Debt consolidation rolls multiple debts into a single payment. It can be a good idea if you qualify for a low enough interest rate.
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Nerdy takeaways
- Two ways to consolidate debt are by getting a balance-transfer credit card with a 0% APR introductory period, or by getting a fixed-rate debt consolidation loan.
- Debt consolidation is a good idea if your monthly debt payments (including mortgage or rent) don’t exceed 50% of your monthly gross income, and if you have enough cash flow to cover debt payments.
- Debt consolidation isn’t a quick fix for severe debt problems.
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Debt consolidation rolls multiple debts, typically high-interest debt such as credit card bills, into a single payment. Debt consolidation might be a good idea for you if you can get a lower interest rate than you’re currently paying. That will help you reduce your total debt and reorganize it so you can pay it off faster.
If you’re dealing with a manageable amount of debt and just want to reorganize multiple bills with different interest rates, payments and due dates, debt consolidation is a sound approach you can tackle on your own.
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How to consolidate your debt
There are two primary ways to consolidate debt, both of which concentrate your debt payments into one monthly bill. The best option for you will depend on your credit score and profile, as well as your debt-to-income ratio.
- Get a 0% interest, balance-transfer credit card: Transfer debt onto this card and then be sure to pay it off during the promotional period to get the interest-rate break. You will likely need good or excellent credit (690 or higher) to qualify.
- Get a fixed-rate debt consolidation loan: Use the money from the loan to pay off your debt, then pay back the loan in installments over a set term. You can qualify for a loan if you have bad or fair credit (689 or below), but borrowers with higher scores will likely qualify for the lowest interest rates.
Two additional ways to consolidate debt are taking out a home equity loan or borrowing from your retirement savings with a 401(k) loan. However, these two options involve risk — to your home or your retirement.
» MORE: 5 ways to consolidate debt
Debt consolidation calculator
Use the calculator below to see whether or not it makes sense for you to consolidate.
When debt consolidation is a smart move
Success with a consolidation strategy requires the following:
- Your monthly debt payments (including your rent or mortgage) don’t exceed 50% of your monthly gross income.
- Your credit is good enough to qualify for a credit card with a 0% interest period or low-interest debt consolidation loan.
- Your cash flow consistently covers payments toward your debt.
- If you choose a consolidation loan, you can pay it off within five years.
Here’s an example when consolidation makes sense: Say you have two or three credit cards with interest rates ranging from 11.21% to 25.7%, and your credit is good. You might qualify for an unsecured debt consolidation loan at 7.99% — a significantly lower interest rate. With less interest accruing each month, you’ll make quicker progress toward being debt-free.
For many people, consolidation reveals a light at the end of the tunnel. If you take a loan with a three-year term, you know it will be paid off in three years — assuming you make your payments on time and manage your spending. Conversely, making minimum payments on credit cards could mean months or years before they’re paid off, all while accruing more interest than the initial principal.
Is it a good idea to consolidate credit cards?
Consolidate your debt if you can get a better interest rate and/or it will help you make payments on time. Just make sure this consolidation is part of a larger plan to get out of debt and you don’t run up new balances on the cards you’ve consolidated. Read about how to tackle credit card debt.
How does a debt consolidation loan work?
A personal loan allows you to pay off your creditors yourself, or you can use a lender that sends money straight to your creditors. Read about the steps required to get a personal loan.
Do debt consolidation loans hurt your credit?
Debt consolidation can help your credit if you make on-time payments or if consolidating shrinks your credit card balances. Your credit may be hurt if you run up credit card balances again, close most or all of your remaining cards, or miss a payment on your debt consolidation loan. Learn more about how debt consolidation affects your credit score.
When debt consolidation isn’t worth it
Consolidation isn’t a cure-all for all of your debt problems. You will still need to take steps such as seeking low-cost financial advice or lowering your living expenses. It’s also not the solution if you’re overwhelmed by debt and have no hope of paying it off even with reduced payments.
- If your debt load is small — you can pay it off within six months to a year at your current pace — and you’d save only a negligible amount by consolidating, don’t bother. Instead, try a do-it-yourself debt payoff method instead, such as the debt snowball or debt avalanche. You can use a credit card payoff calculator to test out the different strategies.
