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What is debt consolidation and should I consolidate?

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by Barbara Friedberg Personal Finance Contributing Editor
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What is debt consolidation?

Debt consolidation is the act of consolidating multiple debts into one single monthly payment, generally for a lower total monthly payment or increased repayment term.

Debt consolidation is a way to refinance and reduce debt into a single payment at lower interest. Debt consolidation can both harm and help your credit. If you do not qualify for debt consolidation, there are several alternatives, including credit counseling, a debt management plan, borrowing from your retirement fund and negotiating debt yourself with your creditors. Combined with healthy spending habits, debt consolidation can be an effective way to reduce debt.

How does debt consolidation work?

Debt consolidation (also known as credit consolidation) is a way of refinancing and reducing debt by combining multiple debts into a single debt that carries a lower interest payment. In most cases, debt consolidation involves taking out a new loan with a fixed rate and a potentially longer repayment term. This relieves you of the hassle of paying different lenders on different dates. It also allows you to lower your monthly payment to an amount you can afford. Typically, debt consolidation companies are for-profit and charge a fee for this service.

Ease of payment should not be the only reason for consolidating your debt. Debt consolidation aims to reduce your debt through lower interest rates and easier payment terms. You can combine your debts into a single account in various ways, such as credit card balance transfers, personal loans, debt consolidation loans and home equity loans.

Does debt consolidation hurt your credit?

Anytime you take out a new line of credit, your credit score will take a slight hit due to the hard inquiry made on your credit by the lender. How much your overall score is affected by a debt consolidation loan, or any line of credit, will depend on your debt to credit utilization ratio. That is, the amount of debt you owe compared to the total credit available for you.

If your credit card has a
$1,000 LIMIT
and you’ve used $100, your
debt-to-credit ratio is 10%

The biggest potential hit to your credit when consolidating your debt comes with closing multiple accounts at once. Doing this lowers the amount of total credit you have available to you, which will impact that debt-to-credit ratio. One way to avoid this is to leave your accounts open even after you’ve paid them off. Doing this will allow your available credit to stay the same, as your overall debt decreases. If you don’t want the temptation of multiple lines of credit, you can slowly close accounts over time to limit the impact on your credit score. Closing an account will do far less damage to your credit score than repeating a cycle of debt.

What’s the best way to consolidate debt?

The best way to consolidate debt depends on your financial situation—how much debt you have, how much money you can pay every month and your credit score. These all factor into determining the best debt consolidation program for you.

The most common ways to consolidate debt are using a balance transfer credit card, taking out a personal loan and securing a home equity loan. Student loan consolidation works differently than personal debt consolidation.

Debt consolidation options

  • 0% balance transfer card: Balance transfer credit cards allow you to move the balance from multiple cards to one card. Balance transfer cards are often available for an introductory 0% APR. If you can pay off your debt within the 0% interest period, typically around 18 months, it can be a great way to pay off your debts without having to worry about drowning in interest rates.
  • Debt consolidation loan: You can take out a personal loan to consolidate debt. To do this, you would have to be approved for a personal loan through a bank or credit union, which could be difficult for those with poor credit. Once approved, you would use the loan payout to pay off all other debt and begin making one, single monthly payment on the personal loan.
    Once you get approved for a personal loan, verify that the interest rate isn’t too high. A personal loan with a high interest rate could have you paying back more than you would if you paid off each account separately.
  • Home equity loan: Home equity loans allow homeowners to take a loan out based on the value of their home. You can take out a lump sum home equity loan to pay off large expenses or debts.
  • Student loan consolidation: Student loans work a little differently. You can apply for federal or private loans for consolidation. For federal student loans, you can apply for a Direct Consolidation Loan. These loans impose an interest rate that is determined by the weighted average of the loans being consolidated. Because of this, borrowers are unlikely to save money by consolidating federal student loans, however, it can help ease the repayment burden by lengthening the repayment term.

