Debt Consolidation

How Does Debt Consolidation Work?

how does debt consolidation work

Living with multiple sources of debt, from credit cards to student loans, car loans and more may lead to financial stress.

Over 125 million Americans carry credit card debt and with a low personal savings rate of 2.9 percent, many are just one small emergency or unexpected bill away from financial disaster.

They don’t have enough in savings to cover outstanding bills. Often this leads to defaulting on debt, which can severely damage their credit score and end up costing them more money in the future. But, there is a solution that can help prevent this from happening: debt consolidation.

What is debt consolidation?

Debt consolidation is a way of taking multiple debt balances and rolling them together into one new debt balance. This might involve taking out a new loan to repay your current creditors, or you may be able to work with a debt management agency to consolidate your debt without having to take on a new loan.

The key is that you are left with just one debt payment after consolidating, rather than several payments.

How does debt consolidation work?

Choosing the right type of loan

When taking on a new loan to consolidate debt, you’ll first have to decide what kind of loan is best suited to consolidate your debt.

You could take out a personal loan for debt consolidation; get a credit card with a great balance transfer deal; tap into your home equity for a home equity loan or line of credit, or even tap into your 401(k) for a loan. There are pros and cons to each method, and you can read more about them here as we’ll cover these methods in greater detail later in this post.

Which option you choose depends on a number of factors, but these two are most crucial: How much time you need to pay off the debt and which option will help you get the lowest rate possible.

For example, you could get a 12-month 0% intro APR on a balance transfer credit card to tackle some high-interest credit card debt. You’d transfer the balances from your other cards onto the new credit card. But if you can’t pay off that new card by the time that 12-month promo period ends, you could easily wind up right back where you started — another credit card with a super high-interest rate.

Eric Rosenberg, a former bank manager and personal finance expert at Personal Profitability, says the best kind of debt consolidation loan is one that takes unsecured debt, like credit cards, and rolls it into a secured loan, such as one that is secured by your home equity. Because secured debts have an asset tied to them — for example, a home equity loan is secured by your home — lenders typically offer better rates on those loans than an unsecured loan.

If you can get approved for a secured loan with a decent rate, “That will lower the out-of-pocket costs of your monthly payment right away,” he said.

Assuming you continue to pay the same or a similar amount toward your now consolidated debt each month, having a lower interest rate will also help you pay off your debt balance faster as more of your money will go toward principal instead of interest.

Choosing your lender

Whether you’re shopping for a home equity loan, debt consolidation loan, or balance transfer, LendingTree’s online marketplace can be a great place to compare offers from several lenders at once.

Rosenberg says the basic process to consolidate your debt with a new loan is to shop around at banks, credit unions and even online lenders to find the best rate and loan you can qualify for.

“I always encourage people to do the math themselves to figure out how much they’ll save by consolidating their debt. It only makes sense if it’s going to save you money,” he said.

LendingTree also has a handy debt consolidation calculator so you can crunch the numbers online.

After you decide which lender to go with, you will have to fill out a new loan application, which involves having your credit history pulled and analyzed, as well as other factors that affect your repayment ability, like your employment history and income information.

Rosenberg says the credit score needed to qualify for a debt consolidation loan will vary from lender to lender and even product to product depending on what type of loan you are applying for. Find out here what credit score is needed for a personal loan.

There are several options for consolidating your debt and they all work slightly differently.

Balance transfer credit cards

One option you may be considering if you have credit card debt is using a balance transfer to move your debt from one or more higher interest cards to a lower interest card. This is especially true if you are offered a 0% intro APR balance transfer offer.

Rosenberg says this can be a good option to consider to help you save money on credit card interest and to pay off your debt faster, but you need to consider the cost of the transfer first.

“Most balance transfer credit cards have a fee they charge when you consolidate your debt. Depending on how big the transfer fee is, it might eat up all of the benefits of consolidating your debt,” he said.

Although some cards offer no-fee balance transfers, you’ll typically see balance transfer fees of 3 to 5 percent.

Even with a fee, this can be a good option to consider if it will save you money. Depending on the size of your debt, it could save you hundreds or even thousands of dollars. But, the key is to pay off as much of your new credit card balance as possible before the 0% interest promotional period ends.

