How Does Debt Consolidation Work?

What is debt consolidation, and how does debt consolidation work? 

Debt consolidation means replacing multiple more debts with a single loan. Essentially, you take out a new loan—sometimes called a debt consolidation loan—and use it to pay off multiple debts. That could include credit cards, medical debt, auto loans, student loans, or a mixture. After you've consolidated, you'll only have one monthly repayment to keep track of.

Debt consolidation can simplify payments and make things more manageable. In some cases, debt consolidation loans could also lower the interest rate and reduce your monthly payments. 

We’ll walk you through some possible debt consolidation solutions and explore how debt consolidation works.

How Does a Debt Consolidation Loan Work?

Debt consolidation works by using one loan to pay off multiple other debts. It's a form of refinancing that can work well if you want to simplify your payments and possibly reduce the cost of your debt. 

Debt consolidation loans could:

• Lower your monthly payment

• Simplify your debt payments

• Reduce the interest rate on your balances 

• Help you to pay off your debt faster

How do you make this happen? The first step is to decide whether debt consolidation is right for you. Then you can work out which debt consolidation route makes the most sense. 

You May Like These

What Is Bill Consolidation?

Is Debt Consolidation a Good Idea?

Which Debt Should You Pay Off First?

How to Decide if Debt Consolidation Is Right for You

You can choose from many different ways to handle debt. Debt consolidation works best if you can qualify for a debt consolidation loan, have a plan to pay off debt, and are confident you can keep on top of payments. 

If you're considering debt consolidation, think about your goals. For example, lowering your monthly payments might be more important to you than accelerating your debt payoff plan. Or vice versa. 

Debt consolidation could be the right choice for you if you have:

• High-interest debt. Debt consolidation could be an opportunity to save on interest with a new, lower-interest debt consolidation loan. 

• Large monthly payments. If you’re starting to struggle to make the payments, debt consolidation could help by stretching them over a longer period. 

• Trouble keeping track of multiple bills. Debt consolidation has the benefit of simplifying bill paying by reducing the number of monthly payments you have to make.  

• Decent credit. If your credit is in good shape, that improves your chances of qualifying for a debt consolidation loan.

Sources of Debt Consolidation

We’ll take you through the different types of debt consolidation loans and their pros and cons.  Here are some common debt consolidation possibilities:

Cash-out refinance mortgage

If you own property, cash-out refinancing works by replacing your existing mortgage with a new, larger loan. You get the difference back in cash that could go toward debt repayment. It can make sense if you qualify for better terms on the new loan. 

• Pros: A cash-out refinance can give you a large sum of money to use for debt repayments or other financial goals. The other big advantage is that you'll generally get a lower interest rate than with most other kinds of financing. 

• Cons: Cash-out refinancing has relatively high upfront costs. You'll have to pay closing costs just as you did when you took out the original mortgage—as much as between 2% and 6% of your total loan amount. 

Also, you're restarting the clock on your mortgage payments. This could mean you pay more in interest over the long term. Finally, you're backing the loan with collateral: your home. If you don't keep up with the repayments, you could lose it.

Home equity loan

A home equity loan or home equity line of credit (HELOC) lets you borrow additional money against your home, leaving your current mortgage in place. Some people call home equity loans second mortgages. Terms on home equity loans usually range from five years to 30 years. 

• Pros: Rates on home equity loans are often slightly higher than for a cash-out refinance, but they’ll still beat many other forms of credit. Unlike credit cards, where the interest rate is variable, home equity loans are usually fixed-rate. 

• Cons: As with a cash-out refinance, the lender can foreclose and take your house if you don’t repay your loan as agreed. Watch out for fees. Closing costs on home equity loans are generally lower than mortgage refinances, but you'll likely still have to pay some closing costs. 

Personal loan

You could use a personal loan to consolidate debt. Personal loans are typically unsecured, which means they aren’t guaranteed by something of value that you could lose if you default on the loan.

• Pros: Personal loan interest rates are typically higher than mortgage rates but lower than credit card rates. If you have a lot of credit card debt, a personal loan could consolidate that debt into a single, lower-interest, fixed-rate loan.

• Cons: One issue that might catch you off guard is that your monthly payment may increase even if a personal loan has a lower interest rate than your credit cards. This is because personal loan terms commonly run between two and ten years, while credit card minimum payments can keep you in debt for decades.

Balance transfer credit card

A balance transfer credit card offers a low introductory interest rate for a limited time—often 0%. The introductory period could be 12, 15, or 18 months. If you qualify, balance transfers can be a good way to consolidate credit card debt.

• Pros: You can use the interest-free period to pay down your credit card balance without racking up interest charges. This could help you to become debt-free faster. Your new card may also have extra benefits.

• Cons: You'll usually need to pay a balance transfer fee that’s between 2% and 5% of the balance. Also, if you won't be able to pay off your debt before the introductory period ends, you’ll pay the card’s regular interest rate on the remaining balance until it’s paid off. The new card may have an annual fee. 

