If you have multiple sources of debt, like several credit cards or medical bills, managing all the monthly payments can be a lot of work — and that’s before you factor in how much interest you’re paying on that debt.
However, there may be a way for you to streamline your payments and pay less in interest overall: Through debt consolidation.
What is debt consolidation?
Debt consolidation is when you take out a loan and use it to pay off multiple debts which can simplify how many payments you have to make each month. You can borrow the full amount to pay off your outstanding unsecured debt, like credit cards, medical bills and more. Then you can make one payment on your new loan until the balance is paid in full.
For instance, let’s say you have some unpaid medical bills and balances on a handful of credit cards totaling $15,000. If you’re approved for a $15,000 debt consolidation loan, you can use that money to repay those debts and then make payments on your new loan.
Keep in mind: Some debt might not qualify for debt consolidation, like an auto loan, mortgage or other debt that comes with collateral.
How debt consolidation works
Debt consolidation works when you take out a new loan or line of credit — ideally with a lower interest rate than what you’re paying now — to pay off existing debt. If you have many different types of debt with multiple interest rates, find the average rate of all and try to get a lower rate than that average.
“Generally debt consolidation can be a good idea if you can get a lower interest rate,” says Kevin Matthews II, author and founder of financial literacy company BuildingBread. “There are a few routes you can take to consolidate your debt including a personal loan, balance transfer credit card or loan from your 401(k).”
Once you use those funds to pay off your outstanding debt, you’ll make a single payment on the new debt consolidation loan. You’ll make payments on the new loan for the terms of your agreement until it’s paid in full.
How and where to get a debt consolidation loan
A debt consolidation loan is usually an unsecured personal loan. Unsecured loans don’t require collateral — something you offer up to secure the loan, such as your house or car, which you would lose if you didn’t repay the loan.
Typically, lenders require good to excellent credit to be eligible. There are some debt consolidation loans and products available for those with poor credit but you’ll generally pay higher interest rates with these loans.
Personal loans and credit cards are unsecured and rely mostly on your credit history to see if you’re a good lending candidate.
Pros of debt consolidation
- Streamline debt payments: Consolidating debt can help you combine multiple debt payments into one. This can make it easier to stay on top of your debt when you have fewer due dates, interest rates and payments to keep track of.
- Lower interest: If you can secure a lower interest rate than the average of all the debt you’re paying interest on right now, you’ll save yourself money on repayment.
- Pay off debt sooner: If you have credit cards with high balances and you’re only making minimum payments, it could take years to pay off your debt in full. Consolidating your debt might mean a higher monthly payment, but you’ll likely pay it off sooner compared to your current payment plan.
Cons of debt consolidation
- Potential upfront costs: Most personal loans charge an origination fee, home equity loans have closing costs and origination fees and balance transfer credit cards usually charge a balance transfer fee.
- Lower interest rate not guaranteed: Even if you qualify for a debt consolidation loan, there’s a chance you might not get a lower interest rate than what you’re paying right now. You might still opt for a debt consolidation loan, however, if your priority is simplifying your payments.
- Missing payments can cost you: If you miss a payment on your home equity loan or line of credit, you could lose your home. Missing credit card or personal loan payments can also cause your credit score to tank.
When you should consolidate debt
Here are some signs a debt consolidation loan might be right for you.
1. You qualify for a lower interest rate
If you’re struggling to get out of debt but still have good enough credit to qualify for a debt consolidation loan with a lower rate, you should consider it. Paying less in interest means paying less out of your pocket on top of the principal amount you borrowed. If you’re combining multiple debts, add up each debt’s interest rate and figure out the average. You should aim to get a rate lower than that average.
Ready to find the right loan? Here are the best debt consolidation loans
2. You want to simplify repayment
If you’re carrying debt on a few credit cards, and maybe even owe money on some medical bills, a debt consolidation loan can help simplify the repayment process. Since you’ll pay off multiple debts with a new loan, you’ll then have just one payment and due date to worry about instead of the three, four or five you had to worry about before consolidation.
3. You want to get out of debt sooner
If you’re drowning in debt, a debt consolidation loan can help you pay off your total debt sooner. If you take out a debt consolidation loan with a lower interest rate, you can put the money you save from paying less in interest toward the new loan as extra payments.