How to consolidate debt

  1. Make a list of all your debts: The first step to taking control of your finances and consolidating debt is making a list of all your loan and credit card balances. Write down your monthly payment amounts and interest rates so that you can focus on finding a debt consolidation loan with a lower interest rate than what you're paying today.
    Many debt consolidation companies specialize in credit card debt consolidation. If you have multiple credit card payments, calculate your average interest rate so you can measure that against a single, lower interest rate loan option.
  2. Decide which debts you want to pay off: Before you decide how you want to consolidate your debts, you’ll need to choose which debts you want to consolidate. These are typically the biggest debts or the ones you are finding the most difficult to pay off.
  3. Explore your debt consolidation options: Consider the pros and cons of debt consolidation before making a decision. If you decide to consolidate your debt, there are several methods available to you. You could opt for a balance transfer card, meaning you will transfer all your remaining debt to one credit card. You can also open a home equity loan or home equity line of credit (also known as a HELOC), take out a personal loan or tap into savings. Each option comes with its own advantages and setbacks. You might also want to speak to a credit counselor, who will help you decide the best path forward for reducing your debt.
  4. Compare companies: It’s important to know how to choose a debt consolidation company that works for you. Start by comparing all of your options. The best way to choose a reputable debt consolidation company is to understand the services, fees and reputation of the firm. Look for a debt consolidation company that will take the time to get to know you and your financial situation so they can help you consolidate your debts, and eventually free you of those debts, with the best rates available. Before signing up, check reviews.
  5. Consolidate your debt and stick to a budget: Once you’ve chosen a debt consolidation company and consolidated your debt, you will need to keep up the hard work of paying off the debt. Make sure you have enough cash flow to pay off your debt bill. It’s crucial that you change your spending and saving habits to avoid falling more into debt. Debt consolidation can work if you are willing to put in the effort and discipline for the long haul. The process can take up to five years, so it’s not always a quick-fix solution, but, in many cases, debt consolidation can help consumers greatly slash or eliminate their debt.
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Debt consolidation alternatives

Debt consolidation is only a good option for reducing debt if you have the right qualifications. You must have good credit or collateral to get a low-interest rate for a loan to consolidate your debts. If you don’t qualify, you may want to consider some debt consolidation alternatives. Get to know the variety of debt relief programs available before you jump in.

  • Do-It-Yourself: You can do debt consolidation yourself if you have the discipline to pay your debt on your own. Analyze your debts, prepare a budget and make a payment plan. Contact your creditors to negotiate for lower interest rates and longer repayment terms. Line up your payment schedule, and commit to making timely payments.
  • Credit counseling: Credit counseling companies offer money and debt help along with free educational materials and workshops. You might work with them to negotiate a debt repayment plan to reduce the interest rates on your loans. Arrange to make one monthly payment that the company will use to distribute payments to your multiple creditors. Make sure to check fees and the company’s reputation in advance. Non-profit doesn’t always mean low-fee.
  • Debt management plan (DMP): Debt management is another option to consolidate debt without taking on a new loan. You will need a credit counselor who will analyze your financial situation and negotiate with your creditors to lower your interest rates. Your counselor will then discuss the process and fees of the debt management program. Again, be sure to check the fees and reputation of the debt management company.
  • Borrowing from your retirement fund: You can borrow from your retirement fund, but only use this approach as a last resort. Interest rates of 401(k) loans are typically low with just one percentage point over the prime rate. Interest payments to your 401(k) loan go back into your account. If you default on your loan, you could be slapped with high taxes and penalties. If you lose your job, you’ll be required to pay your loan in full.

Bottom line: Should I consolidate my debt?

Consolidation loans usually lengthen the repayment term, meaning you may end up paying more in the long run. However, consolidation offers the benefit of streamlining your debt repayment process and giving borrowers a sort of grace period through longer repayment terms, which can alleviate the debt burden for many.

If you want to consolidate your debt, consider a debt consolidation loan, and know whether you want it to be secured or unsecured. Speak with a credit counselor if you need additional help deciding which type of loan is right for you. A balance transfer credit card might be a good option if you need to find a way out of credit card debt. Another option for consolidating debt is a home equity loan. Carefully consider all your options, and soon you’ll be on your way to reducing or eliminating your debt.

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Profile picture of Barbara Friedberg
by Barbara Friedberg Personal Finance Contributing Editor

Barbara Friedberg, MBA, MS is a former investment portfolio manager with decades of financial experience. Friedberg taught Finance and Investments at several universities. Her work has been featured in U.S. News & World Report, Investopedia, Yahoo!Finance and many more publications.