What is debt consolidation? How and when to consolidate debt
Consolidating multiple debt balances into a new account with just one monthly payment can have a lot of advantages. But it may not be right for every situation.
7 min read
Reaching your financial goals can be difficult if you’re juggling multiple payments and high interest rates each month. If you’re looking to reduce your debt burden and simplify monthly payments, you may consider a tactic known as debt consolidation. As its name implies, debt consolidation combines multiple debts into a single debt—potentially with more favorable payment terms.
Debt consolidation can be a useful financial tool that provides meaningful debt relief, but it’s not for everyone. In this article, we’ll go over the basics and help you figure out if it’s right for your individual situation.
What is debt consolidation?
Debt consolidation is a debt-relief tactic that involves combining multiple debts into one. This is usually done by opening up a new loan and using the funds from that loan to pay off existing debts.
There are a few major benefits to debt consolidation. For one, it can be confusing and overwhelming to keep track of multiple debts, so debt consolidation offers a way to simplify the process. Secondly, consolidating your debt can actually save you money if your new loan has a lower interest rate than the loans you plan to consolidate.
You can use a debt consolidation loan to pay off a number of different types of debt, including:
- Credit card debt
- Auto loans
- Personal loans
- Medical debt
Remember: consolidating your debts can help you save money only if you qualify for a lower interest rate, so you have to be mindful when considering different loan offers. Still, when done right, this debt-relief strategy can give you peace of mind and ultimately help you get out of debt faster.
How does debt consolidation work?
The process of debt consolidation is relatively straightforward. It involves combining a number of your existing debts into a new loan or, in some cases, a credit card. Here’s a quick overview of how the process typically works at a high level:
- Open up a new loan account. This account should ideally have a lower interest rate and more favorable terms than your existing loan accounts.
- Use the funds from your new account to pay off your existing debt balances. By paying off your high-interest balances first, you can close out those debts and “transfer” them to your new loan account, where you’ll be able to pay off the balance with better terms.
- Continue paying off your new loan balance until it’s fully paid off. It’s important to remember that debt consolidation doesn’t magically make your debt disappear. You’ll still need to pay off what you owe, but at least now you can do it in one place and with better payment terms.
This is only a high-level overview, and there are various methods to consolidate debt. You might, for example, be juggling multiple credit card payments and decide to consolidate all of those payments onto your card with the lowest interest rate. This doesn’t involve opening up a new account, but it can still help you save money on interest.
Debt consolidation vs. debt settlement
Debt consolidation is different from debt settlement, primarily in that it doesn’t get rid of the money you owe. Debt consolidation is a strategy for debt payment, but it is not debt forgiveness.
If you’re feeling hopeless about the prospect of ever paying off your various debts, you may want to consider which debt-settlement options are available to you.
While debt settlement doesn’t strictly eliminate outstanding loans, it can reduce your credit obligations to lenders. If you’re interested in exploring this route, you can seek help from credit-counseling services and debt-relief organizations, which may be able to help you renegotiate your debt with your creditors.
What’s the best way to consolidate your debt?
There are several debt-consolidation options that may be available to you depending on a number of factors, including where you live and what kinds of debts you owe. Here are some common options that you may be able to consider:
Fixed-rate debt consolidation loan
A fixed-rate debt consolidation loan combines debts into one monthly payment with a fixed interest rate. This can help make your monthly payments more predictable, as the interest rate should stay fixed (i.e. it won’t change) over the course of the loan.
Keep in mind that you may not find anything that’s specifically marketed as a “debt consolidation” loan. These loans are typically personal loans and may be available from credit unions, banks, or online lenders. Depending on the lender and your credit profile, it may be difficult to find one with a competitive interest rate.
Balance transfer credit card
A balance transfer card allows you to move your balances from multiple credit cards onto a single credit card—typically one with a lower rate or even a promotional rate for a limited time.
This option can be great for managing multiple credit card debts, but may not be available for everyone. Balance transfer cards may also come with fees and other terms that you’ll have to pay close attention to, so don’t neglect to read the fine print.
Savings account loan
You’re borrowing money from your retirement or savings account with this option—so, essentially, you’re borrowing from yourself. The benefit is that you won’t necessarily have to pay interest to someone else, but borrowing from your own savings can also come with very real drawbacks.
Some retirement accounts may penalize you for withdrawing funds before you reach a certain age, and then there’s the opportunity cost of not allowing that money to grow over time. In general, this is not necessarily an option to jump to first if other, better options are available.
Home equity loan
If you have equity in your home, you may be able to borrow against that equity. This is called a home equity loan. Since this loan is secured by your home, you may be able to qualify for a lower interest rate than you would with, say, an unsecured personal loan. But there’s a caveat: if you miss payments, your house could be at risk.
When to consider debt consolidation
Is debt consolidation a good idea? Well, it’s not for everybody. Remember that this debt-repayment strategy doesn’t get rid of all your debt. You still end up with debt— albeit with a more straightforward payment method and a lower interest rate.
Debt consolidation is not a way to make debt disappear. But it can help you create a strategic plan to address the money you owe. It can also help you regain a sense of control over your financial situation.
When debt consolidation may not be worth it
If your credit history is less than impeccable, you might face higher interest rates when looking for a debt consolidation loan. In some cases, these rates may be higher than those of your existing loans.
This is what we’d call a bad credit consolidation loan. It’s generally not a good idea, since you’ll end up paying more each month with your new loan. If you can only qualify for a loan with subpar terms, you may be better off using other debt-payment solutions such as the debt snowball strategy, debt avalanche, and the 50/30/20 rule.
With the debt avalanche strategy, you first make the minimum payments on all your outstanding accounts. Then, you use any remaining money designated for your debts to pay off the account with the highest interest rate first. The avalanche strategy is a popular choice, since it minimizes the amount of interest you pay over time.
Another debt-reduction alternative is the debt snowball method. With this method, you begin by paying off your minimum payments. Then, with any money left over, you tackle the smallest debts first before moving on to the larger debts. This method can be effective in building motivation, and it’s easy to implement. But keep in mind that you may incur more interest charges and take more time to pay off all your outstanding debts.
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Depending on your situation and needs, debt consolidation may be a good way to regain control over your finances.
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