Struggling to pay off high interest debts from medical expenses or credit cards can be absolutely overwhelming. Of course, there are many ways to tackle your debt—but which one is right for you? Understanding the basics of debt consolidation is a good place to start if you are trying to understand if this is the step for you to take.
Debt consolidation simply means combining all of your debts into one; the total amount of your debt after you consolidate it is the same as it was before you began. So why do people consolidate debt? Because consolidating debt could save money in interest over time, and it streamlines your bill paying–which could make it easier to manage your monthly payments and eventually pay off the debt.
Here, we’ll discuss how and when to consolidate debt, in addition to other debt relief options, to help you understand what debt consolidation means and help you decide if it’s right for you.
How debt consolidation works
There are several different ways to approach debt consolidation. Each one has different pros and cons, and the method you choose to consolidate your debt will depend on your situation and needs, but you’ll generally follow these basic steps:
- Determine your total debt load – or at least the debt you hope to consolidate and pay off.
- Calculate the weighted average of your interest rates, based on the balance and interest rate for each debt (your debt consolidation loan, transfer card, or other solution must have a lower rate than the weighted average).
- Put together a monthly household budget, if you haven’t done so already, and determine how much money you can put toward your consolidated debt each month.
- One you know how big a loan you’ll need, the rate you’ll need to beat, and how much you can pay toward debt consolidation each month, you’ll be ready to choose the right method for you.
But before you begin a debt consolidation plan, you’ll want to understand when it makes sense to do so. There are other alternatives, such as debt settlement, that may be better options for you. As a rule of thumb, debt consolidation can be your best option as long as you can find a better rate than what you’re currently paying and have enough cash each month to pay down your balance.
Debt consolidation through balance transfer credit cards
A credit card balance transfer allows you to move balances from multiple credit cards to a single, low-interest (sometimes as low as 0 percent) credit card. Sometimes the promotion for a balance transfer includes an opportunity to move debts that aren’t on credit cards, such as a medical bill. But be aware of balance transfer fees and other potential downsides of this method.
Personal or debt consolidation loan
With personal loan or debt consolidation loans, you can consolidate debt and pay your creditors off in one fell swoop. However, it’s important to note that you are not actually paying off your total debt. Instead, you are moving your debt to a different creditor, and consolidating multiple payments to multiple creditors into a single loan payment. A personal loan or consolidation loan could help you start reducing your debt because your loan payments will apply to both the interest and principal debt owed.
Unlike credit cards, which have variable interest rates, debt consolidation loans have fixed interest, which makes the monthly cost of your loan more predictable. Average interest rates on personal loans are also typically much lower than the interest rates on credit cards. They usually range from 14 to 18 percent, but can vary from as low as about 4 percent annually for people with exceptional credit, to 25 percent or higher for people with poor credit. Unless you can qualify for a loan at an interest rate that is lower than the average amount of variable interest you are paying on your debts now, a consolidation loan probably does not make financial sense as a debt consolidation tool.
When you consolidate debt with a loan, it’s important to shop various lenders to find the best loan terms and interest rates. Keep in mind that to determine what rate to offer you, each lender will probably “pull your credit”. This means they will examine your FICO score, an action that could itself impact your score. However, FICO ignores multiple mortgage, auto, and student loan inquiries made in about the 30 days prior to scoring. So if you find a debt consolidation loan within 30 days, the multiple inquiries shouldn’t have extra impact on your score.
Debt management programs
If you are having trouble paying your bills each month and need moderate debt relief, credit counseling and a debt management plan (DMP) could be an effective debt consolidation option. Credit counseling doesn’t reduce the amount of debt you owe, but a credit counselor can set up an affordable payment plan at lower interest rates that have been negotiated with your creditors. This allows you focus on one interest rate and make just one payment per month.
How a debt management program works:
- Credit counselors will work with your enrolled creditors to try to lower your interest rate, also called a “concession rate”
- The DMP will calculate your new monthly payment to creditors, based on the concession rates
- You stop using your credit cards while in the program (sometimes you may have one open just for emergencies)
- You pay the DMP monthly and they use this money to pay your creditors
Through a debt management program, you could consolidate debt and save money as long as the concession rate on the debt is lower than the average of your previous interest rates.
A DMP could help protect you from creditor collection actions and could prevent you from becoming delinquent. However, if you are currently struggling to make minimum payments and are concerned that the credit counseling fee could mean you pay more each month than you are now, then this may not be the right option to help you consolidate your debt.
Debt consolidation through cash-out refinancing
If you own a home and have enough equity in your home, you may be able to take out a home equity loan or line of credit and use the money to pay off all of your debts at once. Or, you can refinance your home for more than the mortgage balance (a cash-out refinance) and, at closing, use the extra cash to pay off your debts. Either way, you will be moving your debts onto your mortgage, which means they will be at a significantly lower interest rate.
Depending on how many of your debts you pay off, this type of debt consolidation can offer a huge savings in interest over the life of the debt. However, using your home to consolidate debt can be very risky. If you can’t make the payments, then you will be at risk of foreclosure.
Debt settlement programs
Another way to get a handle on your debt is by enrolling in a debt settlement (also called debt relief) program like the one offered by Payment Genius. Instead of paying all your creditors on a monthly basis, you make one, affordable payment into the program each month. These monthly payments are not payments on the debt, they are deposits into a bank account that will later be used to fund debt settlements negotiated on your behalf.
On a bi-weekly or monthly basis, you deposit money into an account you control until the amount becomes large enough that the debt settlement company you’re working with can approach your creditors and negotiate with them to settle for less than the full amount of your debt to consider the debt paid. Once you agree to the terms of the settlement, the funds you have been saving in that bank account are processed as payments to your creditor until the debt is considered resolved.
Although all debt settlement programs charge a fee for negotiating your debts, by reducing the total amount you owe creditors, these programs could still help you get out of debt faster and for less money than by continuing to make minimum, or even more than minimum, payments.
Frequently Asked Questions About Debt Consolidation
Will I save money through debt consolidation?
It’s possible to save money through debt consolidation, although that’s not the ultimate aim of this debt reduction approach. If you choose a consolidation loan, for instance, you may end up paying less overall by virtue of moving your debt to a lower-interest loan. Also, by paying off your debt faster than you otherwise would have, you won’t accrue as much interest.
However, it often depends on how quickly you’re able to pay the debt down. For instance, debt consolidation credit cards offer low interest rates that typically go up after the introductory period ends.
What are my debt consolidation options if I have bad credit?
If your goal is to consolidate debt into one loan with a lower interest rate, it may be more difficult to find a consolidation loan if you have bad credit. But it’s not impossible and just takes a little more perseverance. Make sure you shop around and consider peer-to-peer lenders and online financial institutions that may rely on different metrics for determining who’s creditworthy. Other options such as debt management or debt settlement are often better options to consolidate debt for those with lower credit scores.
If I want to consolidate debt with a loan, how do I know if a financial institution is trustworthy?
There is truth in the saying, “the large print giveth and the small print taketh away,” so you always want to fully understand what you’re getting into if you decide to consolidate debt with a personal loan. For instance, you may find a lender who offers competitive interest rates, but also charges high fees, doesn’t allow for early payoff of the loan, or imposes other unfavorable terms.
Your best bet is to check reviews and ratings from reputable third-party institutions, such as the Better Business Bureau. Also, make sure you can spot the telltale signs of predatory lenders.