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What is debt consolidation?
Debt consolidation is a payment method where you merge multiple debts together into a single debt—ideally one with a lower interest rate. Consolidating your debt can lower your monthly payments, and also makes it easier to keep track of your payments because it means you only have one bill to pay.
Debt consolidation can be a great way to simplify your finances and improve your credit score. However, whether it’s the right move for you depends on your circumstances.
How does debt consolidation work?
When you pursue debt consolidation, you use a loan or credit card to pay off all of your other debts. You then only have one bill to pay each month.
If you’re able to get a loan or credit card with a lower interest rate than the debts you’re consolidating, you can pay less overall each month, saving money in both the short and long term.
Consolidated debt isn’t erased or forgiven, and you’re still obligated to pay back everything you owe. However, debt consolidation often makes the process easier. 1
How to consolidate your debts
Your bank or lender can walk you through how to consolidate your debt, so start by contacting them. Lenders want you to pay them on time, and if consolidating your debt makes you more likely to do that, they have an incentive to help you.
You’ll generally need to have a good credit score to qualify for a loan or line of credit with a lower interest rate than your current debts. If your lender can’t find a loan option for you or you don’t qualify for the options they offer, you can contact another lender.
It might also be worth contacting a nonprofit debt counseling agency; they may be able to point you in the right direction. Look for one that offers free consultations.
Types of debt consolidation
There are several different types of loans and credit that you can use to consolidate your debt. Regardless of which method you choose, aim for an interest rate that’s lower than the rate on your original debt.
Debt consolidation loan
A debt consolidation loan is a special type of installment loan designed specifically to let you pay off your debts. They can be either secured loans or unsecured loans. A secured loan is guaranteed by collateral (typically a high-value asset like your car).
Some lenders specialize in debt consolidation and offer related services when you take out their loans. For instance, many will be willing to directly pay your creditors on your behalf, saving you a step, and some offer complimentary financial education courses.
If you can’t find a lender that offers debt consolidation loans, taking out a home equity loan might be a good idea. A home equity loan is a secured loan that uses the equity in your home as collateral. You can also take out a general-purpose personal loan—just check that it has a lower interest rate than your other debts.
Credit card balance transfer
Similar to a consolidation loan, a credit card balance transfer allows you to transfer debt from multiple credit cards to a single card with a lower interest rate. You can use a low-interest credit card that you already have open (if its credit limit is high enough to handle all of your debts) or take out a special balance-transfer credit card.
Sometimes, you can get balance-transfer credit cards with an introductory 0% APR, meaning that your debt won’t generate interest for a while (several months to several years). These cards are useful if you’re close to being able to pay off your credit card debts and the accumulating interest is the main thing standing in your way.
If you perform a balance transfer, bear in mind that most credit scoring models take into account the amount of credit you’re using (known as your credit utilization rate or debt-to-credit ratio) when calculating your score. They look at the balance on each individual card in addition to the total amount you’re using across all of your cards, so you could see a drop in your credit score if you consolidate your debts onto a single card. 2
Student loan consolidation and refinancing
If you want to consolidate debt from student loans, then you can consolidate your federal student loans into something called a Direct Consolidation Loan. 3
Note that this won’t necessarily save you money because your new loan will have the same interest rate as your average interest rate across all of your federal student loans. However, it will simplify your life by allowing you to only make one payment.
If you have private student loans (or a mix of private and federal), then you can also get a new loan from a private lender. This is referred to as refinancing rather than debt consolidation.
Debt management plan
Enrolling in a debt management plan (DMP) is an indirect way of consolidating your unsecured debt (usually credit card debt). DMPs are often designed to help you clear your credit card debt. When you enroll, you stop paying your bills directly to your creditors. Instead, you make a single, affordable monthly payment to a credit counseling agency, and your credit counselor will disburse the money to your creditors.
The main benefit of a debt management plan is that as long as you hold up your end of the agreement, you know that your debts will all be repaid within a certain period. Also, in many cases, your credit counselors will be able to negotiate better terms on your debts, such as a lower interest rate, which will last as long as you stick to the agreed-upon payment plan.
The main drawback is that you may have to agree not to use your available credit or apply for new credit, and if you drop out of the program then you may face penalties. 4 What’s more, the duration of these programs varies and depending on how much you owe, it could take 4 years or longer to fully pay off your debts. 5
401(k) loans are not loans in a traditional sense because you’re not borrowing from a lender—instead, you’re dipping into your own retirement savings.
Because they have no credit score requirements, short-term 401(k) loans can be a good option to pay off debt that you’re really struggling with, but it’s important to remember that you’re essentially borrowing from yourself. This carries a certain amount of risk and has the potential to reduce the amount of money you’ll have available in retirement (even after you pay the loan back). Weigh your options carefully before committing to a 401(k) loan.
Pros and cons of debt consolidation
Debt consolidation has several pros and cons that you should consider before pursuing it.
Advantages of debt consolidation
Debt consolidation offers the following benefits:
- Easier payment management with only one bill to keep track of
- A (potentially) lower interest rate, which translates to lower monthly payments, saving money, and making it possible to pay off your debt earlier
- A fixed payment amount, which makes it easier to plan and organize your finances
- The chance to rebuild your credit by reducing the risk of making late payments and giving you a chance to build a positive payment history
Disadvantages of debt consolidation
Like other approaches to debt relief, debt consolidation also has its disadvantages:
- Your options for consolidation loans might be limited if you have a bad credit score
- You might face extra costs (for instance, performing a credit card balance transfer often has associated fees)
- Your credit score might drop in the short term (e.g., from hard inquiries if you’re applying for new credit)
Should I consolidate my debt?
Ultimately, whether debt consolidation is the best move for you depends on your financial situation. If your income is sufficient to repay your debts and you’re just looking for a way to simplify or reduce your monthly payments, then debt consolidation might be the answer.
When to consolidate your debt
You should consider consolidating your debt if the following conditions apply to you:
- You have difficulty managing the payment schedules for multiple debts at once
- You have a reliable income that will cover your monthly debt payments
- Your monthly debt payments take up less than 50% of your income
- You have a good credit score (670 or higher) that will qualify you for a low-interest credit card or loan
Is debt consolidation worth it?
Debt consolidation can be worthwhile if you’re in the right financial position. If most of the conditions above apply to you, then you probably are.
However, if your debt is relatively small, then consolidating your debts might be more work than it’s worth—in which case you’d be better off leaving them separate.
At the other end of the spectrum, if you’re deep in debt and paying it all off sounds unrealistic, you might need to look into more drastic solutions, such as debt settlement or credit card debt forgiveness. Talk to a nonprofit credit counselor; they’ll be able to help you weigh your options and pick the one that’s best for you.