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What Is debt consolidation?

Debt consolidation involves combining multiple unsecured debts into one bill, which can be helpful if you’re overwhelmed by an assortment of monthly payments. You can consolidate a variety of debts, including credit cards, payday and personal loans, utility bills and medical expenses, so instead of having to send a separate payment to each creditor or collector every month, you’d make just one. This can help eliminate missed or late payments and ensure that you’re addressing all your debts.

Debt consolidation can be a great option, not only because it streamlines monthly payments, but also because, in many situations, you may get a reduced interest rate and lower total monthly payment.

Maggie Germano, a certified financial education instructor and financial coach in Washington, D.C., said debt consolidation comes up “pretty frequently” with her clients. “Most of my clients have credit card debt,” she said. “It can be really overwhelming when you have five credit cards to pay and you don’t even know where to start. I’ll sometimes float the idea of debt consolidation so they only have one bill to pay or so they can have a lower interest rate.”

There are numerous debt consolidation methods to consider, some of which work better in different situations.

A word to the wise, though: Debt consolidation isn’t for everyone struggling with debt. Determining which method will benefit you the most will involve some homework and some calculations … or a visit to a debt counselor.

How does this work?

Debt consolidation can take many forms, including a personal loan, a balance-transfer credit card, a home equity line of credit (HELOC) and a debt management plan, among others. (We’ll get into the details of those options later on.)

No matter what strategy suits you best, the idea is the same: Lump together all or most of your debts into a single payment as a way to save money, simplify your finances … or both.

For example, if you have multiple high-interest credit card debts and outstanding medical bills, you may want to take out a personal loan to repay those debts. Then you can focus on repaying that personal loan, which requires just one monthly payment and, ideally, has a lower interest rate than what you were paying across multiple debts (it may not have a lower rate, but it’s in your best interest to find the lowest one you can).

The specifics of how debt consolidation works will vary by the type of debt you have and the method you choose.

What types of debt can I consolidate?

Any type of personal debt can be consolidated. This includes but is not limited to:

  • Credit cards (retail or bank cards)
  • Student loans
  • Unsecured personal loans, including payday loans
  • Medical bills
  • Utility bills, including cellphone bills
  • Money owed to collection agencies
  • Taxes
  • Court judgments

“Depending on the type of consolidation, there are debt consolidation firms that will negotiate any sort of debt that’s out there,” said Rod Griffin, director of consumer education for the credit bureau Experian. “There may be restrictions by the lender, but generally, most debts can be consolidated or settled.”

How to consolidate debt in 4 easy steps

No matter what type of debt consolidation loan option you’re looking into, it is important to understand how to consolidate debt. The following four steps will walk you through calculating how much debt you have, choosing the debt consolidation loan, setting a timeline to be debt free and teaching you how to control your spending.

1
UNDERSTAND
YOUR DEBT

Determine how much debt you have

2
CHOOSE A DEBT
CONSOLIDATION LOAN

See which type of debt consolidation loan is right for you

3
PAY OFF
YOUR DEBT

Set a timeline to pay off your debt

4
STAY OUT
OF DEBT

Create a budget and learn to control your spending

Debt Consolidation Methods

Personal Loan

You can take out a personal loan to pay off existing debts and then work to pay off that loan over time. This makes the most sense when the personal loan has a lower interest rate than you’ve got across your existing debts.

Pros

  • Personal loans can be easy and quick to obtain, compared with options like HELOCs or a cash-out refinance.
  • Loan fees are low compared with other options.
  • The fixed loan term and interest rate make payments predictable and force you to stick to a schedule.
  • Terms are short (commonly one to five years), so you get your debt paid off expediently.

Cons

  • If you have bad credit, it might be difficult to find a personal loan with a lower interest rate than what you’re managing with existing debts.
  • The fixed monthly payment and loan term offer no flexibility.
  • Because terms are shorter, monthly payments are higher.
  • Because personal loans are unsecured, they have higher interest rates.

Balance Transfer

For individuals with debt on several credit cards, it can make sense to transfer the balances over to the card with the lowest interest rate, creating one payment and lowering interest overall. Some people even open a new card with a 0 percent APR for a promotional introductory period (many of these run the gamut from six to 24 months) and transfer other balances over to that card. This can be a viable solution if you think paying the card off within that promo time frame is doable.

“If you’re not absolutely positive that you can pay off your debt in that time frame or if you think you might struggle with building up your debt on credit cards once again, I think getting a new credit card is probably not a good idea,” said Germano.

Pros

  • You can save money on interest.
  • The single bill replaces several monthly payments.
  • The end of the promotional period can be a motivating deadline for getting out of debt.

Cons

  • Balance transfer cards have limits, so if your debt exceeds the credit limit you’ve received, you won’t be able to pay off all your credit card debt with a balance transfer.
  • Balance transfers often carry a fee, as well, so do the math to make sure it’s worth it.
  • If you don’t pay off the balance before the end of the promotional period, the remaining balance will be subject to the ongoing APR, which may be very high.
  • You will need excellent credit to qualify for the best balance transfer offers, which may be problematic if you’ve been struggling to keep up with debt up to this point..

