What Is Debt Consolidation & How Does It Work?

Credit: forbes.com

Generally speaking, the process of debt consolidation involves taking out a new, lower interest loan and using it to pay off existing debts. If you improved your credit score since you obtained your current loans—or even if you just struggle to remember individual payment dates—debt consolidation can be a great way to streamline loans while reducing your monthly payments.

We’ll walk you through the debt consolidation process and help you determine whether a debt consolidation loan or balance transfer credit card is a good fit for your financial needs.

What Is Debt Consolidation?

Debt consolidation is when a borrower takes out a new loan and then uses the loan proceeds to pay off their other individual debts. This can include everything from credit card balances, auto loans, student debt and other personal loans.

Debt Consolidation vs. Debt Settlement

The terms debt consolidation and debt settlement are often used interchangeably—but there are some important differences. Most significantly, debt settlement involves hiring and paying a third-party company to negotiate a lump-sum payment that each of your creditors will accept in lieu of paying the total outstanding balance. These settlement companies typically charge a fee between 15% and 20% of the total debt amount and are often a scam.

In contrast, debt consolidation requires the borrower to pay their full debt balances using funds from a new loan. Unless there are origination fees or other administrative fees, borrowers don’t have to pay anyone to complete the consolidation process. Instead, the debt consolidation process requires borrowers to take inventory of their debts and develop a plan to pay them off in a more streamlined—often less expensive—way.

How Debt Consolidation Works

When consolidating debt, a borrower applies for a personal loan, balance transfer credit card or another consolidation tool through their bank or another lender. In the case of a debt consolidation loan, the lender may pay off the borrower’s other debts directly—or the borrower will take the cash and pay off his or her outstanding balances. Likewise, many balance transfer credit cards have a preferred process for consolidating a cardholder’s existing cards.

Once the borrower’s pre-existing debts are paid off with the new loan funds, the borrower will make a single payment on the new loan each month. While debt consolidation often lowers the amount a borrower owes each month, it accomplishes this by extending the loan period of the consolidated loans. Consolidating debts also streamlines payments and makes it easier to manage finances—especially for borrowers who struggle to manage their money.

Say, for example, you have four outstanding credit cards with the following balances:

  • Credit card A: $3,400
  • Credit card B: $2,600
  • Credit card C: $6,000
  • Credit card D: $4,000

Under this example, you have a total of $16,000 in outstanding credit card debt, across four cards and with annual percentage rates (APRs) ranging from 16% to 25%. If your credit score has improved since applying for your existing cards, you may qualify for a balance transfer card with an introductory APR of 0% that will let you pay off these cards interest-free for a set period of time. Alternatively, you might opt to take out a debt consolidation loan with an 8% APR—not 0%, but lower than your current rates.

Types of Debt Consolidation

Because debt consolidation can be a way to manage multiple types of debt, there are several types of debt consolidation. Here are the different types of debt consolidation to meet individual borrower needs:

Debt Consolidation Loan

Debt consolidation loans are a type of personal loan that can be used to lower a borrower’s interest rate, streamline payments and otherwise improve loan terms. These personal loans are typically available through traditional banks and credit unions, but there are a number of online lenders that also specialize in debt consolidation loans.

When shopping for a consolidation loan, take time to compare available loan terms, fees and interest rates. Many lenders offer an online prequalification process that lets borrowers see what interest rate they may qualify for based on a soft credit check, which should be your first step when getting a debt consolidation loan.

Credit Card Balance Transfer

A credit card balance transfer occurs when a borrower takes out a new credit card—preferably with a low introductory interest rate—and transfers all of his existing balances to the new card. As with other types of debt consolidation, this results in a single payment to remember, can lower the borrower’s monthly credit card payment and may reduce the overall cost of the debt by lowering the interest rate—possibly to 0%, depending on the card you qualify for.

When deciding whether to transfer your credit card balances to a new card, consider available interest rates, applicable transfer fees, transfer deadlines and consequences of missing a payment.

Student Loan Consolidation

Student loan consolidation is the process of combining multiple federal student loans into a single, government-backed loan. In addition to lowering and simplifying their monthly payments, graduates may be able to take advantage of borrower protections like Public Service Loan Forgiveness (PSLF). This term is often discussed in conjunction with student loan refinancing, which involves combining several federal and/or private student loans into a single private loan.

Home Equity Loan

Consolidating debt with a home equity loan involves taking out a loan that is secured by the borrower’s equity in their home. The money is issued in a lump sum and the borrower can use the cash to pay off—or consolidate—existing debts. Once funds are dispersed, the borrower must pay interest on the entire loan amount, but—because the loan is collateralized by their home—is likely to qualify for a much lower interest rate than available with a debt consolidation loan.

Cash-out Mortgage Refinance

A cash-out refinance occurs when a borrower refinances his mortgage for more than the outstanding balance of the loan. This enables the borrower to withdraw the difference in cash and use it to pay off other outstanding debts. The borrower can then roll their other debt payments into a single payment with his mortgage. And, because the loans are rolled into a secured mortgage, the interest rate is likely much lower than on the original debts.

Is Debt Consolidation a Good Idea?

Your credit score and whether you’re taking other steps to improve your financial habits typically determine if debt consolidation is a good idea. Debt consolidation may be a good idea if:

  • You’re committed to paying off the full amount of your debt under a consolidated loan.
  • Your cash flow is sufficient to cover all of your debt payments.
  • You’re comfortable paying off your loans over a longer period of time—or you’re prepared to make early payments.
  • Your credit score has improved since you took out your original loans, so you’re likely to qualify for a more competitive interest rate.
  • You have a plan in place to avoid running up your debts again.

Alternatively, debt consolidation may not be the best option if:

  • You’re not ready to take additional steps to pay off your debts.
  • You don’t have a plan for avoiding new debts.
  • You won’t be able to cover the new monthly payment on your debt consolidation loan.
  • Your outstanding debt could be paid off in under a year, so you wouldn’t save a significant amount through consolidation.
  • You’re willing to, instead, eliminate your individual debts with a debt snowball or debt avalanche approach.

Pros and Cons of Debt Consolidation

Just as debt consolidation isn’t the best option for every borrower, it’s important to consider the advantages and disadvantages of debt consolidation before committing. These are the pros and cons of debt consolidation:

Pros of Debt Consolidation

  • Makes it easier to manage debt by combining loans into a single, streamlined payment
  • Could lower a borrower’s overall interest rate by consolidating into a secured loan, zero-interest credit card balance or low-interest personal loan
  • May lower a borrower’s overall monthly payment on debt by extending the loan term—though this can result in higher interest costs over time
  • Fixed loan payments can help borrowers pay their debt off sooner—especially if consolidating a large amount of credit card debt