How Does Debt Consolidation Work?

Americans are no strangers to debt. In fact, U.S. consumer debt hit a record in the fourth quarter of last year: $17.94 trillion, according to the Fed's latest Quarterly Report on Household Debt and Credit. Credit card balances jumped $24 billion to $1.17 trillion. Add on student loans and mortgages, and you'll see that much of America has some pretty hefty monthly debt payments.

If you have a mix of debts, 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.

If you feel like you’re juggling too many debts, it might be time to set the balls down and consider a new debt management strategy: debt consolidation. While consolidating your debts can sometimes help lower your interest rates, the real benefit is that it can simplify your payments, making it easier to manage. But there are some downsides, too.

We’ll help you understand what debt consolidation is to help you decide whether this strategy should play a part in your money management.

What is debt consolidation?

When you consolidate debt, you take out a single loan and use the money to pay off multiple debts. The result is a single monthly payment when you may previously have had several.

As a result, you take high-interest debt, like for credit cards and turn it into a singular loan—hopefully one with a lower interest rate. So, not only does debt consolidation simplify your monthly budget; it could also save you thousands in interest charges.

Suppose you owe $10,000 on a credit card at 17 percent interest and $10,000 on another card at 20 percent interest. Right now, you’re just paying the minimum, or a little more than $500 a month total. At that pace, you’ll eliminate your credit card debt in just over five years—and pay over $11,000 in interest.

With a great credit score, though, you might qualify for a personal loan that covers the entire $20,000 balance at an 8 percent interest rate. If you still pay about $500 a month, now you’ll wipe out your debt in just four years and save yourself about $11,300 - $3,000 in interest.

Ways to consolidate debt

Consolidating debt with a loan

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

Consolidating debt 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. If you’re able to pay most or all of what you owe over that first year, this could be a smart strategy. (If you go this route, make sure you watch out for balance transfer fees.)

You can also reach out to your credit card company to see what you can do to get out of debt faster. By asking the right questions, you may be able to have a late fee waived, lower your APR or even get more favorable terms.

You could also work with a bank to get a personal line of credit. With this method, the bank gives you approval to access a certain amount of money, and you pay interest only 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.

What’s your credit score?

Your credit score will help lenders determine if you qualify for a loan, your credit limit and the interest rate you can expect to pay. Credit scores are three-digit numbers that typically fall within five categories ranging from poor to excellent.

Consolidating debt with home equity

Another approach is to tap into the equity you’ve built in your home with a cash-out refinance, a home equity loan or a home equity line of credit.

With a cash-out refinance, you get a new loan. The proceeds will first pay off your existing mortgage balance, and any remaining funds can be used as you wish, such as to pay off other debts. This results in a new mortgage, meaning you may wind up paying down your mortgage for longer than you originally planned (your monthly payment may also go up).

With a home equity loan, you take out a loan using the equity in your home as collateral.

Finally, you could take out a home equity line of credit, which can give you more flexibility for your budget. With this type of loan, you are approved to use a certain amount, but you can withdraw funds as you choose.

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 may cost money

When consolidating, you may have to pay 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.

Debt consolidation can temporarily lower your credit score

Like any type of loan or credit application, debt consolidation could cause your credit score to take a slight dip initially. Over the long term, you’ll find that debt consolidation does improve your credit score as you make payments and get rid of debt.

Debt consolidation may also be reflected on your credit report for up to 10 years after the loan is closed.

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 a home equity loan, 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 that are faster and less expensive. Debt consolidation can be an effective way to do that. However, there are pros and cons to each strategy.

Pros and cons of debt consolidation

Pros

• You can simplify your debt. Converting many accounts into one makes debt easier to think about and more “achievable.”
• You may be able to save money. If the interest rate of the consolidation loan is more favorable than your debt accounts, you can save money in the long term.
• It provides a way to boost your credit score. Once you pay off your debt, your credit score should improve.

Cons

• There can be fees associated with consolidating. Look for hidden fees that may make consolidation more costly than expected.
• Consolidating could give a false sense of security. While debt consolidation can help you get out of the hole, it doesn’t fix the problem that led to debt in the first place.
• You may get an unfavorable lending rate. If the interest rate for the consolidation loan is higher than your debt accounts, consolidation may not help much.

Talk to someone you trust

If you’re looking for ways to get out of debt, your financial advisor can help. Your advisor will get to know you and your values—and your pain points—to help you create a comprehensive financial plan that accounts for paying off your debt alongside other goals. Your advisor will also look for blind spots and find opportunities to grow and protect your money.

Certified Financial Planner Board of Standards Center for Financial Planning, Inc. owns and licenses the certification marks CFP^®, CERTIFIED FINANCIAL PLANNER^®, and CFP^® (with plaque design) in the United States to Certified Financial Planner Board of Standards, Inc., which authorizes individuals who successfully complete the organization’s initial and ongoing certification requirements to use the certification marks.