How Does Debt Consolidation Work? See the Math
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?
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.
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.
|Old debt balance #1||Old debt balance #2||Total for old debt||Debt consolidation loan|
|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
|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.
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.
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.
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.
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.