When you shouldn’t consolidate debt
Here are some reasons you might want to reconsider a debt consolidation loan.
1. You can’t handle a higher monthly payment
If the higher monthly payment is too much for you to afford, debt consolidation might not be the right move for you. Missing payments not only causes your credit score to tank, but can hurt your chances of qualifying for other loans and lines of credit down the line.
2. You can’t get a lower interest rate
Even if you’re eligible for a debt consolidation loan, you may not get a lower interest rate than what you’re paying right now. If you can’t get a lower interest rate, you’ll end up paying more in interest, which means it might not be worth consolidating if your goal is to save money. However, if your goal is only to simplify your payments, you’ll have to decide on your own if it’s worth it.
3. You only owe a small amount
If you have a couple of credit cards to consolidate, but you only owe a small amount on each, debt consolidation may not be the best route to take. Since debt consolidation can come with fees that are usually a percentage of your balance, taking out a personal loan or transferring debt to a credit card could end up costing you more than it’s worth with a small balance. Just make sure you compare the fees for each lender or credit card to see if you’d save money even after the added cost.
Alternatives to a debt consolidation loan
Debt consolidation loans are one tactic to pay off debt, but they’re not the only way. Here are some other options to help you pay off debt:
- Home equity loan: If you’re a homeowner, you may have the option of taking out a home equity loan. Just keep in mind that this is a secured loan and if you fail to make payments on this type of loan, you could get a lien on your home.
- Home equity line of credit (HELOC): Like a home equity loan, a HELOC is secured by your home. It’s easier to qualify for home equity products because you’re using your home as collateral — but it’s key for you to understand that your home is at risk if you’re unable to repay your home equity debt.
- Credit card: You can always consider applying for a 0% APR credit card offer. If you can pay off the balance before the promotional period ends, you won’t have to pay any more interest on that debt. But keep in mind that transferring a balance to a credit card usually comes with a fee that’s a percentage of the total amount transferred.
If you can’t take out another loan or line of credit (or just want to avoid doing so), you can always use these popular debt pay off strategies:
- Debt snowball method: List all your outstanding debt, including minimum payment amount, interest rate, due date and total amount owed. Make minimum payments on all of your debt and then put any extra money you can toward the debt with the lowest balance. Do this until that debt is paid in full. Then, move onto the next-smallest debt and continue until all of your debt is paid off. This method can be a good idea for those who are motivated by small wins.
- Debt avalanche method: Just like the debt snowball method, start by listing out all of your debt. But instead of focusing on the smallest debt, you’ll put all your extra cash toward the debt with the highest interest rate. This method can take longer than the debt snowball, but you’ll save money over time since you’ll pay less in interest once your debt is paid off.
Find out which strategy is right for you: Debt snowball vs. debt avalanche
Frequently asked questions (FAQs)
Debt consolidation can be a good way to get out of debt. If you have good to excellent credit and you’re eligible for a debt consolidation loan, securing a lower interest rate than what you’re currently paying can help you save money and put more toward paying off debt.
Debt consolidation is helpful if you need to merge two or more large debts into one manageable payment. You should aim to get a lower interest rate through a personal loan or credit card.
Debt settlement typically comes after many months of nonpayment, which means your credit score and history are likely in bad shape. So you hire a company to negotiate your debt on your behalf in an effort to settle for less than what you currently owe. Since this also means paying the company handling your debt a percentage of the settlement, you should only settle if you don’t have any other option for rehabilitation.
“Debt consolidation may be a better choice if the total debt amount is manageable and you have a high credit score,” says Matthews. “Debt settlement could be a better option if you feel that the total debt amount is too big to tackle. But keep in mind that it could have a negative impact on your credit score.”
Taking out a new loan or line of credit will temporarily cause your credit score to drop. Along with that, if you end up paying off debt and closing accounts, that could also cause your score to take a small dip. But your score will eventually rebound after a few months of on-time payments.
A debt consolidation loan remains on your credit report as long as the account is open. If you settle your debt, however, that will remain on your report for up to seven years after the delinquency first arrived.