Cash-Out Refinance

Cash-out refinancing involves replacing your mortgage loan with a new one for more than you owe, taking part of the difference between your old and new loans in cash. Some people use this cash to pay off other debts.

Pros

  • This option can make sense if you are able to get a new mortgage interest rate that’s lower than your current one and lower than the rates you’re paying on your other debts.
  • Interest is low because this loan is secured by your home, and may be tax-deductible.
  • Monthly payments are very low because the loan term can be stretched up to 30-plus years

Cons

  • If you default on this loan, you risk foreclosure.
  • Losing equity in your home might alter your long-term financial plans, especially if retirement is on the horizon.
  • Cash-out refinancing involves a lengthy process and comparatively higher upfront costs.
  • Stretching out the loan term can mean you pay more interest in the long run, even if the rate is lower.
  • A cash-out refinance is a new first mortgage, so closing costs can be more expensive than those for a HELOC or home equity loan.
  • If you refinance more than 80 percent of the loan’s value, you may have to pay mortgage insurance

Home Equity Loan

A home equity loan gives the borrower access to home equity in cash, which can be used to pay off other debts. A home equity loan does not replace the existing mortgage as a cash-out refinance does, but it is another loan in addition to the existing mortgage.

Pros

  • The loan is secured by collateral (your home) so interest rates are lower.
  • Interest payments may be tax-deductible.
  • The fixed interest rate and repayment term make monthly payments predictable and help you stay on schedule for paying off your debt.
  • You can get a longer term with a home equity loan than you can generally get with a personal loan.

Cons

  • Because this loan is secured by your home, if you default, you could lose your home.
  • Losing equity in your home can negatively impact long-term financial plans.
  • Because terms are relatively longer with a home equity loan, you may pay more interest overall, even if the rate is lower than what you are currently paying.

Home equity line of credit (HELOC)

HELOCs differ from home equity loans in that, instead of receiving a lump sum of cash, borrowers have an agreed-upon amount that they can take from their equity, and access as needed over time. This money can be used to pay off existing debts.

 

Pros

  • Interest rates are low, because this debt is secured by your home, and interest payments may again be tax-deductible.
  • You only pay back (and pay interest on) the portion of the line of credit you use.
  • A line of credit can come in handy in case of future emergencies or necessary home repairs.

Cons

  • Having access to a line of credit that is greater than the sum of one’s debts might tempt some individuals to overspend.
  • Variable interest rates can make payments unpredictable.
  • Defaulting on a debt secured by your home can result in foreclosure.
  • Any balance you have at the end of a HELOC’s repayment period comes due immediately and can result in a balloon payment.
  • You will have to pay closing costs, though they are likely lower than those associated with a cash-out refinance

Student loan consolidation

There are two categories: a federal Direct Consolidation Loan and private consolidation or refinancing options. You can consolidate most federal student loans with a Direct Consolidation Loan, which you can read more about here. There are also a variety of private lenders that will allow you to consolidate either private or federal student loans.

Pros

  • You get a chance to change the repayment schedule for your loans, either by extending or shortening your loan term.
  • Potentially lower your interest rate.
  • Potentially lower your monthly payment.
  • Deal with one lender and one loan payment instead of several.

Cons

  • The best refinancing terms require very good credit. You may not qualify for consolidation at all if your credit is lacking.
  • If you consolidate a federal loan through a private lender, you will lose access to the benefits that come with federal student loans, like student loan forgiveness and income-based repayment plans.

How much can I save by consolidating?

Debt Consolidation Calculator

By consolidating debt with a personal loan, you can save considerably — sometimes up to 40 percent of the total debt. Enter your current debts into our loan calculator to start creating a plan to eliminate your debt.

Why isn’t consolidation for everyone?

While debt consolidation certainly has merits, it is not the right choice for every individual. Above all, the approach has to match the need and the comfort level of the borrower. Some people prefer a DIY debt management plan, while others benefit from simplified singular payment of a debt consolidation loan.

“Debt consolidation really depends on the person and the type of debt,” Germano said. “A debt consolidation loan can help you manage your payments easier and less stressfully. That makes sense for a lot of people.”

She added: “But some people would rather tackle a debt management plan themselves. If you know that wouldn’t be overwhelming to you, that makes a lot of sense. If you know that you’re not great at keeping up with your payments without someone reminding you to, looking into credit counseling or debt management options is a good idea.”

According to Germano, a good rule of thumb is this: Consolidation is not a good option if your debt is more than 50 percent of your income. It is also not a fit if you do not have a consistent source of income that more than covers your monthly payment. Finally, bad credit can keep you from getting a good interest rate, which negates the purpose of a consolidation loan.

Germano also explained that embarking on debt consolidation can be futile without attempting to make changes to your financial habits.

“I usually recommend financial coaching to work on the habits and the emotions and the history behind money issues,” she said. “If you don’t make any changes in that realm, then you’re probably going to grow your debt again.”

Debt Consolidation vs. Debt Management vs. Debt Settlement

Sometimes, the terms debt consolidation, management and settlement can be confused. While they all describe methods of eliminating debt, they each feature a different approach.

