What is Debt Consolidation and Is It Right for You?

Key takeaways

Debt consolidation helps streamline the debt repayment process and could save you money.
Common options include debt consolidation loans, balance transfer credit cards, student loan refinancing, home equity loans and HELOCs.
Explore various forms of debt consolidation and get prequalified to view potential loan offers.
Consider the benefits and drawbacks of debt consolidation to decide if it is right for you.

Debt consolidation is a form of money management where you pay off existing debts, like credit card debt, personal loans, or medical debt, by taking out one new loan. Usually this is possible through a debt consolidation loan, balance transfer credit card, student loan refinancing, home equity loan or a HELOC.

By consolidating your debt, you can save money in the long run if you can secure a lower interest rate or more favorable terms. However it’s not a one-size-fits-all solution and there are potential risks that come with consolidating debt.

Example of debt consolidation

To illustrate how debt consolidation works, assume you have four credit cards with an aggregate balance of $31,000. If the average APR is 20.99 percent and you want to pay them off in 36 months, you’d need to pay $1,167 each month to meet your goal. Plus, you’d incur $11,039 in interest costs.

However, you can consolidate the balances into a 36-month debt consolidation loan with a fixed interest rate of 11 percent to save a bundle in interest. Your monthly payment would drop to $1,015, and you’d pay $5,536.41 in interest.

Consolidating four credit cards with an average interest rate of 20.99%

Loan Details	Credit Cards (4)	Consolidation Loan
Principal	$31,000	$31,000
Interest %	20.99%	11.00%
Payments	$1,167	$1,015
Term	36 months	36 months
Total Interest	$11,039	$5,536.41

Types of debt consolidation

There are multiple debt consolidation options that can make it easier to pay off high-interest student loan debt, personal loans and credit card debt.

Debt consolidation loan

Debt consolidation loans are personal loans that consolidate multiple loans into one fixed monthly payment. Debt consolidation loans generally have terms between one and 10 years, and many will let you consolidate up to $50,000.

Many lenders don’t specify how the loan proceeds can be used, but it’s always best to check before applying to be sure you can use the funds to consolidate outstanding debt. Once approved, you’ll begin making monthly payments to the new lender for the duration of the loan.

Ideally, you want to focus on the debts with the higher interest rates first. That being said, debt consolidation only makes sense if your new loan’s interest rate is lower than the interest rates of your previous credit card or loan products. While you could get a more affordable monthly payment if the lender extends the loan term, you’ll end up paying more in interest in the long run.

Best for: Borrowers who want a more streamlined repayment process.
How to find the best loan for you: Decide what your financial goal is for a debt consolidation loan. Compare interest rates between different lenders to find a loan option that provides the best option for your goal.
Key takeaway: Debt consolidation loans give you a predictable monthly payment and can help you get out of debt faster if you qualify for a lower interest rate and opt for a shorter loan term.

Balance transfer credit card

A balance transfer credit card can help you pay down your debt and minimize your interest rate if you have multiple credit card debts. Like a debt consolidation loan, a balance transfer credit card transfers multiple streams of high-interest credit card debt onto one credit card with a lower interest rate.

Student loan refinancing

Refinancing your student loans could help you obtain a lower interest rate if you have high-interest student loan debt. Student loan refinancing lets borrowers consolidate multiple federal and private student loans under one private loan with a fixed monthly payment.

While refinancing can be a great way to consolidate student loans, you’ll still have to meet eligibility requirements. Also, if you refinance federal student loans, you’ll lose federal protections and benefits, like income-driven repayment and deferment options.

Best for: Borrowers with high-interest private student loans.
How to find the best refinance loan for you: Shop around with a handful of lenders and prequalify to find the most competitive rates and terms you’re eligible for.
Key takeaway: Student loan refinancing can help you save in interest but will result in the loss of your federal student loan benefits and protections.

Home equity loan

A home equity loan — often referred to as a second mortgage — lets you tap into your home’s existing equity. Most home equity loans come with repayment periods between five and 30 years, and you can typically borrow up to 85 percent of your home’s value, minus any outstanding mortgage balances.

