What Is Debt Consolidation?

Working to pay off existing debt can seem like an uphill battle, especially if you have multiple debts. You may be looking for something that gives you just one payment to worry about, instead of multiple payments with different due dates. This is where debt consolidation may be able to help.

What Is Debt Consolidation And How Does It Work?

Debt consolidation is when you take out a new loan or balance transfer credit card, use the new funds to pay down or replace existing balances, and make payments on the new loan or balance transfer card. This simplifies your previous payments into a single payment to one creditor, and may also help save you money on interest depending on the terms.

Types of debt you can consolidate include auto loans, credit card debt, personal loans, student loans and payday loans.

People typically use a debt consolidation loan to lower their monthly payments or their interest rate, or because they would rather make one monthly payment instead of juggling multiple loans. That said, it’s also possible to get a lower monthly payment that costs you more money over time depending on the length of the total repayment term.

Example Of Debt Consolidation

It helps to see what all this looks like in practice. Let’s do a quick example.

Your first credit card has an $8,000 balance with a 25% interest rate. The second balance is $10,000 at 21%. A third balance sits at $15,000 with a 17% interest rate. You’ll want to do a blended rate calculation to determine the relative interest rate you’re paying now, assuming these were all consolidated into one payment. Knowing the blended rate is helpful because it gives you a target to determine whether consolidating will save you money.

Here’s the formula:

(Balance 1 × Interest Rate 1) + (Balance 2 × Interest Rate 2) + (Balance 3 × Interest Rate 3)

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Sum of All Balances

If we plug the numbers above into this formula, you get a blended rate of 20.152%. The formula listed here will work for any number of balances.

When evaluating consolidation options, you’d want to look for something with a lower rate than 20.152% to get a good deal.

Who Qualifies For Debt Consolidation?

In general, to qualify for a debt consolidation loan, you’ll need to be able to provide documentation regarding your income and assets. Additionally, lenders will look at your credit history. Generally, the higher your score, the better your terms will likely be.

Types Of Debt Consolidation

There are several forms of debt consolidation. Let’s run through them.

Credit Card Debt Consolidation

When you consolidate credit card debt, you combine the balances of several cards into one payment, commonly through a balance transfer. The idea is that you transfer your credit card balances to the card with the lowest rate, assuming you’re able to do so.

Before going this route, be aware that balance transfer fees may apply. Some cards offer a break on balance transfer fees and a 0% annual percentage rate (APR) on the portion of your balance that’s been transferred during an introductory period that usually ranges from 16 to 21 months. Make sure you go in with a plan to pay off your debt, so you don’t end up paying a higher interest rate on your balance after the offer expires.

Debt Consolidation Loan

Most often in the form of a personal loan, a debt consolidation loan is taken on with the express purpose of getting your high interest debts into one payment. The goal is to get a lower interest rate or monthly payment after consolidation than you had before.

As with most loans, it’s important to be aware of closing costs such as origination and processing fees. Every lender is going to be different, but a percentage fee of 5% – 10% of your loan amount is common.

Cash-Out Refinance

A cash-out refinance takes your existing home loan and replaces it with a new mortgage at a new interest rate and term length, a portion of which you can use to pay off other existing debt. Because it’s based on your primary mortgage, cash-out refinancing typically yields a lower interest rate than other types of equity loans, like a personal loan.

Outside of VA loans, when you refinance a mortgage, you’re required to keep 20% equity in your home after you close. It’s important to make sure you have enough existing value in your home that you’ll be able to accomplish your goals if you cash out your equity.

The new interest rate will replace the current interest rate on your home. If you have a low interest rate on your mortgage, you’ll likely want to consider other debt consolidation options. A blended rate calculation could help you decide what’s worth it.

To get a cash-out refi, you’ll typically need a debt-to-income ratio (DTI) no higher than 50% and a credit score of 620 or higher.

Finally, when doing a cash-out refinance, your home is the collateral for the loan. You’ll want to be sure you can handle the payment associated with a higher mortgage balance, or risk foreclosure on your home.

Home Equity Loan

Functionally, a home equity loan works like a cash-out refinance. You get a lump sum of money to pay off other debt and essentially transfer the balance into a new loan using your home as collateral. The difference from a cash-out refinance is that it’s a separate loan from your primary mortgage, so you can save by keeping the lower rate on your existing mortgage.

