Debt Consolidation

How Does Debt Consolidation Work? See the Math

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Debt consolidation is the process of combining several debts into one, with one monthly payment. This can help simplify your finances, lower your overall cost of debt and even help you pay down your debt faster — but it can also come with some potential pitfalls if you don’t know what to look out for.

To help you decide whether consolidation is right for you, we’ll take a deep dive into debt consolidation options and show you how to figure out which option is best for you.

How does debt consolidation work?
4 ways to consolidate debt
When you’re ready to consolidate debt

How does debt consolidation work?

Debt consolidation combines several debts into a single loan — ideally with a lower interest rate. The idea is to simplify your monthly payments, lower your overall cost of repayment and possibly adjust your repayment period to one that works better for your money. For example, you may choose a longer repayment period to lower your monthly payment in exchange for paying more in interest charges over time, or vice versa.

Debt consolidation is usually reserved for unsecured debts like credit cards, because these debts typically come with higher interest rates than secured debts like mortgages or auto loans. However, while debt consolidation provides the convenience of one monthly payment, it can be risky. If you’re struggling financially and are unable to stop using credit cards, you could wind up deeper in debt than you were before.

Common options for consolidating debt include: debt consolidation loans, balance transfer cards and secured loans like a secured personal loan or home equity loan. We’ll discuss these options in more detail later.

Keep these two fees in mind…

  • Prepayment penalties on your old debt: Some lenders include prepayment penalties in their terms to ensure you pay a certain amount of interest before paying off your loan. This prepayment penalty is usually a percentage of your remaining balance. Read through the fine print in your loan agreement to determine whether you have to pay a prepayment agreement.
  • Origination fee on your new loan: With debt consolidation loans and secured loans, you may be charged a fee to originate the loan. With a debt consolidation loan, a type of personal loan, this can be equal to 1% to 8% of your loan amount.

See the math for yourself

Debt consolidation doesn’t eliminate your debt — rather, it simply combines multiple debts into one. So how does consolidating your debt work to help you repay your debt for less?

Let’s say you have two high-interest credit cards. One has a balance of $2,000 and a 24% APR, while the other has a balance of $3,500 with a 26.5% APR. You’re currently only making the minimum payment on each card, which totals $220.

Now say you’ve qualified for a debt consolidation loan with an 11% APR and no balance transfer fee, and you want to pay off both your credit cards with this new loan. Here’s a look at how your total interest paid and payoff timeline would change with that debt consolidation loan if you continued to make that same $220 payment each month.

How debt consolidation can save you money
Old debt balance #1 Old debt balance #2 Total for old debt Debt consolidation loan
APR 24% 26.5% 25.25% 11%
Loan amount $2,000 $3,500 $5,500 $5,500
Repayment period 36 months 37 months 37 months 29 months
Total interest repaid $800 $1,648 $2,448 $776
Total amount repaid $2,800 $5,148 $7,948 $6,276
Source for table: Credit card payoff calculator from MagnifyMoney

As you can see from the table above, by consolidating the two credit cards into one lower-rate debt consolidation loan, you would pay off your debt eight months earlier, plus you’d also save $1,672 in interest. In this case, it could make sense to take advantage of debt consolidation, as long as you can commit to not using your old credit cards and charging up more debt while paying off the new loan.

All that said, the APR you receive on a debt consolidation loan depends on your credit and financial health. If you can’t qualify for a lower APR than you’re currently being charged, debt consolidation might not save you money.

4 ways to consolidate debt

Common ways to consolidate debt
What it is Who qualifies
Debt consolidation loan A personal loan you use to pay off high-interest debt Those with credit scores of 580 and above, but the best loan terms are reserved for those with strong credit
Balance transfer card A credit card with a 0% APR on balance transfers for an introductory period which you can use to transfer your existing debts to the new card for less People with “good” or “excellent” credit (FICO score of 670 or higher)
Secured personal loan A personal loan backed by an asset, such as your vehicle; if you fail to make payments, you can lose your collateral People who don’t qualify for an unsecured loan due to their credit score, but have assets that a bank will accept as collateral
Home equity loan A secured loan you use to borrow against a portion of your home’s equity People with good credit history, a debt-to-income ratio less than 43% and plenty of equity in their home

Debt consolidation loan

With a debt consolidation loan, you apply for a loan and use the proceeds to pay off credit cards and other high-interest debts. If the APR on the new loan is lower than the rates you’re currently paying on the old debt, you can pay off your debt faster while making the same monthly payment. That’s because more of each payment will go toward the principal rather than interest.