Debt consolidation

Debt consolidation usually involves obtaining a personal loan that pays off all of your unsecured debts. Then, instead of making multiple payments at high interest rates, you have only one payment to make at lower interest. Because all your outstanding debts are paid in full, this type of debt consolidation can be beneficial to your credit score.

“Debt consolidation in this sense can be viewed as very positive,” said Griffin, of Experian. “You have all the accounts being reported as paid in full and you have a new account that is active and showing a good payment history.”

Debt management

Debt management is the creation and execution of a detailed timeline and plan to pay off debts. It takes interest rates and amounts owed into account, and outlines the best way to get debt paid with the lowest amount of interest. You can do this on your own or with the help of a credit counselor.

Credit counselors help consumers organize their debt and personal finances, creating a tailored payoff plan. Credit counselors can also negotiate lower monthly payments that are more feasible for individuals, helping to minimize growing interest.

“If you work with a quality nonprofit credit counseling service, they may help you discover new sources of income or make changes to budgeting or spending habits,” Griffin said. “Accounts will be reported as being repaid through a debt management plan. In some cases, that can be viewed as beneficial by lenders.”

Debt settlement

Debt settlement is negotiating with a creditor to settle a substantial debt for less than the amount owed. Often, consumers opt to engage a debt settlement company to do this on their behalf. Individuals can also call creditors personally and attempt to negotiate debts.

“You can always call your creditors and ask them for assistance,” Griffin said. They may be able to offer multiple programs like lower interest rates, lower principal amounts, settlement terms or a combination of things.”

Creditors tend to negotiate only after you have to let your accounts go into default for several months, which can have a negative impact on your financial history. Settled debts will also be noted in your credit report.

“That status is going to hurt your credit history long-term,” Griffin said. “If an account is marked as ‘settled,’ it will remain on your credit report for seven years from the original delinquency date or the status update date.” He added that debt settlement is almost as bad for your credit score as bankruptcy, so it’s not an action to take lightly.

How do you decide which approach is best for you?

“Always start by talking to your lenders first,” Griffin said. “They may be able to work with you to resolve any issues and repay that debt over time.” After that, research nonprofit credit counselors (you can search for one on NFCC.org) and debt management plans find a strategy you’re comfortable with.

Debt Consolidation FAQ

What is bill consolidation?

Bill consolidation is just another term for debt consolidation. They are the same thing – combining multiple payments into one by paying off existing debt with a new loan. Ideally, that new loan has a low enough interest rate to save you money.

How do I know if I need debt consolidation?

Debt consolidation is best for someone with a manageable amount of debt from multiple creditors. Remember that rule of thumb from above: Debt consolidation works best when your debt does not exceed 50 percent of your income and you consistently bring in enough money to cover a regular payment. Individuals with good credit can get lower-interest loans and credit cards, so for them, debt consolidation can really mean a significant savings.

How does debt consolidation affect my credit score?

As long as you stay on plan and don’t run up new debts, debt consolidation should have a positive effect on your credit score in the long run. You may, however, see a drop in your credit score when you apply for a consolidation loan or close the accounts you pay off with the new loan. You can read more about debt consolidation and your credit score here.

Can I consolidate debt if I’ve been sued?

Yes, court judgments are one of the types of unsecured debt that can be paid off via a debt consolidation loan.

What is the difference between a secured loan and an unsecured loan?

A secured loan has collateral to back it in case of default. For example, a mortgage is a secured loan because if you stop paying the mortgage, your lender can repossess your home and sell it to recoup lost costs. Typically, secured loans have a lower interest rate because they are less risky for lenders. An unsecured loan, like most personal loans, means there’s no collateral for a lender to take if you don’t make your payments, so such loans tend to require higher credit qualifications and/or higher interest rates.

How do I determine if a lender is legit and has my best interests in mind?

The biggest sign of a fraudulent lender is demanding huge fees upfront, according to the Federal Trade Commission. Before engaging with any creditor, it can be prudent to check their record with the Better Business Bureau. You can also do an internet search to easily find any existing consumer complaints.

Can I get a debt consolidation loan if I have bad credit?

Yes, you can qualify for a debt consolidation loan with less-than-stellar credit, but it can be difficult. If you qualify, you may have to pay a higher interest rate and may have to put up collateral, such as home equity. This can be chancy, because if you default on the consolidated loan, you risk losing your collateral.

Is it smart to pay off debt by taking out more debt?

Taking out a debt consolidation loan can save you money on interest and allows you to become debt-free faster and with less hassle. If you are not committed to paying off your debts and exercising financial responsibility, then taking out more debt is probably not a good choice.

What is the difference between debt settlement and bankruptcy?

Debt settlement involves working with a settlement company to pay off your debts for a lower negotiated sum. Chapter 7 bankruptcy liquidates all of your assets to pay your creditors and clear your debts. Chapter 13 bankruptcy allows you to create a financial plan to address all debts within five years. While debt settlement and bankruptcy both have negative affects on your credit score and financial history, the consequences of bankruptcy can be more severe and longer-lasting.