debts. It's a form of refinancing that could work well if you want to simplify your payments and possibly reduce the cost of your debt. 

Debt consolidation and bill consolidation are the same thing. They focus on payments you make every month. The goal is to simplify payments by combining some of them into a single payment.

This could make your life easier in a few ways. Debt consolidation loans could:

• Simplify your debt payments. By borrowing from one source to repay some of your existing debts, you could merge two (or more) monthly payments into one. This makes it easier to manage your payments so you don't miss any. It also makes it easier to track your overall progress towards paying down debt.

• Lower your monthly payment. Consolidating bills doesn't reduce what you owe. However, it could reduce your monthly payments. This can be done by finding a consolidation loan with a lower interest rate than your current debts. You could also lower monthly payments by stretching the repayment period out over a longer time.

• Reduce the interest rate on your balances. Getting a consolidation loan is an opportunity to lower the interest rate on current debt balances. This is especially true if you have high-interest credit card debt. This not only may reduce your monthly payments, but could also reduce the total amount of interest you pay in the long run. 

• Help you pay off your debt faster. You could also structure your consolidation loan so that you pay off debt faster. If you can lower the interest rate, that allows more of each payment to go towards paying down debt. Also, if you can afford to pay more each month, that could pay your debt off sooner and mean you pay less interest.

What you're able to accomplish depends on the type of debt you have now, and the terms you get on a debt consolidation loan.

Because of its high interest rates, credit card debt is often an excellent candidate for debt consolidation. However, under the right circumstances, just about any type of debt could be a good candidate for consolidation.

How do you get started? The first step is to decide whether debt consolidation is right for you. Then you can work out which debt consolidation route makes the most sense. 

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How to Decide if Debt Consolidation Is Right for You

There are multiple ways to handle debt. Debt consolidation works best if you:

• Can qualify for a debt consolidation loan

• Have a plan to pay off debt

• Are confident you can keep on top of payments. 

If you're considering debt consolidation, think about your goals. For example, lowering your monthly payments might be more important to you than accelerating your debt payoff plan. Or vice versa. 

Debt consolidation could be the right choice if you have:

• High-interest debt. Debt consolidation could mean you save on interest with a new, lower-interest debt consolidation loan. 

• Large monthly payments. If you’re struggling to make payments, debt consolidation could help by stretching them over a longer period. 

• Trouble keeping track of multiple bills. Debt consolidation simplifies bill-paying by reducing the number of monthly payments.  

• Decent credit. If your credit is in good shape, that improves your chances of qualifying for a cost-effective debt consolidation loan.

Step-by-Step Process for Debt Consolidation

If you've looked at your situation and decided to consolidate some of your bills, it's time to make it happen. 

Here's are the steps to take:

1. Take stock of the problem. List your current debts, including the balance owed, monthly payment, and interest rate.

2. Add up your total debt burden. From the above list, total the balances of all the debts to see how much you owe. This lets you know your starting point so you can track progress towards paying down debt.

3. Total the monthly payments. This tells you the amount of money you currently have to come up with every month. You need to know this to measure the impact debt consolidation might have. 

4. Research consolidation loan options. The next section of this article details some of those options. See which ones are available to you, and look into interest rates and other loan terms.

5. Decide on your debt consolidation goals. Compare your loan options with your current debts. Decide what you can accomplish by consolidating debts into a new loan. You may decide that some debts should be consolidated, while others should be left the way they are. 

6. Look at the potential impact of consolidation. Once you have a handle on which debts you want to consolidate, compare those debts with what you'd be facing with a debt consolidation loan. Look at the total monthly payments for those debts versus what the monthly payment on a consolidation loan. Also compare the total amount of interest you'd pay in each scenario until the debts are paid down.

7. Make a consolidation budget. Look at how the monthly payments on a consolidation loan and your current expenses would fit into your take-home pay. This budget should also include a plan for avoiding the type of regular borrowing that allowed debt to build up. 

8. Apply for your consolidation loan. Make sure you can get a loan that meets your consolidation goals. Otherwise, you might find you have to adjust those goals.

9. Use loan funds to pay off existing debts. This should have an instant impact on your monthly payments. Be sure to change any automatic payments you set up on your old debts.

10. Make the new, consolidated payments. You now have fewer payments to make. Keep up with these payments, and stick to the budget you made so new debts don't build up.