Depending on the lender, you may have to pay an origination fee on your new loan. Take this fee into account when determining whether this option is worthwhile.

Choose a debt consolidation loan if…

  • You have good credit, and can qualify for a lower APR on the debt consolidation loan than you’re currently paying on your other debts.
  • You’re able to avoid new debts while you pay off your new loan.

Balance transfer card

Many credit card issuers offer balance transfer offers with 0% APR for anywhere from six up to as many as 21 months. If you’re approved for the card, you can pay off your old balances, either by asking the card issuer to make the payments directly or using a check they’ve provided. This can save you a significant amount of interest if you can pay off the balance in full before that introductory period expires. (If you don’t, you’ll be charged all the interest that has accrued up to that point.)

Balance transfer cards usually come with a transfer fee, usually 3% of the balance being transferred. Be sure to take that fee into account when estimating your potential savings.

Choose a balance transfer card if…

  • You’re able to avoid taking on more credit card debt while you pay off your consolidated balance.
  • You’ll save money with a lower APR than you’re currently paying, even after taking into account the balance transfer fee.
  • You’re able to pay off your balance within the introductory 0% APR period.

Secured personal loan

With a secured personal loan, you put up collateral, such as your vehicle or another asset. You can use the proceeds of the loan to pay off other high-interest debts. However, if you default on your loan, the lender can take your collateral.

Despite this drawback, a key benefit of a secured personal loan is that they can be easier to qualify for and can come with a lower interest rate compared to an unsecured personal loan. That’s because your collateral offsets the risk the lender takes on in lending to you.

Choose a secured personal loan if…

  • You have assets you can use as collateral and are willing to risk losing those assets if you default on the loan.
  • You don’t qualify for a low interest rate on an unsecured loan.
  • You’re committed to changing your spending habits to ensure you don’t run up other debts while paying off the new loan.

Home equity loan

If you own a home, you may be able to consolidate high-interest debt using a home equity loan. Home equity loans can be your lowest-cost option because they’re secured by your home. To qualify, you must have enough equity in your home. Most lenders will only allow you to borrow up to 85% of your home’s value minus your mortgage balance.

For example, say the value of your home is $250,000, and your current mortgage balance is $200,000. It would be difficult to find a lender willing to give you a home equity loan on the entire $50,000 of equity on your home ($250,000 value minus $200,000 mortgage). Instead, the most you could borrow from a home equity loan would likely be $12,500 — that’s $212,500 (85% of your home’s $250,000 value) minus your existing $200,000 mortgage.

Keep in mind, you’ll be using your home as collateral. If you lose your job or face other financial troubles and can’t make your loan payments, you run the risk of losing your home. Further, home equity loans come with a lot of paperwork and, thus, are not a good option for those seeking fast loans.

Choose a home equity loan if…

  • You have at least 20% equity in your home and are comfortable with the inherent risk of using your home as collateral.
  • You will save money, even after taking into account closing fees and potentially extending the timeframe for paying off your debt.
  • You’re committed to changing your spending habits and won’t run up new debts after consolidating your old debts into a home equity loan.

When you’re ready to consolidate debt

If you’re ready to consolidate your debt, be sure you shop around to compare your options and find the lowest interest rate and fees possible. LendingTree is an online loan marketplace that can help you explore multiple loan offers at once with a soft credit check.

Make sure you run the numbers to see how much you’ll really save by consolidating your debt. Our handy debt consolidation calculator can help you figure out how long it will take you to pay off your new loan, and how much money you can save over time.


Debt Consolidation Loans Using LendingTree