Debt Consolidation: What It Is and How It Works

Debt consolidation means combining your debts into one so that you have one single payment — with potentially a lower interest rate. Why would you want to consolidate debt? In the long run, you could save money on interest and have a more organized way to manage your money.

• Who it's best for: If you have steady income and need to tackle high-interest debt.

• Not ideal if: You are still accumulating debt or you don't qualify for a lower rate.

• What to keep in mind: You should only consolidate your debt if you can get a lower APR than your current average rate. Avoid getting one if it extends your payoff timeline.

Before taking out a consolidation loan to pay off debt, read on to learn more about debt consolidation and a suggested offer from Accredited Debt Relief.

Key Takeaways

• Debt consolidation simplifies repayment by rolling multiple debts — like credit cards, personal loans and medical bills — into one loan with a single monthly payment and one interest rate. Federal student loans, tax debt and child support usually can't be consolidated.

• You can save money if your new rate is lower than your current average, but watch for fees, extended terms and the temptation to rack up new debt that could cost you more over time.

• Consolidate only if you have steady income, a clear payoff plan and can secure a lower APR — otherwise stick with your current payments or explore a debt management program first.

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What Is Debt Consolidation?

Debt consolidation can help if you have a lot of debt by making your finances easier to manage. How so? Instead of keeping track of various debts separately, debt consolidation brings them all together into one package.

You'll have only one:

• Loan to deal with

• Monthly payment to make

• Interest rate to keep in mind

Debts you can typically consolidate:

• Credit card balances

• Personal loans

• Medical bills

• Car loans

Debts you can't usually consolidate:

• Federal student loans

• Tax debt

• Child support

Why is this helpful? Imagine you have debts with different due dates and interest rates. It can get overwhelming trying to remember when each payment is due and how much interest you're paying for each debt. Debt consolidation solves that problem by combining everything into a single loan.

Not only does debt consolidation make things simpler, but it can also save you money by potentially getting you a lower interest rate on the consolidated loan. When you have multiple debts, each with its own interest rate, you might end up paying more in total interest. But with debt consolidation, you have a chance to secure a better interest rate, which can reduce the overall amount of interest you’ll pay over time. It’s like getting a discount on your debts.

How Debt Consolidation Works

Here's how debt consolidation works:

1. Instead of making separate payments for each debt, you take out a new loan or credit card specifically for consolidating your debts.

2. This loan or card has a fixed interest rate and a set repayment period.

3. With this new loan or card, you pay off all your other debts, leaving you with just one monthly payment to make.

Debt consolidation can have positive and negative effects, depending on how you manage it.

Positive impact on credit:

• Consistent payments can have a positive impact on your credit score

• A good credit score can make it easier to qualify for future loans, credit cards, or better interest rates.

Potential negative impact on credit cards:

• You might close credit card accounts.

• Closing credit card accounts can reduce your credit score because it reduces your overall available credit limit and if you have had the card open for a long time, it could affect the length of credit history. 

Debt consolidation alone doesn't magically fix your credit. You’ll want to practice good financial habits, such as making payments on time and not accumulating more debt, to maintain a healthy credit profile.

Example of Debt Consolidation

There are different ways to consolidate debt, depending on individual circumstances.

Using a Personal Loan

One common approach is obtaining a personal loan for debt consolidation from a financial institution to pay off existing debts. By doing so, all the debts are consolidated into a single loan with a fixed interest rate and monthly payment.

Balance Transfer Credit Cards

Another method is through balance transfer credit cards. You transfer the balances from multiple credit cards onto a single card that offers a lower interest rate or an introductory 0% interest period, consolidating your credit card debts and simplifying payments.

5 Benefits of Debt Consolidation

Debt consolidation offers several benefits that are worth exploring. 

1. Chance To Simplify Repayment

By consolidating your debts, you combine them into a single loan or payment. You only need to keep track of one due date and one interest rate, which can make it easier to stay organized and avoid missed payments.

2. Possible Lower Interest Rates

The potential to nab a lower interest rate for your debts is a huge perk, especially if you're dealing with high-interest credit card debt or payday loans.

These types of debts often come with sky-high interest rates, which means you end up paying more money in the long run. But with debt consolidation, you have a chance to renegotiate and get a better deal.

3. Possibly Reduced Monthly Payments

Consolidating your debts can potentially lower your monthly payment amount. For example, you may secure a lower interest rate on the consolidated loan, resulting in a reduced monthly payment.

Extending the repayment term can spread out the payments over a longer period, which can make them more affordable each month. Lower monthly payments can provide immediate financial relief and free up some of your budget for other expenses or savings.

4. Debt Payoff Strategy

Debt consolidation allows you to simplify your debt repayment strategy. Instead of feeling overwhelmed by multiple creditors, due dates, and many different interest rates, you can focus on a single loan.

You can create a clear plan to pay off your debt systematically. You can allocate your resources more effectively, potentially paying down the debt faster and regaining financial control.

5. Opportunity To Improve Your Credit Score

Debt consolidation can have positive effects on your credit score. It can lead to a lower credit utilization ratio by increasing your available credit, potentially counteracting any negative impact from opening a new account.

Making timely payments on your new loan can gradually improve your payment history, which plays a big role in your overall credit score. However, you'll still have to demonstrate that you're responsible with your finances and be consistent with your payments to experience these benefits. Finally, it's important to note that when you first open a new account, you might see a slight decrease in your credit score.

Factors To Consider Before Consolidation

If you need a cheat sheet for what to think about before you consolidate your debt, take a look at the following:

Go with it if:

• You know your exact total debt amount.

• Your new rate is lower than your current average rate.

• You're extending your repayment term unnecessarily.

• Fees are reasonable — less than 5% origination and balance transfer around 3% to 5%.