- If the total of your debts is more than half your income, and the calculator above reveals that debt consolidation is not your best option, you’re better off seeking debt relief than treading water.
» LEARN: What Canadians should consider about debt consolidation
How To Consolidate Your Debt
When consolidating debt, a borrower applies for a personal loan, balance transfer credit card or other consolidation tool through their bank or another lender. In the case of a debt consolidation loan, the lender may pay off the borrower’s other debts directly—or the borrower will take the cash and pay off his or her outstanding balances.
Whether a borrower should choose a balance transfer card or personal loan to consolidate credit card debt comes down to the interest rates offered and which repayment arrangement is best for their budget.
Once the borrower’s pre-existing debts are paid off with the new funds, the borrower will make a single payment on the new loan each month. While debt consolidation may lower the amount a borrower owes each month, it accomplishes this by extending the loan period of the consolidated loans. Consolidating debts also streamlines payments and makes it easier to manage finances—especially for borrowers who struggle to manage their money.
Say, for example, you have four outstanding credit cards with the following balances:
- Credit card A: $3,400
- Credit card B: $2,600
- Credit card C: $6,000
- Credit card D: $4,000
Under this example, you have a total of $16,000 in outstanding credit card debt, across four cards and with annual percentage rates (APRs) ranging from 16% to 25%.
If your credit score has improved since applying for your existing cards, you may qualify for a balance transfer card with an introductory APR of 0% that will let you pay off these card balances interest-free for a set period of time, such as 12 to 24 months. Afterward, interest could jump to the standard rate, which is currently 22.75% on average.
Alternatively, you might opt to take out a debt consolidation loan with an 8% APR—not 0%, but lower than your current rates, and the rate stays fixed for the entire term. Average personal loan terms range from 12 to 84 months.
A loan consolidation calculator can help you estimate what monthly payments and long-term costs might be for different term options.
Types of Debt Consolidation
Because debt consolidation can be a way to manage multiple types of debt, there are several types of debt consolidation. Here are the different types of debt consolidation to meet individual borrower needs:
Debt Consolidation Loan
Debt consolidation loans are a type of personal loan that can be used to lower a borrower’s interest rate, streamline payments and otherwise improve loan terms. These personal loans are typically available through traditional banks and credit unions, but there are a number of online lenders that also specialize in debt consolidation loans.
To identify the best consolidation loans you can qualify for, take time to compare available loan terms, fees and interest rates. Many lenders offer an online loan pre-qualification process that lets borrowers see what interest rate they may qualify for based on a soft credit check, which should be your first step when getting a debt consolidation loan.
While some lenders offers debt consolidation loans for bad credit, working on your credit before applying can help you land a lower rate to save you money and help you pay off debt faster.
Credit Card Balance Transfer
A credit card balance transfer occurs when a borrower takes out a new credit card—preferably with a low introductory interest rate—and transfers all of his existing balances to the new card.
As with other types of debt consolidation, this results in a single payment to remember, can lower the borrower’s monthly credit card payment and may reduce the overall cost of the debt by lowering the interest rate—possibly to 0%, depending on the card you qualify for.
When deciding between a balance transfer or personal loan to consolidate, consider available interest rates, applicable fees, transfer deadlines and consequences of missing a payment. The best credit card consolidation loans clearly outline fees and interest rates so you can compare options.
Student Loan Consolidation
Student loan consolidation is the process of combining multiple federal student loans into a single, government-backed loan. In addition to lowering and simplifying their monthly payments, graduates may be able to take advantage of borrower protections like Public Service Loan Forgiveness (PSLF).
Home Equity Loan
Consolidating debt with a home equity loan involves taking out a loan that is secured by the borrower’s equity in their home. The money is issued in a lump sum and the borrower can use the cash to pay off—or consolidate—existing debts.
Once funds are dispersed, the borrower must pay interest on the entire loan amount, but—because the loan is collateralized by their home—interest may be much lower than what’s available with a debt consolidation loan.