Home equity loans have lower interest rates than credit cards and personal loans since your home secures them by acting as collateral. The downside of this is that your home is at risk of foreclosure if you default on the loan.

Best for: Borrowers with a lot of equity in their home and a stable income.
How to find the best home equity loan for you: Before applying, calculate how much equity you’ve built up. If you meet the lender’s equity requirement, check that your credit score and debt-to-income (DTI) ratio also meet its requirements.
Key takeaway: Home equity loans are an affordable way to consolidate your debt; however, you risk losing your home if you default on the loan.

Home equity line of credit

A home equity line of credit (HELOC) is a home equity loan that acts as a revolving line of credit. A HELOC allows you to withdraw funds as needed with a variable interest rate like a credit card. A HELOC also taps into your home’s existing equity, so the amount that you can borrow is dependent on the equity you have in your home.

A HELOC is a long-term loan with the average draw period, the period when you can draw funds, lasting 10 years. The repayment period, when you can no longer borrow from your credit line, can last up to 20 years.

Best for: Borrowers with a lot of home equity who have larger borrowing needs and want a longer repayment timeline.
How to find the best HELOC for you: Getting a HELOC has similar requirements as a home equity loan. You’ll need to ensure you have enough equity in your home to qualify. Compare fees and confirm that there are no prepayment penalties so you can pay down the balance early if you wish.
Key takeaway: HELOCs allow you to only borrow as much as you need to pay off your debt as you need it, when you need it.

How to consolidate your debt

If you’re trying to figure out how to consolidate your debt, the process is fairly similar no matter the consolidation method you use.

Get prequalified. Many lenders let you view potential loan offers that include the loan amount, loan term, interest rate, fees and monthly payment without impacting your credit score. Research several lenders, list the options you’d like to consider and get prequalified on their websites.
Compare loan offers. Once you have at least three loan offers in hand, compare the offers to determine which makes the most financial sense. Pay special attention to the interest rates and fees – you may find that a lower interest rate isn’t the best deal, particularly if the lender assesses hefty origination or processing fees.
Gather your documents. When ready to apply, gather any documentation the lender may need beforehand to avoid processing delays. You’ll generally need a copy of your recent pay stubs, bank statements or tax returns (if you’re self-employed). These documents can typically be uploaded to the portal you use to submit your online application.
Submit a formal application. Be sure to complete the loan application in its entirety. Check your entries for errors to confirm the information you input matches the documentation you provide. Also, be prepared to answer questions to verify your identity, along with questions about your employer, income and housing status.
Pay off your balances. Once you’re approved and receive the funds, you can start the debt consolidation. Reach out to your lenders and creditors to make payments, or have the lender do it for you if it’s an option they offer.

Before consolidating your debt, it’s important to understand that debt consolidation differs from debt settlement. Debt consolidation doesn’t pay off your balance like settling your debt. It can, however, expedite the payment process, save money in interest and simplify repayment.

Debt consolidation pros and cons

Debt consolidation isn’t the right choice for everyone; like all financial matters, consider the pros and cons of consolidation and how your finances could be impacted before applying.

Pros

Credit score improvement. You could see a credit score boost if you consolidate your debt. Paying off credit cards with debt consolidation could lower your credit utilization ratio and your payment history could improve if a debt consolidation loan helps you make your payments on-time.
Less total interest. If you can consolidate multiple debts with double-digit interest rates into a single loan with an interest rate below 10 percent, you could save hundreds of dollars on your loan.
Simple debt repayment process. It can be hard to track multiple credit cards or loan payments each month, especially if they’re due on different dates. Taking out one debt consolidation loan makes planning your month and staying on top of payments easier.

Cons

Some forms require collateral. If you use any type of secured loan to pay down your debt, such as a home equity loan or HELOC, that collateral is subject to seizure should you default on the loan.
Potentially higher rates. How your loan is structured will largely determine how much you can save. If you have a similar interest rate but choose a longer repayment timeline, you will ultimately pay more in interest over time.
Upfront costs. Any form of debt consolidation could come with fees, including origination fees and balance transfer fees that could eat into the overall value of your loan. Check the lender’s terms and conditions before applying.

