How does debt consolidation work?

Types of debt consolidation

Debt consolidation is a common practice for people who have several debts to pay off at high interest rates, and there are many ways to do it:

• Balance transfer: Balance transfer credit cards offer a 0% annual percentage rate (APR) on consolidated debt for up to 21 months. That said, these cards usually charge a balance transfer fee equal to 3% to 5% of the transferred debt amount. Furthermore, intro offers don't last forever, and the card's APR will reset to a variable APR once the introductory offer ends.
• Debt consolidation loan: Debt consolidation loans are personal loans with fixed interest rates, fixed monthly payments and a set repayment schedule that will not change. Personal loans for debt consolidation tend to be popular, since their rates are usually much lower than the variable purchase interest rates credit cards charge.
• Line of credit: Lines of credit can also be popular for debt consolidation, provided the rate is lower than the average rate you’re paying on other debt. Like credit cards and personal loans, lines of credit can be unsecured with no requirement for collateral.
• Home equity loan: Home equity loans let you use part of your home equity as collateral, at which point you can access a lump sum of money and pay it off with a low interest rate and within a set repayment term.
• 401(k) loan: A 401(k) loan makes it possible to borrow from your 401(k) retirement plan if your employer allows it. These loans charge interest even though you're borrowing from your own assets, and the interest you pay goes back into your 401(k). Also, any unpaid amounts become a distribution to you, and you may owe the balance of the loan in full if you leave your job.
• Cash-out mortgage refinance: A cash-out mortgage refinance lets you access some of the built-up equity in your house while also refinancing your home loan. Ultimately, this type of loan lets you take out a mortgage in a larger amount and get the difference back in cash.
• Student loan consolidation: If you have student loan debt, you can refinance your loans into one new student loan with better rates and terms. Private lenders allow you to refinance both federal and private student loans into a new loan product. Or you can use a Direct Consolidation Loan if you’d like to consolidate federal loans only.

How do debt consolidation loans work?

Debt consolidation can help you accomplish a number of goals, or even several at once. For example, if you’re paying exceptionally high interest rates across several debts, you may be able to reduce the number of bills you pay, score a lower monthly payment and save money on interest all at once.

How does debt consolidation work? Consider the following example where we imagine someone has three credit cards with the following balances:

• $2,500 in debt at 16% APR with a monthly payment of $50
• $3,000 in debt at 18% APR with a monthly payment of $60
• $3,500 in debt at 21% APR with a monthly payment of $70

With the individual's current debt load of $9,000, they're forking over $180 per month toward three different credit card payments. If they stay the course and pay only these minimum payments until their debts are paid off, they will ultimately pay $8,603 in interest until all three debts are paid off in 116 months.

Now let's say they consolidate this debt with a 24-month personal loan at 11.23%, which is the average rate across personal loans with this term as of November 2022, according to the Board of Governors of the Federal Reserve System. If they were able to afford it, they could begin repaying the new personal loan with a monthly payment of $421 and become entirely debt-free after 24 months. Over that time, they would only pay $992 toward interest.

Or, if they qualified for a 48-month debt consolidation loan with the same rate, they could pay just $234 per month and become debt-free over that timeline. Over the course of four years, they would fork over $2,096 in interest payments.

Finally, let's say the same person decided to consolidate debt with a balance transfer card that offers 0% APR for 21 months. If their card charged a balance transfer fee of 3%, they would begin the debt repayment process owing $9,270. Provided they were able to pay $442 per month toward their debt, they could become entirely debt-free within 21 months with no additional cost other than the $270 balance transfer fee.

Pros and cons of debt consolidation

Debt consolidation can be a way to reduce your interest payments and get out of debt faster. But there are a few advantages and disadvantages you should consider before committing to debt consolidation as your best option.

Pros:

• Pay less in interest (with the right product): As you can see from the examples we shared above, debt consolidation can drastically lower interest costs when you qualify for a new loan or credit card with better rates and terms.
• Simplify your payments: Certified financial education instructor (CFEI) Patrick Di Cesare, who gives basic financial literacy tips on Instagram and TikTok, says debt consolidation can make sense if you’re having trouble keeping up with multiple debts. "Consolidating them can simplify your finances by combining everything into one payment instead of having to track many different debts," he said.
• Pay down debt faster: Di Cesare adds that debt consolidation has the potential to help you pay down debt faster, especially if you are dealing with high-interest credit card debt. When you get to pay down debt at 0% APR, for example, you're reducing the principal balance dollar for dollar with each payment you make.

Cons:

• Fees: We already mentioned that balance transfer credit cards charge fees for the privilege of debt consolidation. But Di Cesare adds that many debt consolidation loans also carry hefty fees for late or missed payments. Some charge origination fees, too.
• Higher interest costs over time: Di Cesare says that, in some cases, debt consolidation can cost more money over the long term. "Your monthly payment may be lower, but dragging out the length of the loan will cause you to pay more overall," he said.
• Good credit required: Just like with other financial products, the best debt consolidation loans and credit cards require good credit. If you have poor credit or no credit, you won't qualify for debt consolidation products with the best rates and terms.

What to look for in a debt consolidation loan

If you're in the market for any type of debt consolidation product, Di Cesare, the CFEI, says the most important factor to look for is a lower interest rate than the one you're paying on your debts right now. After all, the lower rate is what will help you pay less interest over time, and it can also help you score a monthly payment that better fits your budget.

Di Cesare also says to look for a reputable company with a history of responsible lending practices, which you can do by browsing loan options and reading customer reviews on ConsumerAffairs.

In the meantime, look for a loan or balance transfer card that offers flexible repayment options, "like the ability to make extra payments or change the due date," said Di Cesare. Since your debt repayment plan may not always go exactly as you hope, it can help to have some wiggle room when it comes to making payments each month.

Finally, be aware of any fees that are charged, whether that’s a balance transfer fee to use a balance transfer credit card or an origination fee on a debt consolidation loan. Since fees you pay to consolidate debt will eat away at any savings you achieve, you should strive to minimize them.

Bottom line

Debt consolidation can be a smart move if you're sick of making multiple payments each month or you desperately want to pay less in interest. In many cases, you may get a better deal on debt repayment altogether by choosing a new loan with a lower interest rate and a monthly payment that fits better with your budget and bills.

That said, you'll want to compare debt consolidation options before you decide which move to make next.