Cash-out Mortgage Refinance
A cash-out refinance occurs when a borrower refinances a mortgage for more than the outstanding balance of the loan. This enables the borrower to withdraw the difference in cash and use it to pay off other outstanding debts.
The borrower can then roll their other debt payments into a single payment with his mortgage. And, because the loans are rolled into a secured mortgage, the interest rate is likely much lower than on the original debts.
When choosing between a home equity loan or cash-out refinance, consider fees and understand that if you can’t pay back a loan backed by your house, the lender could foreclose on your own.
When To Consider a Debt Consolidation Loan
Your credit score and whether you’re taking other steps to improve your financial habits typically determine if debt consolidation is a good idea. Debt consolidation may be a good idea if:
- You’re committed to paying off the full amount of your debt under a consolidated loan.
- Your cash flow is sufficient to cover all of your debt payments.
- You’re comfortable paying off your loans over a longer period of time—or you’re prepared to make early payments.
- Your credit score has improved since you took out your original loans, so you’re likely to qualify for a more competitive interest rate.
- You have a plan in place to avoid running up your debts again.
Alternatively, debt consolidation may not be the best option if:
- You’re not ready to take additional steps to pay off your debts.
- You don’t have a plan for avoiding new debts.
- You won’t be able to cover the new monthly payment on your debt consolidation loan.
- Your outstanding debt could be paid off in under a year, so you wouldn’t save a significant amount through consolidation.
- You’re willing to, instead, eliminate your individual debts with a debt snowball or debt avalanche approach.
It’s important to consider the pros and cons of debt consolidation before committing. Debt consolidation can make debt easier to manage by streamlining balances, lowering payments and expediting payoff. However, loans may have consolidation fees, higher interest rates and debt could return if you don’t change your spending habits.
What Is Debt Consolidation?
Debt consolidation is the process of paying off multiple debts with a new loan or balance transfer credit card—often at a lower interest rate.
The process of consolidating debt with a personal loan involves using the proceeds to pay off each individual loan. While some lenders offer specialized debt consolidation loans, you can use most standard personal loans for debt consolidation. Likewise, some lenders pay off loans on behalf of the borrower, while others disburse the proceeds so the borrower can make the payments themselves.
With a balance transfer credit card, qualified borrowers typically get access to a 0% introductory APR for a period between six months and two years. The borrower can identify the balances they want to transfer when opening the card or transfer the balances after the provider issues the card.
How Does Debt Consolidation Work?
Debt consolidation works by merging all of your debt into one loan. Depending on the terms of your new loan, it could help you get a lower monthly payment, pay off your debt sooner, increase your credit score or simplify your financial life.
Debt consolidation is a three-step process:
- Take out a new loan
- Use the new loan to pay off your old debts
- Pay off the new loan
For example, let’s say you have $20,000 in credit card debt split among three different cards, each with an interest rate above 20%. If you take out a $20,000 personal loan with an interest rate of 10% and a five-year term length, you could pay off that debt faster and save money on interest.
Is Debt Consolidation a Good Idea?
Debt consolidation is usually a good idea for borrowers who have several high-interest loans. However, it may only be feasible if your credit score has improved since applying for the original loans. If your credit score isn’t high enough to qualify for a lower interest rate, it may not make sense to consolidate your debts.
You may also want to think twice about debt consolidation if you haven’t addressed the underlying problems that led to your current debts, like overspending. Paying off multiple credit cards with a debt consolidation loan is not an excuse to run up the balances again, and it can lead to more substantial financial issues down the line.
Pros of Debt Consolidation
Consolidating your debt can have a number of advantages, including faster, more streamlined payoff and lower interest payments.
1. Streamlines Finances
Combining multiple outstanding debts into a single loan reduces the number of payments and interest rates you have to worry about. Consolidation can also improve your credit by reducing the chances of making a late payment—or missing a payment entirely. And, if you’re working toward a debt-free lifestyle, you’ll have a better idea of when all of your debt will be paid off.