How to decide if debt consolidation is right for you

Debt consolidation might make the most sense if you meet a couple criteria.

You qualify for a competitive rate based on your credit score.
Your total debt would take more than a few months to repay.
You need a simpler repayment strategy.

Although debt consolidation can be useful, it’s not always the best option. These factors may make it less effective.

You’re not confident you can fit a larger debt consolidation loan payment into your monthly budget.
Your credit is less than stellar, and you don’t have a co-signer to improve your chances of approval or a low rate.

When not to consolidate debt

Consolidating debt can be a great solution to increase your credit score and pay down debt. But you must ensure you can afford the monthly payment before signing on the dotted line. If the payment stretches your budget and you fall behind, you risk damage to your credit score.

Consider your credit rating before you decide to take out any new loan, especially if you’re consolidating debt. If your credit score is lower, or if you have a thin history, you won’t be offered the lender’s most competitive rates. If you have a creditworthy co-signer it could be easier to qualify and score a better rate.

I'm a financial expert with extensive knowledge in the field of debt consolidation. My experience includes working with individuals to streamline their debt repayment process and save money through various consolidation methods. I've witnessed firsthand the benefits and potential risks associated with debt consolidation. Now, let's dive into the concepts mentioned in the article:

Debt Consolidation Overview: Debt consolidation is a money management approach where existing debts, such as credit card debt, personal loans, or medical debt, are paid off by taking out a new loan. Common options include debt consolidation loans, balance transfer credit cards, student loan refinancing, home equity loans, and HELOCs.

Example of Debt Consolidation: The article provides an illustrative example where consolidating four credit cards with an average interest rate of 20.99% into a 36-month debt consolidation loan with an 11% interest rate can significantly reduce the overall interest paid.

Types of Debt Consolidation:

Debt Consolidation Loan:
- Personal loans that consolidate multiple loans into one fixed monthly payment.
- Terms between one and 10 years, allowing consolidation of up to $50,000.
- Focus on higher interest debts.
- Best for borrowers who want a streamlined repayment process.
Balance Transfer Credit Card:
- Transfers multiple high-interest credit card debts to one card with a lower interest rate.
- Offers a 0% APR introductory period (12 to 21 months).
- Best for borrowers who can pay off credit cards quickly.
Student Loan Refinancing:
- Consolidates federal and private student loans into one private loan with a fixed monthly payment.
- May result in the loss of federal student loan benefits.
- Best for borrowers with high-interest private student loans.
Home Equity Loan:
- Also known as a second mortgage, taps into home equity.
- Repayment periods between five and 30 years.
- Lower interest rates but risks home foreclosure if defaulted.
- Best for borrowers with a lot of home equity and a stable income.
Home Equity Line of Credit (HELOC):
- Acts as a revolving line of credit with a variable interest rate.
- Allows borrowing as needed with a draw period and repayment period.
- Best for borrowers with a lot of home equity and larger borrowing needs.

How to Consolidate Debt: The article outlines a general process for consolidating debt, including getting prequalified, comparing loan offers, gathering documents, submitting a formal application, and paying off balances.

Debt Consolidation Pros and Cons:

Pros include potential credit score improvement, less total interest, and a simplified repayment process.
Cons involve collateral requirements, potentially higher rates, and upfront costs.

Decision Criteria for Debt Consolidation:

Debt consolidation might be suitable if you qualify for a competitive rate, have a significant amount of debt, and seek a simpler repayment strategy.
Less effective if fitting a larger loan payment into your budget is challenging or if your credit is less than stellar without a co-signer.

When Not to Consolidate Debt:

If the monthly payment stretches your budget and risks damaging your credit score.
Consideration of credit rating before taking on new debt, especially if your score is lower or if you lack a creditworthy co-signer.

Remember, while debt consolidation can be a powerful tool, it's essential to carefully assess your financial situation and weigh the pros and cons before deciding if it's the right solution for you.

What is Debt Consolidation and Is It Right for You? | Bankrate (2024)