Let’s look at some of the details you need to know to make this plan happen. 

Sources of Debt Consolidation

You have a variety of potential sources to fund your debt consolidation plan. Each has its own pros and cons.

Cash-out refinance mortgage

If you have a substantial amount of equity in your home or other real estate, cash-out refinancing works by replacing your existing mortgage with a new, larger loan. You get the difference back in cash that could go toward repaying other debts. It may make sense if you qualify for better terms on the new loan. 

When mortgage rates are low, cash-out refinancing can be used to lower the interest rate on your remaining mortgage balance. If mortgage rates are higher than your existing mortgage rate, a home equity loan might make more sense. 

Pros:

• Good if you need to consolidate a large amount of money—as long as you have enough equity in your home.

• Could possibly save you money on your existing home loan if mortgage rates are lower.

• Long repayment terms are available, which means smaller monthly payments.

• Credit score requirements can be as low as 620.

Cons:

• Potential for high closing costs, though these often can be included in the loan.

• Uses equity in your home as collateral, so you could lose the home if you fail to keep up with payments.

• Depending on the loan term you choose, refinancing your mortgage could lengthen the time it will take to pay off your home loan.

• If you choose a longer repayment period, it could raise the total amount of interest you pay.

Home equity loan

A home equity loan or home equity line of credit (HELOC) lets you borrow additional money against your home, leaving your current mortgage in place. Some people call home equity loans “second mortgages.” Terms on home equity loans usually range from five to 30 years. 

A home equity loan allows you to borrow a set amount with fixed monthly payments. A HELOC allows you to borrow money when you need it. With a HELOC, the monthly payments vary depending on how you use it.

Pros:

• Good if you need to consolidate a large amount of debt, as long as you have enough equity in your home.

• Low interest rates compared to most other consolidation options.

• Relatively long repayment periods can mean smaller monthly payments.

• Credit score requirements can be as low as 620, though some lenders prefer a score above 680.

Cons:

• There may be closing costs, though you may be able to include these in the principal of the loan.

• Using home equity as collateral means putting your home at risk if you can't repay the loan.

• Borrowing against equity may lengthen the time before your home is fully paid for.

• Choosing a long repayment period could raise the total amount of interest you pay.

Personal loan

You could use a personal loan to consolidate debt. Personal loans are typically unsecured, which means they aren’t guaranteed by something of value that you could lose if you default on the loan.

Pros:

• Interest rates are generally lower than credit card rates.

• Provide a fixed-rate, fixed payment loan for predictable repayment.

• You may qualify even with a subprime credit score.

Cons:

• Interest rates are higher than for some forms of debt, such as mortgages and car loans.

• Interest rates could be much higher if you have a poor credit history.

Balance transfer credit card

A balance transfer credit card offers a low introductory interest rate—often 0%—for a limited time. Introductory periods generally range from six to 21 months. If you qualify for one of these offers, balance transfers could be a good way to consolidate credit card debt. However, these credit cards usually charge a balance transfer fee on amounts transferred from other credit cards.

Pros:

• The interest-free period allows you to make more impact with each payment.

• The interest-free period could reduce the total amount of interest you pay until the debt is paid off.

• Payments are flexible, so you can adapt them as needed.

• Some balance-transfer cards are available to people with subprime credit scores.

Cons:

• The 0% period is limited. When it expires, your balance is subject to the card’s regular interest rate, which is usually high compared to other borrowing options.

• You will probably have to pay a balance transfer every time you transfer a balance on to this card.

• The interest-free period is short. You might not pay off your debt before it runs out.

401(k) loan

401(k) plans are employer-sponsored retirement plans. Depending on your employer's rules, you may be able to use a 401(k) loan to consolidate your debts. This money is borrowed from your 401(k) plan balance. You repay the loan into your plan balance.

Pros:

• Low interest rates

• Interest paid goes into your retirement fund

• No credit check

Cons:

• Taking out a 401(k) loan slows down your retirement savings.

• If you don't repay the loan within five years, the unpaid amount may be subject to income taxes.

• Amounts that are not repaid within five years may also be subject to a 10% early withdrawal penalty if you are younger than 59 and a half.

• You may have to repay your loan before the loan term ends if you change jobs.

Debt management plan (DMP)

A debt management plan isn’t a loan. It’s a program in which a credit counseling service takes over the payment of your debts (with money you set aside for the purpose). 

