If you’re deep in debt and trying to lighten your load, you may have considered debt consolidation. Debt consolidation replaces several smaller debts with a single larger one. That can simplify your life by reducing the number of monthly payments you make. It may also give you a lower interest rate. Debt consolidation can be a smart choice if you have balances on several high interest credit cards or loans.
Debt consolidation can help you get out of debt, but it is not the right move for everyone. Let’s look at some debt consolidation basics that will help you decide whether it’s right for you.
What is Debt Consolidation?
Any process that combines several debts into one can be considered debt consolidation. There are several common ways to do this, which we’ll discuss below.
There are two main advantages to consolidating your debts.
- Consolidating your debt can make your financial life simpler. You may be making several payments on several debts, often on different schedules. If you’re not organized, you could easily miss a payment, which can hammer your credit and leave you paying extra fees. Consolidation makes it easier for you to organize your payment schedule by combining several debts into one payment.
- Consolidating your debts can save you money. If the combined debt carries a lower interest rate than the debts it replaces, you’ll pay less interest than you were paying before. You may also be able to pay off your loan faster because less interest will accumulate.
Debt consolidation is not a magic trick. You’ll still have the same amount of debt that you had before. Debt consolidation is designed to save you money via lower interest rates and help you organize your debts, and simplify your payment schedule. It will not make debts go away.
How to Consolidate Debts
There are four main ways to consolidate debt. Each has advantages and disadvantages. You’ll have to decide which method is best for you…
Debt Consolidation Loans
A debt consolidation loan is a personal loan used to consolidate debt. You’ll take out a loan, use it to pay off your debts, and then pay the new loan. These loans may be unsecured or secured by personal property such as a car, a boat, or another financial account. They usually have terms of three to five years.
Interest rates on debt consolidation loans rates vary based on the lender, your credit score, and the collateral you are using. A secured loan will usually have a lower interest rate than an unsecured loan, but you’ll risk losing the collateral if you can’t pay the loan.
You’ll have to compare the cost of your new loan to the cost of paying off your existing balances. Work out the total costs and make sure you’re saving enough to make the deal worth it. If your credit is good or your loan is secured, you can probably get an interest rate well below the rates you are paying on credit card balances. Be sure to consider any fees that come with the loan: many loans have origination fees or other fees.
- Potentially lower interest rate.
- Potentially faster payoff.
- Simplified payments
- Payments may be larger than minimum credit card payments.
- You may need good credit to get a low interest rate.
Debt consolidation loans are usually used to consolidate credit card balances. That’s because interest rates on credit card balances are very high, and it’s usually possible to get a loan at a significantly lower rate. If you wish to consolidate installment loans, it may be hard to get a better rate unless your credit has improved dramatically since you got the loans you want to consolidate.
⚠️ You may get offers for consolidation loans in the mail, especially if you have several credit card balances. If you’re considering one of these offers, read the fine print carefully. There may be hidden fees or other unfavorable terms.
A debt consolidation loan can be a good option if your credit is good enough to qualify you for a low interest rate. If your credit is poor and you don’t have collateral that you’re willing to risk, you may not be able to get an interest rate low enough to be worth the effort.
Let’s say you have two loans with different balances, interest rates, loan terms and monthly payments – Loan A and Loan B.
- Remaining balance: $9,800
- APR: 12.5%
- Loan term remaining: 3 years
- Monthly payment: $328
- Remaining balance: $5,600
- APR: 9.41%
- Loan term remaining: 4 years
- Monthly payment: $140
For these two loans combined, your monthly payment is $468, you will be paying $3,144 in interest alone ($2,002 for loan A and $1,142 for loan B), and it will take you 48 months to pay off both balances.
Instead of paying these loans individually, you could consolidate them into one loan.
- Loan amount: $15,400 ($9800 + $5,600)
- APR: 7%
- Loan term: 3 years
- Monthly payment: $476
If you consolidate loan A and loan B into loan C your monthly payment would be $8 more than before. The amount of interest paid on the new loan would be $2,301.
In this scenario, you have saved $843 in interest, and you paid your debts off 12 months sooner.
➗ Use our online Debt Consolidation Calculator to compare the cost of a consolidation loan to the cost of paying off your existing balances.
Balance Transfer Credit Cards
Another option is to transfer your debts to a credit card with a lower interest rate. Many credit card issuers offer balance transfer cards specifically designed for the consolidation of other credit card balances. These cards usually come with a zero-interest or low-interest promotional period.
To consolidate debt with a balance transfer card, you apply for the card, and if you’re approved, you transfer your other balances onto it. If you pay those balances off before the promotional period expires, all the money you pay will go toward the principal. That can save you a substantial amount on interest.
⚠️ If you don’t pay off the balances before the promotional period ends, you’ll be right back to high interest payments.
- Potential for low or zero percent interest rate.
- Lower interest rates can help you pay balances off faster.
- You’ll need to watch the fees.
- Your interest rate will skyrocket if you don’t pay off the balance before the promotional period ends.
- You’ll need good credit to get the best deals.
