Debt Consolidation: What Is It And How Does It Work?
While you may face tens of thousands of dollars of debt like the average American, you can take the reins of your debt with a consolidation loan. Debt consolidation puts your existing loans into a new, single loan, often with a better interest rate. This product can help you implement a more aggressive debt repayment strategy and decrease how much interest you pay over the life of the loan. Here are the details and how to tell if debt consolidation is right for you.
What Is Debt Consolidation?
Debt consolidation means taking out one loan to pay off your other debts. For example, you might consolidate student loans, credit card debt and an auto loan into one new loan. Doing so allows borrowers to roll multiple debts into one loan with a single monthly payment. Ideally, consolidation loans provide a lower interest rate and payment amount. As a result, debt consolidation is a viable strategy for getting out of debt.
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How Debt Consolidation Works
Debt consolidation allows borrowers to combine multiple debts into a single, larger loan or onto a credit card. The goal is to get better terms and a lower interest rate for more affordable monthly payments.
The first step in getting a consolidation loan is filling out an application with a lender. The lender will check your identification, credit, income and debt-to-income (DTI) ratio (the amount you owe versus the amount of income you bring in each month).
If the lender approves the consolidation, you’ll receive a new loan, usually with new terms and a new interest rate. A common type of loan for debt consolidation is a personal loan that enables you to pay off your existing debt. However, you may have numerous options for consolidating debt.
Options For Debt Consolidation
You can use several types of debt consolidation methods to reduce your payment and lower the interest rate. Here are some of the debt consolidation methods that may be available.
Debt Consolidation Loan
Debt consolidation loans are available as personal loans or home equity loans through banks, credit unions or online lenders. Borrowers use the new loan to pay off their old debts and repay the new loan over time.
Borrowers who don’t want to risk their possessions can use an unsecured personal loan. This option allows the borrower to receive a loan without tying it to their home, car, jewelry, etc.The disadvantage of this loan is that it has a higher interest rate than a secured personal loan. That said, refinancing with an unsecured loan will likely get you a lower interest rate than your current form of debt, making consolidation one of the most popular personal loan uses.
Credit Card Balance Transfer
A balance transfer moves debt from one account to another. This type of debt consolidation is typically only used for credit card debt. A balance transfer is advantageous when you obtain a new credit card with a 0% introductory annual percentage rate (APR). This way, you can transfer a balance from a credit card with an APR of 20% or more to a card that doesn’t charge interest for a guaranteed period (usually 6 – 12 months). Instead, you’ll pay a one-time transfer charge that typically ranges from 3% – 5% of the balance.
For example, say you transfer a $10,000 credit card balance from an account with an APR of 18% to a card with a 0% APR. You pay a $500 transfer fee and halt the interest charges of about $150 per month. Therefore, the transfer fee is worth the interest savings.
Home Equity Loan
A home equity loan allows you to tap into your home equity to consolidate your debt. Lenders typically allow you to borrow around 85% of the equity in your home with a home equity loan. You’ll receive a lump sum, which you pay off with a fixed interest rate based on a fixed payment schedule. Because a home equity loan is a second mortgage, you’ll put your home up as collateral for a home equity loan.
Home equity loans provide low interest rates because of the collateral required. As a result, they are suitable for debt consolidation if you’re looking to reduce your monthly payment and save money over the long haul. Remember, you can use a home equity loan with a primary or secondary home.
Home Equity Line Of Credit
A home equity line of credit (HELOC) is another type of second mortgage that allows you to borrow against the equity in your home. Your equity becomes a revolving line of credit you can tap during a span of time called the draw period. It usually lasts 5 – 10 years, and you can continue using the line of credit if you make the required minimum monthly payments.
When you reach the end of your draw period, you’ll shift to repayment mode and must make full interest and principal payments. Lenders usually require you to have at least 15% equity in your home and allow you to borrow up to 85% of your equity.
Remember, HELOCs use your house as collateral for the loan. Therefore, you could also lose your home if you stop paying on the amount you’ve borrowed. So, this type of loan benefits homeowners in a solid financial position to make their payments.
Cash-Out Refinance
A cash-out refinance provides homeowners with a lump sum based on their equity. For example, if you have a $250,000 home, and you owe $100,000, you could refinance into a $200,000 loan and use the excess to pay off your credit cards or installment debts and the closing costs of the loan. Then you could take a check home for anything extra leftover. As a result, a cash-out refinance means tapping your equity and acquiring a larger mortgage balance.
Refinancing your mortgage can give you a stockpile of cash to repay other debt and provide a lower interest rate. Remember, having an adequate amount of equity is necessary for this option.
Student Loan Refinance
Student loan refinancing consolidates your student debt. Because a student loan usually applies to one semester or year, you’ll likely finish your education with multiple student loans with various interest rates. Refinancing will put your student debt into one new loan and potentially provide you a lower interest rate.
Remember, consolidating federal student loans means they become privately held. As a result, consolidated loans aren’t eligible for government student loan forgiveness programs. So, it’s best to consolidate student loans if you know you won’t receive any type of student loan forgiveness.