Also, don’t forget to read the fine print. Some 0% credit cards will charge interest on arrears if the balance isn’t paid in full by the end of the promotional period. This is called deferred interest. If that’s the case, you’ll want to have the entire balance paid off before the promo period ends or you won’t save any money on interest.

Personal loans

Personal loans are a popular option people consider when trying to consolidate their debt.

You’ll find personal loans with the best rates will require candidates with good credit (think a 680 credit score and above). There are some lenders willing to work with borrowers who have poor credit, but you’ll have to be prepared to face a higher interest rate. If the rate is higher than the average rate of the debt you’re looking to consolidate, it might not make sense to consolidate.

Home equity loans or line of credit

If you’re a homeowner with considerable equity in your home, a home equity loan or home equity line of credit may be a good option to use to consolidate other debt. The interest rate on a home equity loan or line of credit will generally be lower than most other types of debt consolidation loans. This is because the risk to the lender is lower since the loan is secured by your home.

However, before you apply for this type of loan, analyze your budget carefully. Rosenberg says you should make sure you have plenty of room in your monthly budget to make the payments. If you default, the bank could foreclose on your home, leaving you on the street.

Debt management plan

Unlike the other options listed, a debt management plan doesn’t require taking out a new loan. It isn’t quite the same thing as consolidating your debt either. But if you’re looking for a way to manage your debt, it can help.

With a debt management plan, you’ll work with your lender to create an alternative payment plan to help you get out of debt. The key is to call your lender and ask them if they have any flexible repayment options for borrowers who are struggling to repay their loans.

Rosenberg says this is an option to consider if “your bills are totally out of control”.

Some lenders could be willing to work with you to create a debt management plan so they receive at least a portion of the money they are owed.

Debt management plans are also available through credit counseling agencies like the National Foundation for Credit Counseling. You can also find debt management services from third-party companies that will help you pay back debt to multiple lenders. They will negotiate your monthly bills on your behalf and disburse your one monthly payment to the multiple lenders you owe money.

If you go this route, keep in mind that it may end up costing you more money. Some debt management companies will keep a portion of your monthly payment as a fee instead of putting all of it toward your debt.

Tips for consolidating debt

The first thing to do is to take stock of your debt. Review your balances, interest rates, monthly payments and if you are behind on any of your bills. Knowing these things will help you to better evaluate debt consolidation options to decide which one is right for you.

Next, check your credit history and credit score. You can pull your credit history for free at This won’t have your credit score, but it will help you see if you have any negative marks on your report. Federal law allows you to pull one free credit report from each of the three credit reporting companies each year: TransUnion, Equifax, and Experian.

If you want to see your actual credit score, you can get your FICO score for free from My LendingTree. Pulling your credit score with My LendingTree doesn’t damage your score.

Finally, Rosenberg emphasizes that it’s important to do the math yourself to see how much you can save by consolidating your debt and if the new loan payments will easily fit within your budget.

“Consolidating makes sense if it saves you more than it would cost to get a new loan or balance transfer,” he said.

Avoid debt consolidation scams

If you decide to move forward with consolidating your debt, make sure you keep an eye out for scams.

Most of the time, if you’re looking to consolidate your debt, you are already in a financial bind. You may be desperate to consolidate quickly so you don’t fall behind on your bills. But, it’s important to do your due diligence to avoid scams.

Rosenberg also cautions that you need to make sure you use a reputable company if you decide to pursue a debt management plan.

“The big red flag is when companies make unrealistic promises about how much money you can save or how quickly you can pay off your debt with their plan,” he said. “Even though you can get your bills under control with a debt management plan, it won’t happen overnight.”

You can check out the reputation of debt consolidation companies and banks online with the Better Business Bureau (BBB), or even a simple internet search to read consumer reviews.

Will debt consolidation work for you?

If you’re serious about getting out of debt, then debt consolidation can be a good way to save money on interest, get a handle on your monthly bills and get your debt paid off. But, if you aren’t committed to becoming debt-free, debt consolidation may end up getting you into more trouble with debt in the long-run.

After you consolidate your debt into one loan or onto a new balance transfer credit card, you have to remain committed to paying it off and avoiding taking on any new debt. Otherwise, you might actually end up with more debt after consolidating than you had before.

Debt Consolidation Loans Using LendingTree