• Your income is steady.

Be careful if:

• The new interest rate is the same or higher.

• Your repayment terms increase the interest you end up paying.

• The fees could zero out any savings you gain.

• Closing credit card accounts or opening new ones can affect your credit utilization ratio or credit history length.

5 Different Methods of Debt Consolidation

There are other methods available to help you tackle and pay off your debt.

1. Personal Loans

You can get a personal loan from a bank or online lender to consolidate your debts. This loan is used to pay off your existing debts, and then you make regular payments on the personal loan instead.

2. Balance Transfers

Some credit card companies offer balance transfer options. This involves transferring your existing credit card balances to a new credit card with a low or 0% introductory interest rate for a specific period. You make payments on the new card to consolidate your debts.

3. Home Equity Loans

If you own your home and have some equity in it, a home equity loan may be an option to explore. These loans use your home value as collateral but do have credit and income requirements to qualify. 

4. Debt Management Programs

These programs are typically offered by credit counseling agencies. They work with your creditors to negotiate lower interest rates or reduced monthly payments. You make one monthly payment to the credit counseling agency, which distributes the funds to your creditors.

5. Debt Consolidation Loans

Similar to personal loans, debt consolidation loans are specifically designed for consolidating debts. You apply for a loan from a bank or lender, and if approved you use the funds to pay off your existing debts. Then you make regular payments on the consolidation loan.

Remember, these options have their pros and cons, so you’ll want to consider which one aligns best with your needs and goals. Take your time to explore each method and compare interest rates, fees, and eligibility requirements. 

Potential Drawbacks of Debt Consolidation

Debt consolidation is not a magical solution that automatically solves all your financial problems. It requires careful consideration and planning to ensure its effectiveness. Here are a few risks to be aware of.

Temptation To Accumulate New Debt

One drawback is the temptation to continue using credit cards or taking on new loans without addressing the underlying spending habits and financial discipline. If you fall into this trap, you might end up with even more debt than before, defeating the purpose of debt consolidation.

Extended Repayment Period

Debt consolidation can sometimes result in a longer repayment period compared to your original debts. While it can lower your monthly payments, it may mean that you end up paying more overall due to the extended duration of the new loan. Evaluate the trade-off between lower monthly payments and the total cost of the extended repayment period.

Potential for Higher Total Interest Paid

Depending on the interest rates and terms of the consolidation loan, there is a possibility that you may end up paying more in total interest compared to your original debts. This is particularly true if you extend the repayment period or opt for a consolidation loan with a higher interest rate. It’s crucial to compare the total interest costs of your current debts with the projected interest costs of the consolidation option. 

Should You Consolidate Your Debt?

Before deciding to consolidate your debt, it’s important to ask yourself some questions. 

Will Consolidation Save You Money or Cost You Money?

Many consumers, especially younger adults just beginning to live independently, often have at least one credit card with a high interest rate — sometimes these rates can be well above 20 percent. The more of these types of cards you accumulate, the harder it can be to keep up with the minimum payments.

At that point, it might make sense to jump on offers to consolidate your credit card accounts onto one lower-interest-rate card. Many credit cards offer zero-percent or low-interest balance transfers to let you consolidate. This lets you make one payment at a lower interest rate for an introductory time.

Many of the low rates these new cards offer are only good for a set period. After that, the interest rate on your new card will probably move higher. And if you haven’t paid off your entire transferred balance before your teaser rate expires — usually 12 to 18 months — your new finance charges could jump as high as the old cards you just paid off. If you don't think you can pay your entire balance within the introductory period, try to hold out for a card with a low fixed rate.

Does Consolidation Help You Make Timely Payments?

One of the biggest advantages of consolidating debt is that, with fewer creditors to pay, you’re more likely to pay on time, which is one of the most important ways to maintain or build a good credit score. Having just one payment to make can simplify your debt pay down strategy.

Is Consolidation Helping or Getting You Into Even More Debt?

It may sound like common sense, but it’s important to remember that debt consolidation is still debt — you’ve only transferred the amount of debt you already have to lower your payments and make the payments easier to make. And while it might seem like you’re on your way to paying off your debt, you technically haven’t reduced any of what you owe.

And while it’s a good first step, it’s not a cure-all. The reality is that most consumers who choose to consolidate their debt end up with more debt a few years later, in some cases maxing out the credit cards that were freed up by the consolidation. 

So Should You Consolidate Your Debt? It Depends on You

There's no question that debt consolidation could save you money and help you make timely payments, but the most important factor to consider when consolidating debt is you: don't let debt consolidation provide you a false sense of security — or permission to yourself — to take on additional debt. You’ll need the discipline and grit to pay off your consolidated debt as quickly as possible.

Taking Charge of Your Finances 

Debt consolidation can be a game changer for getting your financial ducks in a row. It simplifies your finances so that you know exactly what to do to pay it all off. But don't dive in headfirst. Consider all the options and weigh the pros and cons before you decide on a method. 

Your Top Insights

FAQs

Is debt consolidation the right choice for everyone?

Debt consolidation may be suitable for some, but it's not always the right solution for everyone. It depends on factors such as your financial situation, goals, and personal preferences.

What are the risks of debt consolidation?

While debt consolidation offers benefits, risks include the temptation to accumulate new debt, the potential for an extended repayment period that increases overall costs, and the possibility of paying more in total interest. As long as you plan for your expenses well and avoid incurring additional fees according to the terms of your agreement, you can bring that risk down.

Can I consolidate all types of debt?

Debt consolidation options typically include credit card balances, personal loans, medical bills and other unsecured debts. However, certain types of debt, such as mortgage loans or federal student loans, may have specific consolidation programs or restrictions. Check the eligibility criteria and terms for each type of debt you wish to consolidate.