What Is Debt Consolidation?

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ByChristopher Boston
Reviewed byAlvin Yam, CFP
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ByChristopher Boston
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Reviewed byAlvin Yam, CFP
Edited byCasie McCoskey
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Updated: March 7, 2024

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Debt consolidation merges multiple debts into one loan or payment plan, aiming to simplify financial management with a single monthly payment. Often, this comes with the added benefit of a lower interest rate, making it easier to track debts and potentially reducing the total amount paid over time.

While this approach can ease the burden of managing multiple payments and may lower monthly expenses, it also carries potential downsides. Extending the repayment period to achieve lower monthly payments might result in higher total interest costs. Additionally, securing favorable terms typically requires a good credit score.

If you want to maximize the benefits of consolidating your debts, familiarize yourself with your options for debt consolidation, how it works and its benefits and drawbacks.

Key Takeaways

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Debt consolidation involves rolling multiple debts into one and can incorporate credit card debt, auto loan debt, student loan debt and more.

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Consolidating debt can provide convenience and reduced interest, as you’ll only have to worry about one payment and one interest rate.

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Not all debt consolidation loans are ideal. Some may offer you lower interest rates but longer terms, resulting in you paying more interest in the long run.

How Debt Consolidation Works

Imagine juggling multiple credit card balances, a personal loan and medical bills, each with its own due date and interest rate. Keeping track of all these payments can be overwhelming, leading to missed payments and increased stress. This is where debt consolidation comes into play as a strategy to streamline financial obligations.

Debt consolidation combines these various debts into one loan or payment plan. By doing so, it replaces multiple payments with a single monthly payment, often at a lower overall interest rate. This method not only simplifies the management of finances but can also make your debt more affordable in the long run.

The process involves applying for a consolidation loan, using that loan to pay off multiple smaller debts and then focusing on repaying the new loan. To qualify for a debt consolidation loan, you typically need a good credit score, proof of income and a debt-to-income ratio demonstrating you can afford the new loan payments.

However, not everyone can meet these requirements. Debt management plans (DMPs) offer an alternative for those who don't. DMPs don't factor in your credit score or require you to get a loan. They're arranged through credit counseling agencies, which negotiate with creditors on your behalf to lower your interest rates and consolidate your monthly payments into one manageable amount.

DEBT-TO-INCOME AND WHY IT MATTERS

The debt-to-income (DTI) ratio measures a borrower's monthly debt obligations as a percentage of their gross monthly income. It is calculated by dividing total monthly debt payments by gross income.

Lenders typically want to see a DTI of 43% or less for debt consolidation approval. This shows that the borrower's income is sufficient to take on the additional monthly payment of a consolidated loan while leaving room for other living expenses. Although standards vary, a DTI over 50% is generally less favorable for lenders. A lower DTI demonstrates the reasonable ability to manage debt responsibilities from income.

Types of Debt Consolidation

There are various ways to consolidate debt, either through loans or management plans. Knowing your options allows you to choose the method that best suits your financial situation, potentially saving you money on interest and helping you become debt-free faster.

Debt Consolidation Loan

A debt consolidation loan is a type of personal loan that merges multiple debts into one, offering a single monthly payment, often at a lower interest rate, which simplifies managing finances and can reduce interest costs over time. Streamlining payments into one can offer relief and potential savings, but usually, securing favorable terms requires a good credit score of 670 or higher.

While a debt consolidation loan eases payment processes, it could lead to a longer repayment period, inadvertently increasing the total interest paid. To apply for a debt consolidation loan, you need to undergo a credit check, provide proof of income and demonstrate a debt-to-income ratio that supports the ability to manage the consolidated loan.

Personal Loan

A personal loan serves as a versatile financial tool, allowing you to borrow a lump sum of money for various purposes, including consolidating high-interest debts. Most personal loans come with a fixed interest rate and consistent monthly repayment plan, which can simplify budgeting.

Compared to a specific debt consolidation loan, a personal loan provides broader flexibility for managing financial obligations, presenting an appealing option for those aiming to streamline their payments and tackle multiple financial goals simultaneously. However, the potential for higher interest rates and the necessity for a strong credit profile are considerations that weigh against its benefits.

Home Equity Loan

A home equity loan allows homeowners to borrow against the equity they've built up in their property, offering a lump sum that you can use for consolidating higher-interest debts into one loan with a lower interest rate. This type of loan typically comes with fixed repayment terms, making monthly payments predictable and potentially more affordable than the original debts.