2. May Expedite Payoff
If your debt consolidation loan is accruing less interest than the individual loans would, consider making extra payments with the money you save each month. This can help you pay off the debt earlier, thereby saving even more on interest in the long run. Keep in mind, however, that debt consolidation typically leads to more extended loan terms—so you’ll have to make a point of paying your debt off early to take advantage of this benefit.
3. Could Lower Interest Rate
If your credit score has improved since applying for other loans, you may be able to decrease your overall interest rate by consolidating debts—even if you have mostly low-interest loans. Doing so can save you money over the life of the loan, especially if you don’t consolidate with a long loan term. To ensure you get the most competitive rate possible, shop around and focus on lenders that offer a personal loan pre-qualification process.
Remember, though, that some types of debt come with higher interest rates than others. For example, credit cards generally have higher rates than student loans. Consolidating multiple debts with a single personal loan can result in a rate that is lower than some of your debts but higher than others. In this case, focus on what you’re saving as a whole.
4. May Reduce Monthly Payment
When consolidating debt, your overall monthly payment is likely to decrease because future payments are spread out over a new and, perhaps extended, loan term. While this can be advantageous from a monthly budgeting standpoint, it means that you could pay more over the life of the loan, even with a lower interest rate. A loan consolidation calculator can help you estimate your monthly payments.
5. Can Improve Credit Score
Applying for a new loan may result in a temporary dip in your credit score because of the hard credit inquiry. However, debt consolidation can also improve your score in a number of ways. For example, paying off revolving lines of credit, like credit cards, can reduce the credit utilization rate reflected in your credit report. Ideally, your utilization rate should be under 30%, and consolidating debt responsibly can help you accomplish that. Making consistent, on-time payments—and, ultimately, paying off the loan—can also improve your score over time.
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Cons of Debt Consolidation
A debt consolidation loan or balance transfer credit card may seem like a good way to streamline debt payoff. That said, there are some risks and disadvantages associated with this strategy.
1. May Come With Added Costs
Taking out a debt consolidation loan may involve additional fees like origination fees, balance transfer fees, closing costs and annual fees. When shopping for a lender, make sure you understand the true cost of each debt consolidation loan before signing on the dotted line.
2. Could Raise Your Interest Rate
If you qualify for a lower interest rate, debt consolidation can be a smart decision. However, if your credit score isn’t high enough to access the most competitive rates, you may be stuck with a rate that’s higher than on your current debts. This may mean paying origination fees, plus more in interest over the life of the loan.
3. You May Pay More In Interest Over Time
Even if your interest rate goes down when consolidating, you could still pay more in interest over the life of the new loan. When you consolidate debt, the repayment timeline starts from day one and may extend as long as seven years. Your overall monthly payment may be lower than you’re used to, but interest will accrue for a longer period of time.
To sidestep this issue, budget for monthly payments that exceed the minimum loan payment. This way, you can take advantage of the benefits of a debt consolidation loan while avoiding the added interest.
4. You Risk Missing Payments
Missing payments on a debt consolidation loan—or any loan—can cause major damage to your credit score; it may also subject you to added fees. To avoid this, review your budget to ensure you can comfortably cover the new payment. Once you consolidate your debts, take advantage of autopay or any other tools that can help you avoid missed payments. And, if you think you may miss an upcoming payment, communicate that to your lender as soon as possible.
5. Doesn’t Solve Underlying Financial Issues
Consolidating debt can simplify payments but it doesn’t address any underlying financial habits that led to those debts in the first place. In fact, many borrowers who take advantage of debt consolidation find themselves in deeper debt because they didn’t curb their spending and continued to build debt. So, if you’re considering debt consolidation to pay off multiple maxed-out credit cards, first take time to develop healthy financial habits.
6. May Encourage Increased Spending
Similarly, paying off credit cards and other lines of credit with a debt consolidation loan may create the illusion of having more money than you actually have. It’s easy for borrowers to fall into the trap of paying off debts, only to find their balances have climbed once again.
Make a budget to reduce spending and stay on top of payments so you don’t end up racking up more debt than you started with.
When Should I Consolidate My Debt?