- You’ll need to use a card from an issuer that you’re not already using.
You’ll need to have good credit in order to qualify for the best balance transfer credit cards and get approved for the best terms. Some balance transfer credit cards come with annual fees and balance transfer fees. You’ll have to do the math and determine whether you’re coming out ahead. Most credit card issuers will not allow you to transfer balances from their own cards, so you’ll have to use a different company than you’re using now.
If you do transfer your debt to a credit card with a balance transfer promotion, do your very best to pay the balance off before the promotion period ends. If you don’t pay the card off in time, you could end up paying high interest rates on the remaining balances.
Let’s say you have two credit cards that you are looking to consolidate – credit card A and credit card B.
Credit Card A
- Balance: $5,500
- APR: 20%
- Monthly payment: $280
With no additional monthly payments, it will take you 24 months to pay off this credit card, and you will pay $1,218 in interest.
Credit Card B
- Balance: $3,200
- APR: 23%
- Monthly payment: $300
With no additional monthly payments, it will take you 12 months to pay off this credit card, and you will pay $412 in interest.
Your current monthly payments combined total $580, and the total amount you will be paying, in the end, is $10,330.
Now let’s say you apply for and get approved for a balance transfer credit card with a 0% APR for 12 months (20% APR after that) and no credit card fees. Let’s also assume that you will keep making payments of $580 each month.
Credit Card C:
- Balance: $8,700 ($5,500 + $3,200)
- Intro APR: 0% for 12 months
- Regular APR: 20%
- Monthly payment: $580
By the end of the promotional 0% APR period, you would have paid $6,960 of your $8,700 balance. That leaves you with an outstanding balance of $1,740. If you keep making regular payments of $580 after that, you will have paid off your balance in less than 4 months while paying only $70 in interest.
In this scenario, you have saved $1,560 in interest and have paid off your credit cards 8 months sooner.
HELOC Or Home Equity Loan
HELOC stands for Home Equity Line of Credit. Obtaining a HELOC or home equity term loan is another option for consolidating your debt. These loan products use your home as collateral for the loan. You’ll need to have equity in your home in order to qualify for them.
Home equity loans and lines of credit typically have very low interest rates, which is an attractive feature for people who want to use them to consolidate debt. The downside is that if you default on a home equity loan or line of credit, you could lose your home. For that reason, it’s important to borrow wisely when using these types of loans for debt consolidation or anything else.
Be sure to make all of your payments on time, and consider working to pay the loan off early if you can.
- Very low interest rate.
- One easy monthly payment.
- You can only use these methods if you have a home and have enough equity in it.
- If you default, you could lose your home.
Cash Out Refinance
A cash out refinance refinances the entirety of your mortgage balance then adds additional money. You’ll take those additional funds as cash at the loan closing and use them to pay off your debt.
The benefit of this type of move is that you’ll only have one payment; your mortgage payment. And since mortgage interest rates are attractively low, you’ll then be paying a very low interest rate on your credit card debt.
However, if you structure your refinance to a long term, such as 30 years and don’t pay the loan off early, you’re effectively stretching your credit card payoffs to 30-year terms. That could leave you paying more interest in the long run despite the lower rate.
⚠️ Mortgage refinances typically come with closing costs such as origination fees and filing fees. The fees could outweigh the benefit of the refinance. A good mortgage loan representative will be able to help you determine if the math makes sense for you to get a cash-out refinance mortgage loan.
You’ll have to meet credit score guidelines as well as equity guidelines to qualify for a cash-out refinance mortgage loan. Check with a reputable lender for details.
- One easy payment that includes your mortgage.
- Lower interest rates on your credit cards and potentially your mortgage.
- Stretching the loan to a 20-year term or longer could negate the interest savings.
- Origination and other fees could negate the financial savings.
Debt Consolidation May Not Be Right for You
If you qualify for debt consolidation, it could be your best bet for long-term debt reduction. You’ll be paying your debts in full, so your credit should not be adversely affected as long as you make your payments on time.
Debt consolidation won’t work for everyone. If you don’t have good credit, you may not qualify for a debt consolidation loan or a balance transfer card. You won’t be able to use a HELOC, home equity loan, or cash out refinance if you don’t own a home.
If debt consolidation isn’t right for you, you have other debt relief options. You could consider credit counseling, debt management plans, debt settlement, and even bankruptcy. None of these methods is right for everyone, and all of them have drawbacks, but one could be right for you.
The Key to Success
All of these methods have one thing in common: None of them will work if you run up more debt before your old debts are paid off.
Before you consolidate your debts, take a close look at the habits that created those debts in the first place. You’ll have to change those habits if you want consolidation to succeed. Set up a budget, follow it, and minimize credit card spending. Consolidating your credit card debts won’t help if you pile up new credit card balances!
If you don’t make healthy changes to your spending patterns after obtaining a debt consolidation loan, you could end up paying more on your consolidation loan and paying off more credit card balances as well. Debt consolidation can help you get your debts under control. If you want to keep your debts under control, you’ll have to take control of your finances and spend less than you earn!