However, using a home as collateral introduces the risk of foreclosure if you don't make payments, a significant consideration for borrowers. While it can provide immediate financial relief and streamline debt payments, it also requires sufficient home equity, and the process involves fees and potential tax implications.

Home Equity Line of Credit

A home equity line of credit (HELOC) is a flexible loan that gives homeowners access to funds up to a certain limit based on the equity in their home, which can be drawn upon as needed. This option is appealing for consolidating debt because it typically offers lower interest rates than credit cards and personal loans, and its revolving credit nature allows for flexibility in borrowing and repayment.

However, the variable interest rates of a HELOC mean monthly payments can fluctuate, potentially making budgeting more challenging. Additionally, similar to a home equity loan, a HELOC puts your home at risk of foreclosure if you are unable to repay your loan, making it important for homeowners to manage their borrowing carefully.

Balance Transfer Credit Card

A balance transfer credit card allows individuals to consolidate multiple credit card debts onto a single card, often offering a low or 0% introductory interest rate for a set period. This is particularly beneficial for reducing interest costs and simplifying monthly payments, making financial management more straightforward.

That said, the introductory rate is temporary, usually between 12 and 18 months. Once it expires, the interest rate can increase significantly, affecting the cost of carrying a balance. Balance transfer cards also typically charge a fee of 3% to 5% for each transfer, which can offset initial savings if not managed carefully.

Debt Management Plan

A debt management plan (DMP) is a structured program offered by credit counseling agencies to help individuals pay off their debt through consolidated monthly payments. Under a DMP, the agency negotiates with creditors to reduce interest rates or waive fees, making it easier for you to reduce your balances over time. This approach provides a disciplined path toward debt freedom with the convenience of a single payment for multiple debts.

It's worth noting, however, that entering a DMP sometimes requires closing credit accounts, which can impact credit scores and limit access to new credit. The commitment to a fixed payment schedule also demands financial discipline, as failure to adhere to the plan's terms can derail progress toward debt elimination.

Student Loan

Those with multiple student loans can consolidate their debt through student loan consolidation programs. These programs simplify repayment by offering one monthly payment instead of several, making managing loans easier.

For federal student loans, the federal government offers Direct Consolidation Loans that allow you to combine multiple federal loans into one. This can also grant you access to income-driven repayment plans and turn variable-rate loans into fixed-rate ones. Keep in mind, though, that any outstanding interest from your previous loans will become part of your principal.

401(k) Loan

A 401(k) loan allows you to borrow against your retirement savings to consolidate debt, offering the advantage of paying interest back into your own account rather than to a third party. This type of loan can provide immediate access to funds without a credit check, making it a quick solution for debt consolidation.

However, this option risks reducing your retirement savings, as money withdrawn does not benefit from market growth. Should the loan not be repaid on schedule, it’s treated as an early withdrawal, subjecting you to taxes and a 10% penalty if you’re under the age of 59½.

EXPERT TIP

Remember that debt consolidation can make debt repayment more manageable by lowering costs through a lower overall interest rate. However, it doesn't change the spending habits that led to debt accumulation in the first place. — Alvin Yam, CFP®

Pros and Cons of Debt Consolidation

Understanding the pros and cons of debt consolidation helps you make more informed financial decisions. Overall, debt consolidation offers streamlined payment processes and potential interest savings but may extend repayment periods and impact credit scores. Consider these factors and more below.

Benefits of Debt Consolidation

  • Simplified Payment Process: Debt consolidation combines multiple debts into a single monthly payment, reducing the complexity of managing several accounts and due dates. Payments also typically remain static between billing cycles, making them more predictable than credit cards with revolving balances and interest charges. This simplification helps avoid missed payments and late fees, making financial management more straightforward.

  • Lower Interest Rates: Debt consolidation loans often offer lower interest rates than high-rate credit cards or loans. Lower rates can significantly reduce the amount of money paid over the life of the debt, saving money in the long term.

  • Reduced Payments: By securing a lower interest rate and potentially extending the loan term, debt consolidation can lead to lower monthly payments. This reduction makes it easier to manage monthly expenses and improves cash flow.

  • Improved Credit Score Over Time: Consolidating debt and making regular, on-time payments can improve credit scores. Initially, there might be a dip due to the credit check involved in applying for a new loan, but consistent payments contribute positively to credit history.