Pros: 

• No credit requirements

• The debt counselor coordinating the DMP may be able to negotiate concessions from creditors such as lower interest rates, penalty fee waivers, or smaller monthly payments.

Cons:

• There are fees for this service.

• There may be little or no impact on your total monthly payment, so this may not help if you are struggling to make payments.

• You typically have to stop using credit cards while the DMP is in place.

Summary: Pros and cons of debt consolidation sources

Credit score requirements and impact when you consolidate debts

One thing to consider when approaching debt consolidation is your credit score. Your current credit score may limit your debt consolidation choices. Also, you should understand how the debt consolidation process itself may affect your credit score.

There are debt consolidation options open to people in all credit score tiers, though there are fewer if you have a low score. Also, as a general rule, the lower your credit score, the higher the interest rate you're likely to pay.

Here's a breakdown of the credit score tiers required for various debt consolidation options:

How will going through debt consolidation affect your credit score? You may need to be prepared to take a small step backward before taking a bigger step forward in the long run. 

The debt consolidation process could have a minor negative effect on your credit score in a few ways:

• Credit checks when you apply for a consolidation loan

• Opening a new credit account (for the consolidation loan)

• Closing old credit accounts.

You should be aware of these potential impacts, but not intimidated by them. If you need debt consolidation, there's a chance your credit score has already taken some hits. If so, the impact of the above may be relatively minor.

Also, you can soften the impact of closing old credit accounts by doing this one at a time rather than all at once. It may still be worth closing those accounts so you aren't tempted to build their balances back up after you've paid them off with your consolidation loan.

The bigger picture is that these possible negative effects should be minor and short-lived compared to the long-term benefit of debt consolidation. Making your monthly payments more manageable should help you make payments on time and lower your credit utilization. Those are important factors in your credit score. 

How Does Debt Consolidation Work to Lower Monthly Debt Payments?

Debt consolidation could help lower your monthly debt payments because it could reduce your interest rate, stretch your repayment out over a longer time, or both.

However, taking more years to repay your debts could cost you in the long run, even if your new loan has a lower interest rate. It’s wise to pay your debt consolidation loan back as quickly as possible to minimize your interest expense.

Here’s what terms and total interest look like on a $10,000 loan with a 13% interest rate. 

The lower monthly payment can be tempting, but you pay a hefty price if you choose the seven-year term. 

How Does Debt Consolidation Work to Simplify Your Debt Payments?

A big benefit of debt consolidation is that it combines multiple bills into a single payment. You don't have to keep on top of multiple accounts with different payment amounts and due dates. 

If you can reduce your interest rate at the same time, you could reduce the total cost of your debt and pay down your balance faster. 

How Can Debt Consolidation Work to Lower Interest Rates?

Debt consolidation involves using money from a new loan to pay off other debts. The new loan may have a lower interest rate going forward, and paying off the old debts stops their higher rates from costing you.

Credit card accounts are usually unsecured, and are among the riskier types of financing. As a result, they carry relatively high interest rates. If you’re only paying the minimum on these accounts, the interest on your balance can balloon. That’s where replacing high-interest debt with cheaper financing comes in.

Here’s how interest rates on common types of debt usually rank, from highest to lowest:

• Credit card debt

• Personal loans

• Home equity loans

• Primary mortgages.

If you can exchange one of the higher-interest types of debt for one lower on the list, it could save you money.

How Does Debt Consolidation Work to Pay Off Debt Faster?

When you make debt payments, only part of that payment goes toward reducing the initial amount you borrowed. The rest goes toward interest. 

When you consolidate debts with a lower-interest loan, more of each payment goes toward reducing the principal balance. That means you could pay off your debt faster, and pay less interest over the long run.

Cutting interest costs means you put more cash toward the principal. Another way to speed up repayment is to choose a loan with a shorter term when you consolidate your debt. You have higher monthly payments, but you also pay less interest over the loan term.

Alternatives to Bill Consolidation

Consolidating debts and bills won't suit everybody. If you're already behind on your bills and your credit score is in bad shape, debt consolidation may not be your best bet. 

In that case, there are some alternatives to debt consolidation.