Lenders can help you with a blended rate calculation to determine what makes the most sense. However, you may be able to borrow more with a home equity loan because lenders often let you borrow all but 10% of your equity between your first and second mortgages.

Home Equity Line Of Credit (HELOC)

In contrast to home equity loans, HELOCs are lines of credit. Once approved, you can  draw as much or as little as you need from the line of credit to pay down other debts. The important thing to know about a HELOC is that it has two distinct parts.

In the beginning of a HELOC, there’s the draw period. This might last 5 or 10 years depending on the overall term. During the draw period, you can use and replenish your line of credit as much as you wish and you are only required to make payments on the interest.

Following the draw period comes the repayment period. During this time, the balance of the HELOC freezes and you make monthly payments for the remainder of the loan covering both the balance and the interest owed.

Some people like HELOCs for the flexibility and convenience. However, it’s important to keep in mind is that these lines of credit often come with variable interest rates, meaning the rate can change daily.

401(k) Loan Consolidation

While not recommended, in an emergency situation, you might consider a 401(k) retirement plan loan to consolidate debt depending on what your employer allows. However, you should know that the IRS has several restrictions because ordinarily, there are limits on taking money out of your 401(k) before reaching 59½.

Essentially, if you don’t pay back the loan with interest as scheduled, it can be considered a distribution from your retirement account. Most distributions happening before 59½ are subject to a 10% tax penalty, in addition to any taxes you would owe for the withdrawal to begin with. Consider talking to a financial professional to determine if this solution makes sense for you.

At A Glance: Debt Consolidation Pros And Cons

Debt Consolidation Pros

Let’s go a little bit deeper on the pros of debt consolidation:

• Potential for lower rate and/or monthly payment: In an ideal debt consolidation, you want to ensure your interest rate is lower than the blended rate you would receive if you were to combine all your debt payments together at their current interest rates.
• Fewer monthly payments: It may not make sense or even be possible to combine all your debts into one payment, but you will be able to eliminate some payments by rolling balances together. This could make your finances easier to manage.
• 0% interest for credit card balance transfers: Credit card balance transfers are routine, and many credit companies offer a low or 0% introductory rate for a period of time on balance transfers. In this case, you would transfer existing credit card balances to a new credit card with a lower interest rate to help pay it off quicker, ideally before the introductory interest rate ends. Most 0% introductory offers last between 16 and 21 months.
• Credit improvement: You may improve your credit score by consolidating debt, especially if you tend to forget or have difficulty making payments. Putting funds towards one loan can help you establish a more consistent payment history rather than only covering the minimum payments for multiple loans.

Debt Consolidation Cons

Although debt consolidation can be helpful, there may be drawbacks.

• Trading debts: While it may be at more favorable terms, you ultimately trade one debt for another.
• Could involve collateral: The lowest rate financing options for debt consolidation loans are typically going to be secured by some form of property, often your home. You’ll want to be careful because if you don’t make the payments, you could lose the property.
• Balance transfers have time limits: When credit card issuers give you 0% APR or waive balance transfer fees, these benefits are short-term. For example, if you have 18 months to pay off the transferred balance before a high interest rate kicks in, it’s important to pay it off within that time.
• Better terms are not guaranteed: There’s no guarantee you’ll receive better terms if you consolidate your debt. The same credit issues that may be prompting you to seek debt consolidation can also keep you from being seen as an ideal borrower by potential debt consolidation creditors.

How To Consolidate Your Debt In 7 Steps

If you decide to consolidate your debt, here are the steps you’ll need to take.

1. Identify Your Debt

Look at all the debts you currently have and determine which ones you want to consolidate. Keep in mind that using a balance transfer for credit card debt may be easier and less expensive than taking out a consolidation loan. Look at each type of debt to determine your ideal strategy.

Once you’ve identified what debts you want to consolidate, add up the amount you currently owe to arrive at the amount you’ll need to borrow and/or transfer.

2. Compare Your Consolidation Options

It’s best to carefully consider your options and compare the pros and cons of each type of solution before deciding. This, combined with your knowledge about the specifics of your financial situation, will help you pick the right option for you.

