How Does Debt Consolidation Work?

Debt Consolidation
Key Takeaways:
  • Debt consolidation means paying off two or more loans with a new loan.
  • Debt consolidation benefits can include reduced interest rates, lower payments, and replacing multiple payments with a single payment.
  • Debt consolidation does not reduce the amount you owe. It only restructures it.

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

Essentially, debt consolidation means replacing two or more debts with one monthly payment. You can achieve this with a new loan or a debt management plan (DMP).

When looking for a debt consolidation loan, define your goal:

  • Are you looking for a lower payment to get some breathing room? 

  • Do you want help organizing your debt payments?

  • Do you want to reduce the interest rate on your balances? 

  • Or do you wish to pay off your debt as fast as possible? 

This article will introduce some possible debt consolidation solutions and explain which of those options might help with each of the above-listed debt consolidation goals. 

How Does a Debt Consolidation Loan Work?

Debt consolidation is a form of refinancing that uses one loan to pay off multiple other debts.

Consolidating multiple bills into a single payment makes tracking and paying your bills more manageable. And consolidating debt can reduce your interest rate, lower your payment amount, or speed up repayment.

How do you make this happen? The section below mentions a few tools you can use to consolidate debt. Other sections focus on using debt consolidation to meet specific financial goals.

Sources of Debt Consolidation

The following are some debt consolidation possibilities:

Cash-out refinance mortgage

Cash-out refinancing means refinancing your mortgage balance with a larger loan and taking the difference in cash. Cash-out refinance mortgage rates are lower than those of most other kinds of financing, so this can be a good option. However, cash-out refinancing has relatively high upfront costs. And those charges apply to the entire loan amount, not just the cash-out. 

Most borrowers are better off consolidating debt with a home equity loan instead of a cash-out refinance. The exception is the borrower with a relatively low existing mortgage amount who wants a large amount of cash-out. In addition, the new loan should have better terms than the loan it replaces. 

Home equity loan

Home equity loans allow you to leave your current mortgage in place and borrow additional money with a new loan. Some people call home equity loans “second mortgages” for this reason. Home equity loans can have terms ranging from five years to 30 years. 

Home equity loans offer some of the cheapest debt consolidation financing because they are backed with an asset – your home. The lender can foreclose and take your house if you don’t repay your loan as agreed.

Personal loan

If you don’t have equity in a property or don’t want to use it as collateral, a personal loan is another possibility. 

Personal loan interest rates are generally higher than mortgage rates but usually lower than credit card rates. So, if you have a lot of credit card debt, a personal loan can consolidate that debt into a single, fixed-rate loan at lower interest.

One issue that might catch you off guard is that consolidating credit card debt might increase your monthly payment even if a personal loan has a lower interest rate than your credit cards. Personal loan terms commonly run between two and ten years, while credit card minimum payments can keep you in debt for decades.

Balance transfer credit card

A balance transfer credit card offers a super-low introductory interest rate as an incentive to get you to transfer existing credit card balances onto a new card.

That interest rate is often 0%, and the introductory period may be as long as 23 months. That’s 23 months to pay down credit card debt without continuing to rack up interest charges.

If you consider a balance transfer credit card, expect to pay balance transfer fees that cut into your savings. Three percent is a standard balance transfer fee, but they can run between 1% and 5%. Also, if you won’t be able to pay off most or all of your debt within the temporary low-interest period, make sure you won’t be raising the interest rate on your credit card debt in the long run.

401k loan

If you have a balance in a 401k plan, you may be able to borrow against it, depending on your employer’s rules.

A big problem with a 401k loan is that it can slow down your retirement savings. And if you have to leave your company before repaying the loan, the unpaid balance is taxable income, and you are also likely to incur a 10% early withdrawal penalty. However, this may be your only option if credit problems prevent you from borrowing elsewhere.

Debt management plan (DMP)

A debt management plan isn’t a loan. Instead, it’s a program in which a credit counseling service takes over the payment of your debts. 

