Debt Consolidation

What Is Debt Consolidation?

Debt consolidation refers to the act of taking out a new loan to pay off other liabilities and consumer debts. Multiple debts are combined into a single, larger debt, such as a loan, usually with more favorable payoff terms — a lower interest rate, lower monthly payment, or both. Debt consolidation can be used as a tool to deal with student loan debt, credit card debt, and other liabilities.

How Debt Consolidation Works

Debt consolidation is the process of using different forms of financing to pay off other debts and liabilities. If you are saddled with different kinds of debt, you can apply for a loan to consolidate those debts into a single liability and pay them off. Payments are then made on the new debt until it is paid off in full.

Most people apply through their bank, credit union, or credit card company for a debt consolidation loan as their first step. It's a good place to start, especially if you have a great relationship and payment history with your institution. If you’re turned down, try exploring private mortgage companies or lenders.

Creditors are willing to do this for several reasons. Debt consolidation maximizes the likelihood of collecting from a debtor. These loans are usually offered by financial institutions such as banks and credit unions, but there are other specialized debt consolidation service companies that provide these services to the general public.

Debt settlement vs. debt consolidation

An important point to note is that debt consolidation loans don’t erase the original debt. Instead, they simply transfer a consumer's loans to a different lender or type of loan. For actual debt relief or for those who don't qualify for loans, it may be best to look into a debt settlement rather than, or in conjunction with, a debt consolidation loan.

Debt settlement aims to reduce a consumer's obligations rather than the number of creditors. Consumers can work with debt-relief organizations or credit counseling services. These organizations do not make actual loans but try to renegotiate the borrower’s current debts with creditors.

To consolidate debts and save money, you’ll need good credit to qualify for a competitive interest rate.

Types of Debt Consolidation

There are two broad types of debt consolidation loans: secured and unsecured loans. Secured loans are backed by one of the borrower’s assets, such as a house or a car. The asset, in turn, works as collateral for the loan.

Unsecured loans, on the other hand, are not backed by assets and can be more difficult to obtain. They also tend to have higher interest rates and lower qualifying amounts. With either type of loan, interest rates are still typically lower than the rates charged on credit cards. And in most cases, the rates are fixed, so they do not vary over the repayment period.

There are several ways you can lump your debts together by consolidating them into a single payment. Below are a few of the most common.

Debt consolidation loans

Many lenders — traditional banks and peer-to-peer lenders — offer debt consolidation loans as part of a payment plan to borrowers who have difficulty managing the number or size of their outstanding debts. These are designed specifically for consumers who want to pay down multiple, high-interest debts.

Credit cards

Another method is to consolidate all your credit card payments into a new credit card. This new card can be a good idea if it charges little or no interest for a set period of time. You may also use an existing credit card's balance transfer feature — especially if it offers a special promotion on the transaction.

Home equity loans or home equity lines of credit (HELOCs) can also be used for debt consolidation.

Student loan programs

The federal government offers several consolidation options for people with student loans, including direct consolidation loans through the Federal Direct Loan Program. The new interest rate is the weighted average of the previous loans. Private loans don't qualify for this program, however.

Advantages and Disadvantages of Consolidation Loans

If you are considering a debt consolidation loan there are advantages and disadvantages to consider.

Advantages

Debt consolidation is a great tool for people who have multiple debts with high-interest rates or monthly payments — especially for those who owe $10,000 or more. By negotiating one of these loans, you can benefit from a single monthly payment in lieu of multiple payments, not to mention a lower interest rate.

And as long as you don't take out any additional debt, you can also look forward to becoming debt-free sooner. Going through the debt consolidation process can cut down calls or letters from collection agencies, provided the new loan is kept up to date.

Disadvantages

Although the interest rate and monthly payment may be lower on a debt consolidation loan, it's important to pay attention to the payment schedule. Longer payment schedules mean paying more in the long run. If you consider consolidation loans, speak to your credit card issuer(s) to find out how long it will take to pay off debts at their current interest rate and compare that to the potential new loan.

There's also the potential loss of special provisions on school debt, such as interest rate discounts and other rebates. Consolidating debt can cause these provisions to disappear. Those who default on consolidated school loans usually have their tax refunds garnished and may even have their wages attached, for example.

Debt consolidation services often charge hefty initial and monthly fees. And you may not need them. You can consolidate debt on your own for free with a new personal loan from a bank or a low-interest credit card.

Debt Consolidation and Credit Scores

A consolidation loan may help your credit score down the road. Paying off the loan's principal portion sooner can keep interest payments low, which means less money out of your pocket. This, in turn, can help boost your credit score, making you more attractive to future creditors.

At the same time, rolling over existing loans into a brand new one may initially have a negative impact on your credit score. That's because credit scores favor longer-standing debts with longer, more-consistent payment histories.

Also, closing out old credit accounts and opening a single new one may reduce the total amount of credit available, raising your debt-to-credit utilization ratio.

Requirements for Debt Consolidation

Borrowers must have the income and creditworthiness necessary to qualify, especially if you're going to a brand new lender. Although the kind of documentation you'll need often depends on your credit history, the most common pieces of information include a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.

Once you get your debt consolidation plan in place, you should consider who you'll pay off first. In a lot of cases, this may be decided by your lender, who may choose the order in which creditors are repaid. If not, pay off your highest-interest debt first. However, if you have a lower-interest loan that is causing you more emotional and mental stress than the higher-interest ones (such a personal loan that has strained family relations), you may want to start with that one instead.

Once you pay off one debt, move the payments to the next set in a waterfall payment process until all your bills are paid off.

Examples of Debt Consolidation

Say you have three credit cards and owe a total of $20,000 at a 22.99% annual rate compounded monthly. You would need to pay $1,047.37 a month for 24 months to bring the balances down to zero. This works out to $5,136.88 paid in interest alone over time.

If you consolidated those credit cards into a lower-interest loan at an 11% annual rate compounded monthly, you would need to pay $932.16 a month for 24 months to bring the balance to zero. This works out to paying $2,371.84 in interest. The monthly savings would be $115.21, and a savings of $2,765.04 over the life of the loan.

Even if the monthly payment stays the same, you can still come out ahead by streamlining your loans. Say you have three credit cards that charge a 28% annual percentage rate (APR). Your cards are maxed out at $5,000 each and you're spending $250 a month on each card's minimum payment. If you were to pay off each credit card separately, you would spend $750 each month for 28 months and you would end up paying a total of around $5,441.73 in interest.

Consolidating three credit cards into one low-interest loan

Loan Details

Credit Cards (3)

Consolidation Loan

Interest %

Payments

Bills Paid/Month

Principal

$15,000 ($5,000 * 3)

Interest

$5,441.73($1,813.91*3)

$1,820.22($606.74*3)

However, if you transfer the balances of those three cards into one consolidated loan at a more reasonable 12% interest rate and you continue to repay the loan with the same $750 a month, you'll pay roughly one-third of the interest — $1,820.22 — and you can retire your loan five months earlier. This amounts to a total savings of $7,371.51 — $3,750 for payments and $3,621.51 in interest.