Debt consolidation can be a wise financial decision under the right circumstances—but it’s not always your best bet. Consider consolidating your debt if you have:
- A large amount of debt. If you have a small amount of debt you can pay off in a year or less, debt consolidation is likely not worth the fees and credit check associated with a new loan.
- Additional plans to improve your finances. While you can’t avoid some debts—like medical loans—others are the result of overspending or other financially dangerous behavior. Before consolidating your debt, evaluate your habits and come up with a plan to get your finances under control. Otherwise, you may end up with even more debt than you had before consolidating.
- A credit score high enough to qualify for a lower interest rate. If your credit score has increased since taking out your other loans, you’re more likely to qualify for a debt consolidation rate that’s lower than your current rates. This can help you save on interest over the life of the loan.
- Cash flow that comfortably covers monthly debt service. Only consolidate your debt if you have enough income to cover the new monthly payment. While your overall monthly payment may go down, consolidation is not a good option if you’re currently unable to cover your monthly debt service.
How To Get a Debt Consolidation Loan
Qualifying for a personal loan for debt consolidation can be simple and straightforward, especially if you have a good income and a solid credit history. Here’s how to do it:
- Check your credit. Check your credit score and reports from all three major bureaus. Fix any errors that could negatively affect your credit score, and use your credit score to help inform which loans you can qualify for. Even if your credit is low, there are lenders that offer debt consolidation loans for bad credit.
- Gather your loan application documents. This can speed up your loan application process since most lenders require the same documents. You’ll need your most recent pay stubs, W-2s, bank statements and tax returns, among others.
- Get a payoff estimate from your current lenders. For any debt that you’ll be consolidating, you’ll generally need a current debt payoff statement that includes your remaining balance, plus any interest that has accrued since your last payment.
- Shop around for rates. Look for the best rates available to you, both online and in person. Prequalify, if possible, to see which rates you may receive without impacting your credit score.
- Submit your application. Choose the best option and complete your loan application. Quickly respond to the lender if they need any additional information.
- Receive the loan funds. If approved, your lender will contact you about how your loan funds are disbursed. Some lenders pay off your old creditors for you while others require that you do it yourself.
Highlights:
- Debt consolidation is a debt management strategy that combines your outstanding debt into a new loan with a single monthly payment.
- There are several ways to consolidate debt. What works best for you will depend on your specific financial circumstances.
- Weigh the pros and cons of debt consolidation and how it might affect your credit scores to decide whether it’s the right path for you.
If you’re struggling to pay off multiple debts simultaneously, you might consider debt consolidation. Consolidation can be an extremely useful repayment strategy — provided you understand the ins, the outs and how the process could impact your credit scores.
What is debt consolidation?
Debt consolidation is a debt management strategy that combines your outstanding debt into a new loan with just one monthly payment. You can consolidate multiple credit cards or a mix of credit cards and other loans such as a student loan or a mortgage. Consolidation does not automatically erase your debt, but it does provide some borrowers with the tools they need to pay back what they owe more effectively.
The goal of consolidation is twofold. First, consolidation condenses multiple monthly payments, often owed to different lenders, into a single payment. Second, it can make repayment less expensive. By combining multiple balances into a new loan with a lower interest rate, you can reduce cumulative interest, which is the sum of all interest payments made over the life of a loan.
Debt consolidation loans often feature lower minimum payments, saving you from the financial consequences of missed payments down the line. In short, you’ll generally spend less on interest and pay off what you owe more quickly.
Types of debt consolidation
There are several ways to consolidate debt. What works best for you will depend on your specific financial circumstances. These include:
Debt consolidation loan. The most common of these are personal loans known simply as debt consolidation loans. Frequently used to consolidate credit card debt, they come with lower interest rates and better terms than most credit cards, making them an attractive option. Debt consolidation loans are unsecured, meaning the borrower doesn’t have to put an asset on the line as collateral to back the loan. However, borrowers will only be offered the best interest rates and other favorable loan terms if they have good credit scores.
Home equity loan or home equity line of credit. For homeowners, it’s also possible to consolidate debt by taking out a home equity loan or home equity line of credit (HELOC). However, these types of secured loans are much riskier to the borrower than a debt consolidation plan, since the borrower’s home is used as collateral and failure to pay may result in foreclosure.