You make a single monthly payment to the DMP, and the service distributes that money among your creditors. Your counselor may be able to get some concessions from your creditors like a lower interest rate, waiver of penalties and late fees, or a smaller payment. 

There is a fee for this service, and DMPs don’t have a high success rate. The usual reason for failure is that the payment is too high for the consumer to pay month after month over a long term. If your monthly plan payment isn’t manageable, a DMP might not be the right option.  

The following sections give examples of using different tools to meet specific debt consolidation goals.

How Does Debt Consolidation Work to Lower Monthly Debt Payments?

Debt consolidation can lower monthly debt payments in two ways. One is by lowering your interest rate. Another is to stretch repayment out over a longer time.

A cash-out refinance loan or a home equity loan may be a good tool for this job. Both are suited to longer-term borrowing, giving you more time to pay off your debts. 

However, taking more years to repay your debts can 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.

How Does Debt Consolidation Make Debt Manageable?

Besides the potential financial benefits of debt consolidation, it can make expenses more manageable by combining multiple bills into a single payment. 

While streamlining debt repayment may be the goal, it’s a good idea to do this with as low an interest rate as possible. A balance transfer credit card may be an ideal option if you can pay it off during the low-interest introductory period.

If it’s likely to take you longer than that, cash-out refinancing, a home equity loan, or a personal loan are other options for simplifying your debt repayments.

If the problem is coming up with the money to make your monthly payments, a DMP may make that happen.

How Does Debt Consolidation Work to Lower Interest Rates?

If you have high-interest debt, reducing the interest rate you pay may lower your monthly payments and the total amount paid.

Credit card accounts are unsecured and among the riskier types of financing, so they carry relatively high interest rates. That doesn’t matter if you pay off your balances every month. But if you owe a fair amount, a high interest rate can make it challenging to pay off your balances quickly. That’s where replacing high-interest debt with cheaper financing comes in.

While it can depend on the specific debt terms, generally speaking, here’s how some common types of debt rank from highest to lowest interest rates:

  1. Credit card debt

  2. Personal loans

  3. Home equity loans

  4. Primary mortgages

So if you have an opportunity to exchange one of the higher-interest types of debt for one lower on the list, it can save you money.

Also, if you’ve improved your credit rating, you might be able to qualify for a lower interest rate now. So, substantial improvements in credit score can cue you to look at debt refinancing. 

How Does Debt Consolidation Work to Pay Off Debt Faster?

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

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

You can choose a loan with a shorter term to accelerate repayment. Another option is to take a loan with a longer term and low payment and pay extra whenever you can. Paying off debt faster when you can afford to is a great way to get rid of any debt you built up in tougher times. 

Take Action Towards Your Debt Consolidation Goals

Whatever goal you have, debt consolidation is more effective when you act sooner.

Whether it’s shopping for balance transfer credit cards, comparing loan rates, or learning about debt management programs, there are easy steps you can take online right now to get started. 

That’s all it takes to be one step closer to your debt consolidation goals. 

Frequently Asked Questions

How can I get a debt consolidation loan?

First, decide what kind of loan you want from the options described in this article. Then compare rates from banks and other lenders to see who has a good deal. The rate you get depends on your financial situation, so don’t commit to a loan until you have a specific quote. 

How can I tell if a debt consolidation loan will save me money?

Any loan should come with an amortization schedule. The schedule lays out all the payments you would make over the loan, broken into principal and interest. This makes it easy to see the total cost over the life of the loan. Compare that cost to the cost of doing nothing and continuing to pay your accounts.

Is it safe to use a home equity loan to pay off credit card debt?

A home equity loan does raise the stakes because it uses your home as collateral. So, before you use any type of mortgage for debt consolidation, check to see how the monthly payments would fit into your budget. Also, consider factors like whether you have any savings to draw on in an emergency and how secure your income is. 

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