3. Get Your Financial Documents In Order

Here are the types of documentation lenders will most likely ask for:

●      Proof of address

●      Proof of income

●      Statements from any asset accounts used to qualify

●      Social Security number

●      Information about current debt you want to consolidate

4. Evaluate Potential Lenders

When looking at potential lenders, rates are not the only thing you should look for. Keep in mind the new monthly payment and repayment term that will change how much you pay over time. Reviews and customer service ratings, as well as any available fees or discounts are also important to consider.

When it comes to the interest rate itself, be sure you’re also comparing annual percentage rates (APRs). This figure considers the full closing and origination costs for your loan or credit card.

5. Apply For Financing

Some lenders offer a prequalification process where you’re able to see the rates and terms you qualify for before you submit a full application. Doing so may or may not affect your credit score and can be a great step to take when you’re shopping around.

Once you decide on a lender, you’ll need to submit a full application which will likely result in a hard credit inquiry. Depending on the lender, you’ll complete an application online, by phone or in person.

6. Close On The Loan

If you’re approved, you’ll close on the loan. The process will look different depending on the financing. For example, a home equity loan will require you to go through an appraisal process and sign loan documents, whereas a closing on a credit card means you may need to wait until you receive your credit card.

7. Make Payments On Time

Remember, consolidation doesn't get rid of your debt, it simply makes it easier to pay. You will still need to make regular, on-time payments each month. If you fail to do so, you may face consequences such as late fees, your credit score going down or your loan going into default.

On the other hand, on-time payments may raise your credit score over time, helping you to qualify for better loan and credit terms in the future.

Alternatives To Debt Consolidation

If debt consolidation doesn’t make sense for you, there are a couple of other strategies to consider:

• Take a hard look at your budget. If bills are piling up, look at what you can cut from your discretionary spending. The more room you can find in your budget, the more you’ll have to put towards debts.
• Make a plan. If you need to qualify for a mortgage or car soon, consider the loans or credit cards with the largest monthly payment. That will help lower your debt-to-income ratio, which can help you qualify for better terms on your future mortgage or auto loan.
• Negotiate with creditors. If you don’t qualify for debt consolidation and can’t find any room in your budget, you may have to negotiate with your creditors. You can do this on your own or with the help of a reputable counseling agency. Keep in mind, your creditors are not obligated to negotiate with you.
• Consider a debt management plan. Different from debt settlement companies which are often known for scams, a debt management plan from a qualified counseling organization can work with creditors on your behalf and help you come up with a plan to pay down your debt within 3 – 5 years. You can find a qualified organization by visiting the National Foundation for Credit Counseling or the Financial Counseling Association of America.

FAQs About Consolidating Debt

Here are answers to a few questions you may still have about debt consolidation.

Will consolidating my debt always save me money?

While it’s a good option in many instances, debt consolidation doesn’t always save you money. It’s important to do a blended rate calculation on the debt you’re looking to consolidate. If the rate you’re being offered is higher, you won’t save any money.

Will credit consolidation eliminate my debt?

Debt consolidation doesn’t eliminate debt. Rather, the goal is to roll your debts together into one payment and refinance them into a lower interest rate. You will still need a plan to pay it off.

Is it a good idea to consolidate your debts?

If you can get a better interest rate at a payment you can afford, you should consider consolidating your debt. If not, you may look to alternatives like attacking your payments differently or using a debt management plan.

What happens when you consolidate debt?

This depends on how you go about debt consolidation. With some loans, you get a lump sum to pay off your existing debts while maintaining the monthly payment for the new loan. If you try to use a third party to negotiate your debts, you’ll pay the agency your negotiated payment and they will distribute it to your creditors.

Does debt consolidation hurt your credit?

In the long run, debt consolidation should help your credit if it puts you in a situation where it’s easier to manage your payments. If you apply for a loan or balance transfer, there will be a hard inquiry on your credit, which will temporarily drop your score but not for long. Your score will likely go up with future timely payments.

The Bottom Line: Consider Your Finances To See If Debt Consolidation Makes Sense

Debt consolidation can be a good option if you’re looking to better manage high-interest debt. The goal should always be to get a lower interest rate and a more affordable payment. However, it’s important to have a plan. Consolidation doesn’t erase the debt – it just changes it.

There are many options for debt consolidation, and you should consider the pros and cons to determine which one is best for you. If a personal loan sounds like the way to go, you can apply with our friends at Rocket Loans^SM.