401(k) loan

401k plans are employer-sponsored retirement plans. Depending on your employer's rules, you may be able to access some of that money in the form of a 401(k) loan to consolidate your debts.

• Pros: As a rule, 401(k) loans have very low interest rates. Not only that, but you pay that interest into your retirement fund—so it goes back to you rather than to a lender. Finally, there's no credit check. If you're having trouble borrowing elsewhere, this could be a game-changer.

• Cons: Taking a 401(k) loan can seriously slow down your retirement savings. The money you borrow won't be gaining value, which could leave you with a shortfall when you want to stop working. 

If you don't repay the money within five years, it will count as a withdrawal and you'll have to pay a 10% penalty on the unpaid balance. If you leave your company before repaying the loan, it becomes immediately payable.

Debt management plan (DMP)

A debt management plan isn’t a loan. Instead, it’s a program in which a credit counseling service takes over the payment of your debts. 

• Pros: You make a single monthly payment to the DMP, and the service distributes that money among your creditors. Your counselor may be able to get some concessions from your creditors, like a lower interest rate, waiver of penalties and late fees, or a smaller payment. 

• Cons: There's a fee for this service, and DMPs don’t have a high success rate. The usual reason for failure is that the payment is too high for the consumer to pay month after month over a long term. If your monthly plan payment isn’t manageable, a DMP might not be the right option. 

How Does Debt Consolidation Work to Lower Monthly Debt Payments?

Debt consolidation could help lower your monthly debt payments: It can reduce your interest rate, stretch your repayment out over a longer time, or both.

However, taking more years to repay your debts can cost you in the long run, even if your new loan has a lower interest rate. It’s wise to pay your debt consolidation loan back as quickly as possible to minimize your interest expense.

Here’s what different terms and total interest look like on a $10,000 loan with a 13% interest rate. 

The lower monthly payment can be tempting, but you’ll pay a hefty price if you choose the 7-year term. 

How Does Debt Consolidation Work to Simplify Your Debt Payments?

A big benefit of debt consolidation is that it combines multiple bills into a single payment. That means you don't have to keep on top of multiple accounts with different payments and due dates. 

If you’re able to reduce your interest rate at the same time, you could reduce the total cost of your debt and pay down your balance faster. 

How Can Debt Consolidation Work to Lower Interest Rates?

Debt consolidation involves using money from a new loan to pay off other debts. It can also offer an opportunity to lower your interest rate.

Credit card accounts are unsecured and among the riskier types of financing, so they carry relatively high interest rates. If you’re only paying the minimum on these accounts, the interest on your balance can start to snowball. That’s where replacing high-interest debt with cheaper financing comes in.

Here’s how interest rates on common types of debt usually rank from highest to lowest:

• Credit card debt

• Personal loans

• Home equity loans

• Primary mortgages

If you can exchange one of the higher-interest types of debt for one lower on the list, it could save you money.

How Does Debt Consolidation Work to Pay Off Debt Faster?

When you make debt payments, only part of that payment goes toward reducing the initial amount you borrowed. The rest goes toward interest. 

When you consolidate debts with a lower-interest loan, more of your payment goes toward reducing the principal balance. That means you could pay off your debt faster and pay less interest over the long run.

Cutting interest costs means you'll be able to put more cash toward the principal. Another way to speed up repayment is to choose a loan with a shorter term when you consolidate your debt. Higher monthly payments also mean you’ll pay less interest over the loan term.

Alternatives to Debt Consolidation

Debt consolidation won't suit everybody. If you're already behind on your bills and your credit score isn't where you want it to be, debt consolidation may not be your best bet. 

Alternatives to debt consolidation include:

• Debt management plan (DMP): This is similar to debt consolidation in that you roll your debts into one. The big difference is that you don't borrow more money to do it. Instead, you'll work with a credit counselor to make a repayment plan. If your creditors agree to it, you'll make one monthly payment that gets distributed to lenders.

• Debt settlement: This route involves negotiating with creditors to settle your debts for less than you owe. You can do this on your own or with a debt settlement company. It can hit your credit score hard, but if your debt has become overwhelming, it may offer a recovery path.

• Bankruptcy: This is a legal process that can offer a clean slate to people whose debt has become unmanageable. It can be costly and time-consuming. Not everyone qualifies for the kind of bankruptcy that lets you walk away from debt.

There's no right or wrong solution—everybody's situation is different. The best solution for you will depend on things like the amount and type of debt you carry, your credit score, and your ability to manage repayments. The important thing is to understand the consequences of each option and act sooner rather than later. Find out how Freedom Debt Relief works if you're considering debt settlement.

Take Action Toward Your Debt Consolidation Goals

If you're able to qualify for better terms on the money you owe, it could save you money and reduce stress. Even better? There are steps you can take right now to tackle your debt.

Work out what you owe and how much you're paying in interest. Think about whether you need debt consolidation or debt relief. Then you can shop for balance transfer credit cards, compare loan rates, or look for other ways to make that debt more manageable.