What Is Debt Consolidation?

In simple terms, debt consolidation involves combining multiple debts into one debt. It’s one of many possible debt relief options. If you consolidate your debt, your monthly payment will typically be lower than the combined payments on the separate debts you had before. You may also get a lower interest rate, meaning you’ll pay less in the long run. 

Read on to learn how debt consolidation works, how it can be beneficial, and what pitfalls you may face.

How Do Debt Consolidation Loans Work?

You can think of a debt consolidation loan as refinancing your existing debts. Unlike many other debt solutions, debt consolidation involves taking out a new loan. A debt consolidation loan can be used to pay off credit card debt, personal loans, and other high-interest debt. Consolidating your debt streamlines your monthly payment and can save you money in the long run if you get a lower interest rate consolidation loan.

What Are The Most Common Debt Consolidation Options?

The two most common types of debt consolidation are:

• Credit Card Balance Transfers: One of the simplest types of debt consolidation is a credit card balance transfer. You can transfer balances from one or more cards to a new card with a lower interest rate. But this can be risky — especially if you get overly optimistic. Low interest rates on balance transfers are typically time-limited, and if you can’t pay down the debt quickly, you could end up right back where you started.

• Personal Consolidation Loans: Another approach is to take out a personal loan to pay off debts. Your new loan will ideally be at a lower interest rate than you're currently paying on your credit card balance and other unsecured debt. In most cases, the only added expense is a one-time loan origination fee. The origination fee is usually somewhere in the range of 0.99% to 5.99% of the loan balance. Depending on the total amount of your debt, this could mean paying thousands of dollars extra.

How Do You Know If Debt Consolidation Is Right for You?

If you're considering alternative debt solutions such as debt settlement or debt consolidation, consider talking with a credit counselor before you make any decisions. For-profit debt relief companies may steer you in the direction that's best for their own bottom lines, but reputable nonprofit agencies provide credit counseling for free.

Depending on your circumstances, these organizations may also be able to offer you a debt management plan that works much like a debt consolidation loan, but without taking out a new loan. Veterans also have some special options for debt consolidation.

What Type of Loan Is a Debt Consolidation Loan?

A debt consolidation loan may either be an unsecured personal loan or a secured loan. If the loan is secured, you have to agree that some of your property will become collateral for the loan. This means the lender can take that property if you don’t make your loan payments. Unsecured loans don't create this risk, but it may be difficult to get approved for an unsecured loan if you’re already carrying significant debt or you’ve fallen behind on your payments. 

One popular secured debt consolidation loan is a home equity loan. Some people take out a home equity loan and use the funds to pay off several smaller debts. This often allows them to get better repayment terms, lower their monthly payments, and simplify their payment schedule. While this works for some people, it can also be risky. 

When you refinance your mortgage or pay off personal loans and credit card debts with a home equity loan or home equity line of credit, you turn unsecured debt into secured debt. That means if you can’t keep up the payments, you could face foreclosure. 

It’s important to carefully consider your loan options since some debt consolidation loans carry risks that others don’t. Also, the loan term (length) and origination fee can have a serious impact on the amount you end up paying. The Consumer Financial Protection Bureau provides additional information about the possible risks of debt consolidation.

What Debts Can Be Included in Debt Consolidation?

Generally, debt consolidation loans are intended for unsecured debt such as medical bills, credit card debt, personal loans, and payday loans. Private student loan debt can be included in a debt consolidation loan. If you include federally guaranteed student loans, they lose the protections that come with federal loans. If you have multiple federal student loans, you may be able to consolidate them separately to keep those protections. 

Car loans and other secured debts usually can't be managed through debt consolidation. But under some circumstances, you may be able to include auto loans or other secured debt in your debt consolidation loan. 

When you’re deciding whether you can afford to make payments on a debt consolidation loan, don’t forget about your other monthly bills, including secured debt payments that won’t be included in the loan. While a lower interest rate or longer loan term may help improve your financial situation, it's best to look at the big picture, including your spending habits, before you make a decision.

Will Debt Consolidation Affect My Credit Score?

This depends. Many people see their credit score improve after consolidating their debt.

If you pay off credit card balances with a debt consolidation loan, you’ll instantly see a big drop in the percentage of available credit you’re using. This is called your credit utilization ratio, and it’s a key factor in calculating your credit score. Also, if you’ve been juggling payments and falling behind, debt consolidation can put an end to late payments. This also helps your score.

Be careful, though. If you continue to use your credit cards but don't pay them off monthly, you can fall even deeper into debt. Also, your credit score will suffer as you use more of your available credit. 

Some types of debt consolidation may temporarily lower your credit score. That’s because you may be required to close credit cards and other accounts included in the consolidation, especially if you’re in a debt management plan. Closing an account lowers the average age of your credit accounts and may increase the percentage of available credit you're using. Both of these items factor into your credit score. 

Many people who consider debt relief options are carrying high balances and already have a history of late payments. So you may already be fighting bad credit. Timely payments on your new loan will appear on your credit report and help you begin to build a stronger credit history right away.

How Is Debt Consolidation Different From Debt Settlement?

Debt settlement is a completely different form of debt relief. Debt consolidation typically involves a personal loan that rolls all or many of your existing debts into one larger loan. Ideally, the new loan means an affordable monthly payment and lower interest rate. Debt settlement, on the other hand, involves making a lump-sum payment to your creditor for less than your full balance. In exchange for the payment, the creditor agrees to forgive the remaining amount. You can do this on your own or work with a debt settlement company.

A debt settlement company collects funds from you to negotiate with your creditors. But debt settlement companies typically work toward settling one debt at a time. That means that while you're making payments toward your debt settlement plan, your existing accounts are falling further and further behind. And your credit history and credit score will suffer. Debt settlement can be a good alternative for folks with limited debts and the ability to make some lump-sum payments to creditors in exchange for forgiveness of the balance. 

Let’s Summarize…

If you’re struggling with debt, there are many potential solutions, including debt consolidation. When you consolidate your debt, you roll existing debts into a single, new loan. This decreases the number of monthly payments you need to make and can also lower your monthly payment and interest rate. You can consolidate your debt with a credit card balance transfer, a personal loan, or a secured loan like a home equity loan. Consolidating unsecured debt like credit card debt with a secured loan puts the property securing the loan at risk.