How To Consolidate Your Debt
All types of debt consolidation generally require the same process. First, it’s essential to identify the loans you want to consolidate and calculate the loan size you’ll need. Then, you’ll shop around for lenders by comparing terms and interest rates from each one. Once you pick the lender that best fits your needs, you’ll apply for a consolidation loan. Typically, lenders require your credit history, personal identification, proof of residence and proof of income when you apply. In addition, they might consider your DTI, home equity and total assets.
Remember, you might have to secure the consolidation with collateral if you’re getting a personal loan. In addition, you may need to get prequalified before applying for the loan. Prequalification means the lender performs a soft credit pull to give you an estimate of the kind of loan they can offer you.
Lastly, if your lender approves the loan, you’ll receive the new consolidation loan. In addition, your old debts will go away, leaving you with one loan to pay each month.
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Is Debt Consolidation A Good Idea?
Debt consolidation requires work, time and money. Therefore, it’s best to understand how it will benefit you before applying. The following scenarios indicate when debt consolidation is a good idea:
- Your debts have high interest rates or APR. The primary benefit of debt consolidation is saving money with a better interest rate. For example, you might conduct a credit card balance transfer, as outlined above, to obtain 0% APR for a year, giving you plenty of time to pay off the debt. Similarly, you can refinance your student debt if you find interest rates significantly lower than your current rate.
- You plan on applying for a mortgage. Because lenders consider your financial circumstances when deciding to grant you a mortgage, refinancing can help strengthen your position. Specifically, refinancing a year or more ahead of your mortgage application can boost your credit and get you better rates and terms. In addition, refinancing can reduce your monthly debt load, helping you qualify for a mortgage with a lower DTI.
- You want to build a debt-free financial plan. Getting rid of debt is challenging, and refinancing can help you accomplish your goals. For example, if you want to become debt-free by a specific age, consolidating your debt can help you organize your loans into one monthly payment. This way, you’ll have a timeline for paying off debt and can make extra payments when able.
To help you understand the ins and outs of debt consolidation, consider the following summary of the pros and cons.
Debt Consolidation Pros
Here are the benefits you’ll receive by consolidating your debts:
- Simplifies debt: Debt consolidation combines multiple debts into one and makes keeping track of your obligations easier.
- Could provide a lower interest rate: Borrowers can potentially lock in a lower interest rate with debt consolidation.
Debt Consolidation Cons
Though debt consolidation can help many borrowers, there are a few downsides to consider before applying, such as:
- Origination fees: You may have to pay origination fees to consolidate your debt with a loan. This fee goes to the lender for processing your loan application.
- Interest rates could increase: Getting a new loan doesn’t guarantee a lower interest rate. Therefore, it’s crucial to understand the conditions of your consolidation, which could raise your interest rates in the future. For example, a credit card balance transfer usually has a 0% APR at first, but this rate expires after a given number of months and increases to 20% or higher.
- Could ding your credit: When getting a consolidation loan, your lender will check your credit, which may temporarily hurt your credit score.
- You may pay more: Longer repayment terms could mean you pay more over the life of the loan. Consolidation can shrink your monthly payments but at the cost of lengthening your loan term. Between interest and extra payments, you may pay thousands of dollars more than you would have if you’d tackled each debt individually instead.
- Doesn’t mean debt elimination: Ultimately, debt consolidation is not the same as getting rid of debt. You’ll still have to make debt payments, even if you’ve streamlined everything into just one payment.
Debt Consolidation FAQs
Here are the answers to some frequently asked questions about debt consolidation to round out your understanding.
Who qualifies for debt consolidation?
Those with multiple outstanding loans can qualify for debt consolidation by applying with a lender. When applying, borrowers will supply their personal and financial information to qualify for a consolidation loan.
Does debt consolidation hurt your credit score?
When you apply for debt consolidation, your lender will check your credit. This action temporarily lowers your credit score. However, making on-time payments after consolidation will help raise your score to previous or even higher levels.
How long does debt consolidation stay on your credit report?
Your debt consolidation will stay on your credit report while the loan is active. Then, once you finish paying off the consolidation loan, it will fall off your credit report after 7 years.
What’s the difference between debt consolidation and debt settlement?
Debt consolidation allows you to roll multiple debts into a single payment, while debt settlement is an agreement with the company to accept a lesser amount than what is due as negotiated. Usually this is done with an independent company. It can take 3-4 years and be costly. As a result, this is typically a last resort option for borrowers facing severe debts they do not have the ability repay.
The Bottom Line
Debt consolidation rolls multiple debts into one new debt, usually with a better term and/or interest rate or a lower monthly payment. As a result, consolidation is a helpful debt repayment tool that can help you save money and become debt-free quicker, whether you have a mountain of credit card debt or numerous student loans. In addition, you can use a personal loan, credit card balance transfer or home equity product to consolidate.
Remember, consolidation incurs origination fees and can take a few points off your credit. Plus, consolidation on its own doesn’t guarantee a lower interest rate or faster repayment. As a result, it’s best to shop for lenders and understand the details before committing to a consolidation loan.