  • Faster Payoff: When debt consolidation results in a lower interest rate without significantly extending the loan term, it can lead to a speedier payoff of the overall debt. This enables individuals to become debt-free sooner than they would by tackling each debt separately.

Drawbacks of Debt Consolidation

  • Potential for Higher Interest Costs: Extending the term of a debt consolidation loan to achieve lower monthly payments can lead to paying more interest over the loan's life. This can counteract the benefits of a lower interest rate, ultimately making the consolidated debt more costly.

  • Upfront Fees and Charges: Debt consolidation loans might be accompanied by origination fees, application fees and more. These extra expenses can diminish the overall financial benefit of consolidation, potentially making it less practical.

  • Risk of Falling Into More Debt: Clearing up credit lines through consolidation can tempt you to incur new debt before fully repaying the consolidated loan. This risk can exacerbate financial difficulties, leading to a cycle of debt that's hard to escape.

  • Requires Good Credit for Best Rates: Lenders generally reserve favorable interest rates on debt consolidation loans for those with solid credit scores. Individuals with lower credit scores may face higher interest rates, which can lessen the appeal and effectiveness of consolidation.

  • Risk of Hurting Credit: Applying for a debt consolidation loan involves a hard inquiry into your credit report, which can temporarily lower your credit score. Additionally, the initial closing of accounts can further impact your score, although responsible management of the new loan can help it recover over time.

Carefully weighing the above factors ensures you choose strategies aligning with your financial goals and circumstances, clarifying your path to becoming debt-free.

How to Consolidate Your Debt

Understanding the steps to debt consolidation benefits anyone looking to manage and reduce their debt load effectively. This process can simplify your finances, lower your interest rates and help you pay off debt faster. Here are the fundamental steps to take:

1
Add Up Your Debt

Compile a list of all your debts, including credit card balances, loans, medical bills and any other obligations. Knowing the total amount you owe is the first step toward creating a plan to pay it off. This total will give you a clear picture of your financial situation and help you determine how much you need to borrow.

2
Find Your Ideal APR

Research the average annual percentage rates (APR) available based on your credit score. Understanding the interest rates you qualify for allows you to estimate how much you could save by consolidating. A lower APR means lower monthly payments and less money paid over the life of the loan.

3
Determine an Affordable Monthly Payment

Review your monthly budget and factor in essential expenses such as housing, utilities and groceries to identify how much you can consistently allocate toward debt repayment. This confirms the consolidation plan fits within your financial means without compromising your ability to cover necessary living costs. Remember, establishing a realistic and sustainable monthly payment helps prevent financial stress and supports long-term success in debt reduction.

4
Explore Debt Consolidation Options

Look into the various methods of debt consolidation, such as personal loans, home equity loans and credit card balance transfers. Understanding the advantages and disadvantages of each option allows you to choose the best method for your situation. Each has unique benefits and requirements, so selecting the one that aligns with your financial goals is important.

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Explore Lenders and Apply

After selecting the most suitable debt consolidation method for your needs, begin researching lenders that specialize in that particular option. Compare their terms, interest rates and customer service to ensure you find a lender that offers competitive rates and favorable conditions for your financial situation. Find out its eligibility criteria and prepare your required documentation, then proceed with the application process. Be sure to follow the lender's guidelines to maximize your chances of approval.

EXPERT TIP

APR (annual percentage rate) reflects the total cost of borrowing over the loan's lifetime, which factors in both interest and applicable fees. It provides a clearer picture of the actual cost than just looking at the interest rate alone. For example, two loans may have different stated interest rates but cost roughly the same when considering the fees stemming from a higher APR on one of them. This is why comparing only the interest rates can give a false sense of which loan is cheaper. — Alvin Yam, CFP®

Who Should Consolidate Debt

Debt consolidation isn't a one-size-fits-all solution. It can streamline payments and reduce interest costs for some, but it may not address underlying financial habits or be cost-effective for those with smaller debts or low credit scores. Be sure to assess your financial situation to determine if it's the right step for you.

When Debt Consolidation Makes Sense

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    You Have High-Interest Credit Card Debts

    If you're facing high-interest rates on multiple credit cards, consolidating into a lower-interest-rate loan can significantly reduce the amount of interest you pay. This makes managing your debt more straightforward and can accelerate the debt repayment process.

