Debt Consolidation Vs. Refinancing – What's The Difference?

If you’re looking for ways to pay off your debt, two options you may have heard of before include debt consolidation and debt refinancing – but how do you know the difference between them and which option might be right for you?

We’ll cover what each strategy is, how they impact your debt, and considerations to make when reviewing a lender’s offer.

What Is Debt Refinancing?

Debt refinancing is when you take out a new line of credit or loan under different terms to pay off an existing debt (or multiple debts) usually at a better interest rate or lower monthly payment.

For example, let’s say you’re currently paying down loan A with an interest rate of 6% and a remaining balance of $5,000. If you were offered a lower interest rate of 5%, you might take out loan B for $5,000 to payoff loan A using a lower monthly payment and saving money in interest over time.

It's important to note that neither refinancing or debt consolidation eliminates your debt. Ultimately, you'd still be responsible for paying down the remaining balance, but hopefully at a lower interest rate or monthly payment. You can refinance a single debt or multiple debts – individually, or combined (the latter would be considered consolidation).

What Is Debt Consolidation?

Debt consolidation involves taking out a new line of credit to pay off multiple loans, consolidating them into a new, single monthly payment. Similar to debt refinancing, debt consolidation does not eliminate any of your existing debt, but rather, simplifies your payments under new terms.

For example, let’s say you had loan A for $2,000, loan B for $3,000, and loan C for $4,000. You might consolidate them into a single loan of $9,000 to make your payments easier. It’s possible that new loan might use an average weighted interest rate of loan A, B and C –effectively keeping your interest rate the same – or use a new interest rated depending on the terms of the offer. Be sure to read the terms of your new loan closely before signing.

Ideally, in addition to consolidating your monthly payments, you'd also hope to get a lower interest rate or lower monthly payment.

Thinking about consolidating your student loans? If you have private student loans and can get a better offer, then student loan consolidation can make a lot of sense. Depending on the type of student loans you have – federal or private – you’ll want to understand the pros and cons. This is especially true if you have federal student loans or are on an income-driven repayment plan, as there can be significant risks.

The Difference Between Debt Consolidation And Refinancing

The major difference between debt refinancing and consolidation is that debt consolidation must involve more than one debt, while refinancing can be applied to a single or multiple debts.

Both debt consolidation and debt refinancing involve taking out a new loan or line of credit to pay off existing debt. Regardless of which you choose, the new loan will come with new terms that could be beneficial for you. With a new loan, you could:

• Lower your interest rate, saving you money in the long run
• Lower your monthly payment, freeing up cash on the monthly basis
• Simplify your payments, so you only have one debt to pay instead of several

Whether you consolidate or refinance your loans, and what type of offer you might take will depend on your goals: do you want to lower the amount you pay over time, lower the amount you pay monthly, or become debt free sooner? You may also want to simplify your payments.

What To Consider When Refinancing Or Consolidating

Most people refinance because they are looking for either a lower monthly payment, a lower interest rate, or both. Obtaining a lower interest rate could save you the most money in the long run. But it’s also possible that you prefer a lower your monthly payment, regardless of the interest rate or repayment period – even if that extends the repayment period for your debt, it may free up cash for other priorities.

So how do you know whether it's the right decision for you? Consider the following four questions: 

• Will consolidation or refinancing help you manage your payments more easily?
• Will the new offer lower your interest rate, monthly payment, or both?
• Will it increase or decrease the total amount of debt you pay overtime, including interest?
• Will it extend the amount of time you are in debt? This may be particularly important if you're considering another loan or mortgage down the road, as any existing debt will impact your debt-to-income ratio.
• Is there any prepayment penalty in the event you want to accelerate your debt payoff at a later date?

The Bottom Line

At the end of the day, whether you decide to consolidate or refinance your debt will always be a personal decision. Armed with the understanding of the major differences between the two methods, we hope you’re in a better position to decide what might make sense for you on your financial journey.