401 (k) loan. You can also borrow against your 401(k) retirement account to consolidate debts. Although 401 (k) loans don’t require credit checks, dipping into your retirement savings is a dangerous prospect, and you stand to lose out on accumulating interest.
Consolidation can certainly be a tidy solution to repaying your debt, but there are a few things to know before you take the plunge.
Debt consolidation loans and your credit scores
Before you’re approved for a debt consolidation loan, lenders will evaluate your credit reports and credit scores to help them determine whether to offer you a loan and at what terms.
High credit scores mean you’ll be more likely to qualify for a loan with favorable terms for debt consolidation. Generally, borrowers with scores of 740 or higher will receive the best interest rates, followed by those in the 739 to 670 range.
If your credit score is lower than 670, debt consolidation may not be a good option for you. Consolidating debt when you have bad credit can be challenging. Although you may be approved for a loan, the interest rates offered to you will likely be high and may negate the savings you hoped to achieve by consolidating your debt.
It’s also important to understand that debt consolidation involves taking out a new loan. As with any other type of loan, the application process and the loan itself can affect your credit scores. Weigh the pros and cons of debt consolidation and how it might affect your credit scores to decide whether it’s the right path for you.
Pros
- Credit Utilization. Your credit utilization ratio, the amount of revolving credit you’re using divided by the total credit available to you, contributes to your credit scores. Lenders interpret high credit utilization ratios (usually above 30%) as an indicator of risk. So, if you have several credit cards open and each is carrying a large balance, your credit utilization ratio will be high, which typically translates to lower credit scores. However, credit cards and personal loans are considered two separate types of debt when assessing your credit mix, which accounts for 10% of your FICO credit score. So if you consolidate multiple credit card debts into one new personal loan, your credit utilization ratio and credit score could improve.
- Payment History. If you have been struggling with high-interest debt, you already know that missed payments can quickly drag down your credit scores. Debt consolidation offers a solution: if you are able to obtain lower interest rates and lower payments, then it may be easier to meet your monthly obligation and avoid a negative hit to your credit scores.
Cons
- Hard Inquiries. When you apply for loans, including those for debt consolidation, potential lenders review your credit reports, which generates what’s known as a hard inquiry. Hard inquiries help lenders track how often you apply for new credit accounts. Each new inquiry may knock your credit scores down a few points, so you’ll want to be sure that you only apply for loans for which you’re likely to be approved.
- Newer Accounts. The average age of your accounts has a big impact on your credit scores. Opening a new account will lower the average age of your accounts, and you might see a corresponding drop in your credit scores. Closing credit accounts that have been paid off will generally have the same effect.
Alternatives to debt consolidation
Consolidation isn’t the only option for debtholders looking for relief. Consider these alternatives:
Debt management plans. Some non-profit credit counseling services offer debt management programs, where counselors work directly with the creditor to secure lower interest rates and monthly payments. This approach may help you avoid taking out a new loan, but there’s a catch. You’ll also lose the ability to open new credit accounts as long as the debt management plan is in place.
Credit card refinancing. Credit card refinancing involves transferring your debt onto a new balance transfer credit card with an interest rate as low as 0%. This introductory rate is only temporary, however, and these kinds of cards are difficult to get without good credit scores.
Bankruptcy. Filing for bankruptcy is a legal process for individuals and businesses that find themselves unable to pay their debts. During bankruptcy proceedings, a court examines the filer’s financial situation, including their assets and liabilities. If the court finds that the filer has insufficient assets to cover what they owe, it may rule that the debts be discharged, meaning the borrower is no longer legally responsible to pay them back.
While bankruptcy can be a good choice in some extreme situations, it’s not an easy way out. Bankruptcy proceedings will have a severe impact on your credit scores and can remain on your credit reports for up to 10 years after you file. Bankruptcy should generally only be considered as a last resort.
Juggling multiple debts can be overwhelming, but it’s important not to let those bills pile up. With a few deep breaths and some careful consideration, finding a strategy for debt management that keeps your credit healthy is well within your reach.