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    You Have Multiple Monthly Payments

    When juggling several payments becomes complicated and stressful, consolidating into a single monthly payment can simplify your financial management. This streamlined approach reduces the chance of missed payments and late fees.

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    You Have Good Credit

    With a good credit score, you're likely to qualify for debt consolidation loans with favorable interest rates. This advantage means you can consolidate your debts under much better terms, reducing your overall payment burden.

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    You Have a Stable Income

    Consolidating your debt can make financial planning more predictable if you have a stable income and can afford consistent monthly payments. A fixed repayment plan helps with budgeting and ensures steady progress toward debt freedom.

When Debt Consolidation May Not Be Ideal

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    You Have a Small Amount of Debt

    If your total debt is small and you can pay it off within a year, consolidation may not be worth the effort or potential fees. The process and costs involved might outweigh the benefits of debt consolidation.

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    You Have a Low Credit Score

    With a lower credit score, you're unlikely to secure a consolidation loan with terms better than your current debts. High-interest rates on a consolidation loan could cost you more in the long run.

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    You Have an Unstable Income

    If your income is irregular or unstable, committing to a consolidation loan with fixed monthly payments could put you at risk of default. The requirement for consistent payments might not align with fluctuating financial circumstances.

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    You Have Reckless Spending Habits

    If unchecked spending habits are the cause of your debt, consolidating without addressing the underlying issue might lead to accumulating more debt. Without a change in financial behavior, consolidation could provide a false sense of financial relief, potentially worsening your debt situation over time.

EXPERT TIP

Consider the total cost of borrowing, including interest and fees, when evaluating the potential savings from a debt consolidation loan. Consolidating short-term, high-interest debts close to maturity may not save as much in interest compared to other options.

For example, if you expect one credit card with a small balance to be paid in full within three months, rolling it into a longer-term consolidated loan of 48 months would prolong repayment and add unnecessary interest costs. — Alvin Yam, CFP®

Debt Consolidation and Credit Score Impact

Consolidating your debt can indeed impact your credit. Understanding how debt consolidation can affect your credit before pursuing this option is wise, as it can influence your financial health and future borrowing capabilities. Here are the ways debt consolidation can affect your credit:

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    Initial Credit Check

    Applying for a debt consolidation loan involves a hard inquiry into your credit report, which can temporarily lower your credit score. This is a standard part of the application process for any new credit and reflects the lender's assessment of your creditworthiness. Although the impact is usually minor and short-lived, it's relevant to consider.

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    Credit Utilization Ratio

    Consolidating credit card debt into a loan can lower your credit utilization ratio, a key factor in credit scoring. Moving your debt from revolving credit (credit cards) to an installment loan means you're using less of your available credit, which can positively affect your credit score. However, if you subsequently rack up balances on those now-cleared credit cards, your utilization ratio could skyrocket, potentially harming your credit score more than before consolidation.

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    Payment History

    Consistent, on-time payments toward your consolidated debt can improve your payment history, positively influencing your credit score over time. On the flip side, if you struggle to meet the new payment terms and miss payments, this can quickly damage your credit score, reflecting negatively on your payment history and demonstrating to future lenders that you may be a high-risk borrower.

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    Closing Old Accounts

    If consolidating your debt leads to closing old credit accounts, it could negatively impact your credit score by shortening your credit history. The length of your credit history accounts for a significant portion of your credit score, and closing long-standing accounts can reduce that average length. Keeping old accounts open without a balance is sometimes advisable to maintain a longer credit history.

FAQ About Debt Consolidation

It's common to have concerns about debt consolidation, especially for those consolidating their debts for the first time. MoneyGeek compiled a list of frequently asked questions to provide valuable insight and help you make financially sound decisions.

Does debt consolidation hurt your credit score?
What are some alternatives to debt consolidation?
What are the risks involved in debt consolidation?
How can I consolidate debt with a low credit score?
Can debt settlement consolidate your debt?
How do I know if I need debt consolidation?
Can debt consolidation save me money?

About Christopher Boston


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Christopher (Croix) Boston was the Head of Loans content at MoneyGeek, with over five years of experience researching higher education, mortgage and personal loans.

Boston has a bachelor's degree from the Seattle Pacific University. They pride themselves in using their skills and experience to create quality content that helps people save and spend efficiently.


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