Managing multiple monthly debt accounts with different due dates and payment amounts can be a headache, not to mention a strain on your budget. Debt consolidation, where you combine multiple debts into one payment, can make this process easier.
While debt consolidation can improve your financial situation, it is not the right move for everyone. Here’s how this debt management strategy works, as well as the pros and cons of using it.
How to consolidate debt
Debt consolidation involves getting a new loan or line of credit with a lower interest rate that is large enough to cover the debts you want to consolidate. This allows you to pay off multiple existing loans with one new loan, leaving you with one interest rate and monthly payment.
You can consolidate most types of debt, including credit card debt, auto loans, personal loans and medical debt. The most common debt consolidation methods are personal loans, balance transfer credit cards, and home equity loans or lines of credit (HELOCs).
Which option is best for you will depend on your finances. Most people looking to consolidate debt look for loans with lower interest rates than they are currently paying so they can save money and pay off their debts faster.
Homeowners can often secure lower interest rates by using their home as collateral through a home equity loan, or HELOC. If you don’t own a home or haven’t accumulated much capital, a personal loan may be right for you. These fixed-rate loans are convenient because you pay the same amount every month, which is useful for budgeting.
A balance transfer credit card that has a low “teaser” annual percentage rate (APR) on balances and for purchases for a specific period of time—say, one or two years—can be a useful tool for debt consolidation, with a couple of caveats. You’ll need to get a credit limit high enough to cover the debts you want to consolidate, making this option best for people with smaller amounts of debt. Another thing to keep in mind is that you’ll need to pay off the transferred balance before the end of the promotional period and avoid the temptation to write off new debt on that card in the future. Ultimately, the best debt consolidation option for you will be the one that allows you to save the most on interest while still fitting comfortably into your budget.
Regardless of the method, debt consolidation usually requires a good or excellent credit history that shows the lender that you have a record of making on-time payments. While borrowers with good or bad credit may be approved for some types of debt consolidation loans, the terms may not be good enough to justify moving your money.
Once you’ve explored your debt consolidation options, find a lender and apply for a new loan or line of credit. Use the new loan proceeds to pay off any balances you want to consolidate. (When using a card for a balance transfer, please note that credit card companies typically handle the balance transfer. Also note that there may be a deadline by which the balance transfer must be completed in order to qualify for the promotion.)
You then make one payment each month to pay off the consolidation loan. It’s important to make on-time payments and know the terms of your loan, especially terms and deadlines, such as the end of a credit card’s promotional period. Debt consolidation only works if you can actually repay the new loan on time.
Advice: Want a more in-depth explanation of how and when to consolidate debt? Read our debt consolidation guide.
Pros of Debt Consolidation
Depending on your financial goals, debt consolidation can have significant benefits. If you want to pay off debt as quickly as possible, this can help you save money. If you need to reduce the amount you spend on bills each month, this could free up some money in your budget. Here’s a look at the most common benefits associated with debt consolidation.
Simplify your monthly payments
Remembering to pay all your bills on time can be challenging when you have multiple debt payments to make each month. Consolidating all or most of your debts into one payment can help you stay organized and avoid late or missed payments.
Save on interest and pay off debt faster
The best debt consolidation loans can help you get out of debt faster, freeing up more money to pay off your debt. With a lower interest rate each month, more of your money will go toward paying off your loan principal, allowing you to save money and pay off your debts faster.
Reduce your monthly debt costs
If you need to free up money to improve your monthly cash flow, debt consolidation can also help with that. You want to replace the high-interest debt with a lower-interest loan, and then take the monthly savings from the reduced interest and use it to pay other bills. You may even be able to get approved for a consolidation loan with a relatively low interest rate and longer repayment term, further reducing your monthly debt costs. However, there’s a trade-off here: While your monthly payment may be lower, you’re not technically “saving” money because a longer loan term means you’ll pay more interest over the life of the loan.
Improve your credit score over time
When you first take out a debt consolidation loan, your credit score will likely drop slightly as you apply for new credit. But this drop should be short-lived. As you make timely payments on your new loan and reduce your overall debt, your credit score should improve.
Cons of Debt Consolidation
Like most financial moves, debt consolidation has potential downsides. It’s important to understand them before implementing a strategy to ensure you’re making the best decision for your finances.
Interest rates may not be favorable
Many of the benefits of debt consolidation depend on receiving a lower interest rate than rates on existing debts. But this may not be possible, especially if you have good or bad credit. For this reason, debt consolidation is a strategy most suitable for borrowers with strong credit scores. Borrowers with lower credit scores may receive a loan offer with a higher APR than high-interest credit cards, but still higher than other debt, such as a car loan, that you may have. This can still be useful if you need to simplify your billing or spread out your payments over a longer period of time. But in this case, you’ll have to carefully weigh the other potential downsides of consolidation to decide whether it’s worth it.
Initial costs are likely
Most lenders charge an upfront fee for products you can use for debt consolidation. Home equity loans or lines of credit have origination and closing fees that range from 1% to 5% of the total loan amount. Personal loans also have origination fees that can be as high as 10% of the loan balance included in their APR. Credit cards typically charge a fee of 3% to 5% of the amount transferred for balance transfers.
This could allow you to get deeper into debt.
Debt consolidation only works if you can repay the new loan on time. If you’re still accumulating debt—especially high-interest debt like credit cards—taking out a new loan or line of credit is a risk. You may find yourself in even more debt and a worse financial situation than before debt consolidation. If your debt consolidation loan is backed by your home equity, you could even risk losing your home.
Is debt consolidation a good idea?
Consolidation may seem like a simple way to take control of your debt payments. For some borrowers, this is certainly possible, especially if you are approved for a loan with a lower interest rate than your current debts and you have the discipline to pay it off and avoid accumulating additional debt.
However, it is important to keep in mind that debt consolidation will not magically eliminate your debt. You will still have to pay off the principal even though you get a deferment on interest payments. It’s a good idea to take a look at your finances and make sure you understand why you accumulated debt in the first place. If you regularly spend more than you earn, taking out another loan won’t help.
Finally, if you’re struggling to make even the minimum payments on your debts or have already missed several payments, debt consolidation probably won’t help you deal with your situation. If this is the case, it may be time to consider alternative options to get out of debt, such as a debt management plan where you work with a credit counseling agency. With these plans, you typically pay a small monthly fee to a credit counseling agency, which will design a repayment plan that often involves combining multiple debt payments into one and receiving a lower interest rate. Another option is debt relief, which often involves working with a debt settlement company that can help you renegotiate the agreements you have with creditors, ideally reducing the principal amount owed and eliminating penalties.
More money:
Debt Snowball or Debt Avalanche: Which Payoff Strategy is Right for You?
6 ways to pay off debt faster
A Four-Step Guide to Resolving Credit Card Debt