Personal Loans
Advertiser Disclosure

Advertiser Disclosure: Some of the offers that appear on this website are from companies which ValuePenguin receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). The site does not review or include all companies or all available products.

Disclaimer: The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author's alone. For a full list of our advertisers, see our disclosure page.

Opinions, analyses, reviews, or recommendations expressed here are the author’s alone, and have not been reviewed or endorsed by the issuer. We may be compensated through the issuer’s Affiliate Program. For a full list of our advertisers, see our disclosure page.

Advertiser Disclosure

Advertiser Disclosure: Some of the offers that appear on this website are from companies which ValuePenguin receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). The site does not review or include all companies or all available products.

Disclaimer: The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author's alone. For a full list of our advertisers, see our disclosure page.

Opinions, analyses, reviews, or recommendations expressed here are the author’s alone, and have not been reviewed or endorsed by the issuer. We may be compensated through the issuer’s Affiliate Program. For a full list of our advertisers, see our disclosure page.

What is Debt Consolidation and How Does it Work?

It's easy to get yourself into debt but often much harder to dig your way out, especially if you have multiple loans and credit cards. When you have multiple payments to make every month, it's easier to slip up and miss a payment, too. Rather than coming up with a complex system to remember to pay your bills or trying to decide which loan to pay off first, you may be better off taking out a debt consolidation loan.

What is Debt Consolidation?

Debt consolidation is the process of combining multiple debts into fewer debts or a single debt, if practical. The goal of debt consolidation is obtaining a lower interest rate in most cases. This could allow you to pay off the debt faster while simplifying the number of payments you make each month. Other people may consolidate debt simply to lower their monthly payments. For instance, a person may owe $2,000 on each of five different credit cards with interest rates varying from 17.99% to 24.99%. If this person wanted to consolidate their debt and had excellent credit, they could take out a personal loan for $10,000 at a lower 12% interest rate and pay off the cards. That person would save money by paying less interest.

Types of Debt Consolidation

Usually, people consolidate debts using a personal loan or a credit card with a promotional 0% APR on balance transfers. Other options, including 401(k) loans and home equity loans, do exist but generally aren't recommended, especially if you're consolidating unsecured debt.

Personal loans. Personal loans are a common choice because they can be repaid over one to seven years and can sometimes offer lower interest rates than credit cards. Most people can qualify for a rate between 10% and 32% on a personal loan, depending on their credit. Personal loans are unsecured, just like credit cards, which means the lender can't repossess your car or foreclose on your house if you default on the loan.

Balance transfer credit card. A credit card with a promotional 0% APR on balance transfers normally offers the promotional rate for a limited period, ranging from just a few months to as long as 21 months. Of course, if you don't pay off the balances you transfer before the promotional period ends, you'll have to either pay the higher interest rate or transfer the remaining balance to a new promotional 0% APR balance transfer card.

401(k) loan. Using a 401(k) loan can be complicated and have unintended consequences if you deviate from your plan. For instance, if you lose your job while repaying your loan, you may have to pay the balance owed in full or have the remaining balance treated as a distribution, which requires paying taxes and penalties. In most cases, using a 401(k) loan to consolidate debt isn't a good idea.

Home equity loan. Home equity loans use the equity in your home to secure the debt, which means the lender can foreclose on your home if you default on the loan. You may get a lower interest rate because the loan is secured by your home. But you may end up losing your home, which isn't a risk with other debt consolidation options. For this reason, many people recommend not using a home equity loan for debt consolidation.

Pros and Cons of Debt Consolidation

Debt consolidation can be instrumental in helping you pay off your debt faster, but it can also be a huge problem if you don’t have your ducks in a row.

Pros

  • Potentially lower interest rate.
  • Fewer monthly payments to worry about.
  • You can potentially pay off debt faster.
  • Should not damage your credit.
  • Relatively easy to do on your own.

Cons

  • If you haven’t fixed the reason you got into debt, such as spending more than you earn, it could put you further into debt.
  • You have to pay off the full amount owed rather than a smaller negotiated amount.
  • Fees, such as loan origination fees or balance transfer fees, can be costly.

Debt Consolidation vs. Debt Settlement

Debt settlement is very different from debt consolidation. With debt settlement, you or a company that works on your behalf negotiates with your creditors to pay a lump sum that's less than the full amount you owe. In exchange the debt will be considered paid off in full. While paying less than you owe sounds attractive, debt settlement has many negative consequences.

In most cases, creditors won't negotiate to settle your debt if you're making at least the minimum payment on time every month, so you may be asked to quit making payments on the debts you wish to settle. This will damage your credit score in more ways than one. First, the record of your payment history, which is the biggest piece of your FICO score, will be riddled with late payments. Next, those late payments and the fact that you settled your debt will remain on your credit report for seven years, negatively impacting your credit score for much longer than most would think.

Debt settlement companies almost always charge a fee, so even if your debt is substantially reduced, there's still a cost to this process. When you're not making payments on your debt, you'll likely incur late fees, interest and even penalty APRs in some cases, which can increase the amount of debt to be settled. In most cases, you'll owe taxes on the amount of debt that is forgiven by your lender.

Debt Consolidation vs. Debt Management Plans

A debt management plan focuses on negotiating with current creditors to come up with a way to repay your debt without lowering the balance owed. Unlike debt consolidation, you won't move all of your debt to one loan. Instead, most people work with a credit counseling service, which negotiates with each individual creditor to lower your interest rate and come up with a reasonable repayment period, normally ranging from three to five years.

Once all debts are negotiated, you'll send your credit counselor a single monthly payment, which they will distribute among the creditors according to the plan. Usually, credit counseling services are not-for-profits, which means most only charge a small set-up fee and/or a small monthly maintenance fee for providing their services.

Debt management plans won't lower your credit score if you make all of your payments on time. However, when you start the process, the credit counseling agency may put a note on the account in your credit report stating you're enrolled in a debt management plan. When potential lenders see this note, they may decide not to grant you new credit while you're in a repayment period.

Also, all affected accounts will be closed when you enroll in a debt management plan, which can result in changes to your credit score that do not result from negative marks. For instance, your credit mix could be negatively affected if all of your credit cards are closed during a debt management plan.

Comments and Questions