How Does Debt Consolidation Work?

Americans are no strangers to debt as most of us have credit card balances, student loans, a mortgage or maybe a little of everything.

We all do our best to pay those loans back, but sometimes making loan payments can feel like a game of debt whack-a-mole, funneling money toward multiple bills with different due dates, interest rates and minimum payments. And with some debts, even when you make the minimum payment, it barely dents the actual loan balance.

It doesn’t have to be this difficult. If you feel like you’re juggling too many loans, it might be time to set the balls down and consider debt consolidation. It’s an effective way to simplify your budget, help you erase your debt faster and save a lot of money in the process.

WHAT IS DEBT CONSOLIDATION?

When you consolidate debt, you combine multiple loans into a single debt with one monthly payment.

As a result, you take high-interest debt, like credit cards or student loans, and bundle them into a loan that typically carries a lower interest rate. So, not only does debt consolidation simplify your monthly budget it could save you thousands in interest charges.

Suppose you owe $10,000 on a credit card at 15 percent interest and $5,000 on another card at 20 percent interest. Right now, you’re just paying the minimum, or about $300 a month. At that pace, you’ll eliminate your credit card debt in just over nine years and pay more than $11,600 in interest.

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With a great credit score though, you might qualify for a personal loan that covers the entire $15,000 balance at an 8 percent interest rate. You’ll still pay about $300 a month, but now you’ll wipe out your debt in just five years and save yourself over $8,000 in interest.

WHAT ARE DEBT CONSOLIDATION TECHNIQUES? 

Consolidating with a loan. When you take out a debt consolidation or personal loan, you borrow all the money you need to pay off every outstanding balance. Then, instead of paying multiple creditors, you only pay the provider of that consolidation loan.

Consolidating with credit. Typically, paying credit card debt with another credit card is a risky strategy. However, some providers offer an interest-free promotional rate, typically for a year, if you transfer loan balances to their card. You’ll want to pay the whole balance during that introductory period before interest rates spike to normal levels. Also, watch out for balance transfer fees.

You could also work with a bank to get a personal line of credit. The bank gives you approval to access a certain amount of money, and you only pay interest on the amount you utilize. You don’t have to put up collateral for the money, but you’ll need to have a good credit score for approval.

Consolidating with home equity. Alternatively, you can tap into equity you’ve built in your home with a cash-out refinance or home equity line of credit (HELOC).

With a cash-out refinance you get a new loan based on the value of your home. The proceeds will first pay off your existing mortgage balance, but any remaining funds can be used as you wish. This results in a new mortgage — including closing costs — that might have different terms than your original mortgage. 

You can also take out a home equity loan, in which your equity serves as collateral for the lender. It’s essentially a second mortgage with its own repayment terms.

WHAT SHOULD I KNOW BEFORE CONSOLIDATING MY DEBT?

While consolidation has some real advantages, keep a few things in mind:

You need to qualify. The best consolidation options and lending terms require good credit and steady income. Plus, even if you do qualify, there’s no guarantee that you’ll get a better interest rate.

Consolidating costs money. You may have to pay for the privilege of consolidation through refinancing fees, closing costs, balance transfer fees, loan origination fees and more. Look at the total cost before consolidating to ensure you’re coming out ahead.

You may be in debt longer. Some consolidation loans ease the burden of monthly payments by extending the term of the loan. That may be a good option for you, but keep in mind that you’ll continue paying interest for all those extra years that you have your loan.

Be careful with secured debt. Credit card debt isn’t tied to any of your assets. But moving that debt to your home, for instance, means that if you can’t pay the loan back, the bank can take your home.

Overall, it’s always good to explore ways to get out of debt faster and cheaper. Debt consolidation can be an effective way to do that. However, there are pros and cons to each strategy. If you’re feeling a little unsure about next steps, a financial advisor can help you develop a solution that improves your financial health without exposing you to unnecessary risks.