Debt payment strategies: snowball and avalanche methods

A look at how you make your monthly payments—especially credit card payments—may help you use your money more effectively. The debt snowball and debt avalanche are two strategies for doing this:

• The debt snowball involves targeting your smallest debt balance first. Pay the minimum required amount on all your debts, but put any extra money towards your smallest debt. This is the fastest way to eliminate one of your debts. Then you can move onto the next smallest debt and work to eliminate that one.

• The debt avalanche is the most cost-effective way of making payments, and is the fastest way to get rid of your overall debt. With the avalanche method, you target the debt with the highest interest rate first. Paying that down first saves you the most on interest charges. That way, more of each subsequent payment goes toward paying down the balance owed instead of to interest charges. 

Debt management plan

A debt management plan (DMP) is similar to debt consolidation in that you make one monthly payment instead of multiple payments. The big difference is that you don't borrow more money to do it. Instead, you work with a credit counselor to make a repayment plan. If your creditors agree to it, you make one monthly payment that gets distributed to them.

This simplifies your monthly payments. A credit counselor may also be able to negotiate a lower interest rate. 

Because this approach doesn't require a loan, it may be worth considering if you'd have trouble qualifying for a loan. There are monthly fees to be in a DMP, typically under $50. You’ll be expected to close all of your credit cards while you’re in the plan. The monthly payment on a DMP is typically very high. So high that many people can’t stick with it. It’s designed to fully repay all of your unsecured debts within three to five years. 

Debt settlement

Debt settlement involves negotiating with creditors to settle your debts for less than you owe. You can do this on your own, or with a debt settlement company. 

This is an option to consider if you are unable to pay what you owe even if you consolidate your debts. It also may be a solution for people who can’t qualify for a consolidation loan.

Debt settlement typically hurts your credit standing. However, if your credit score has already suffered because you're struggling to pay your bills, debt settlement may not have much additional impact. Once you get rid of your debts and are on more stable financial footing, you could be in much better shape to build and maintain good credit.  

Bankruptcy

Bankruptcy is legal protection from creditors. However, it's not a get-out-of-debt-free card. It can be costly and time-consuming. 

Not everyone qualifies for the kind of bankruptcy that lets you walk away from debt. You may have to continue to make some debt payments. If you do get to walk away from your debts, you might have to give up some of the things you own. For example, if you have a lot of home equity, you might have to sell your home and give some of the money to your creditors.

Everybody's situation is different. The best solution for you depends on things like the amount and type of debt you carry, your credit score, and your ability to manage repayments. The important thing is to understand each option and act sooner rather than later. If you're considering debt settlement, find out how Freedom Debt Relief works.

Common Debt Consolidation Mistakes to Avoid

Debt consolidation could help make your bills manageable, but it can be undermined by some common mistakes. Here are some things to avoid:

• Choosing a method without considering the alternatives. There are a few types of loans you can consider for debt consolidation. There are also alternatives such as debt settlement, or different payment strategies. Take a look at all the options to see what best fits your situation. 

• Failing to compare terms. Once you decide on the type of loan you need to consolidate debts, get quotes from a few lenders. Anything you can save on fees or interest adds to the money that could go toward paying off debts faster.

• Committing without seeing how it fits your budget. Do a reality check before you apply for any sort of consolidation loan or credit card. Look at what the monthly payment will be, and make sure you can afford it given your other expenses. This may force you to cut those expenses.

• Choosing consolidation based solely on monthly payments. Making monthly payments affordable is a major goal of debt consolidation. However, you should also look at the total cost of paying off the debt. Choosing a longer-term loan could make monthly payments more affordable, but it's likely to cost you more interest in the long run.

• Running up new balances on paid-up credit cards. For people who have maxed out their credit limits, debt consolidation can create a temptation—clearing your credit card balances can be an invitation to use those cards again. However, debt consolidation only works if you avoid building up other debts while you're paying off the consolidation loan.

• Not addressing what created the debt. Sometimes debt comes from a one-time event, like an accident or an illness. Often, though, it's the result of routine expenses that have gotten out of hand. Make the benefits of consolidation last by creating a budget so you can live within your means. 

Take Action Toward Your Debt Consolidation Goals

If you're able to qualify for better terms on the money you owe, it could save you money and reduce stress. Even better? There are steps you can take right now to tackle your debt.

Work out what you owe, and how much you're paying in interest. Think about whether you need debt consolidation or debt relief. Then you can shop for loans or look for other ways to make that debt more manageable. 

People just like you are seeking debt relief across the country. The first step is the most important one.