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What is Debt Consolidation and How Does it Work?

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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. Generally, debt consolidation loans or balance transfer cards are seen as the best way to consolidate debt. Other riskier options include home equity or 401(k) loans. The goal of debt consolidation is to obtain a lower interest rate in most cases. This could allow you to pay off your 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, let's say you owe $2,000 on each of five different credit cards with interest rates varying from 17.99% to 24.99%. If you wanted to consolidate your debt—and you have excellent credit–you could take out a personal loan for $10,000 at a lower interest rate of 12%, and use that to pay off the cards and then pay off the personal loan. By consolidating these debts, you would save a lot of money.

How Does Debt Consolidation Work?

When you get a debt consolidation loan, you'll receive a lump sum to pay off your existing debts that you've decided to consolidate. This means that your outstanding debts will be paid in full and combined into this new loan with a single payment, interest rate and loan term. This means that you can focus on paying down this one debt rather than having to pay different loan bills each month. And if you have a good credit score, you may qualify for a debt consolidation interest rate that is lower than what you're currently paying.

With debt consolidation, you are able to combine different types of debts, including credit cards, utility bills, payday loans, student loans, taxes, medical bills and other loan types. If you are applying for debt consolidation, be sure to get your credit score as high as you can to qualify for a low interest rate. Also, when you apply, there will be a hard credit check on your credit, which will lower your score temporarily, making it harder to qualify for other things that require a credit check.

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 for debt consolidation, 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 they aren’t secured by collateral, so the lender can't repossess your physical property, such as your car or 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. This will allow you to transfer your debt balances and pay 0% APR up until the promotional period ends, meaning that if you pay off your debt by then, you won't pay any interest. Of course, if you don't pay off the balances that you transferred before the promotional period ends, you'll have to either pay the higher interest rate on the balance or transfer the remaining balance to a new promotional 0% APR balance transfer card to avoid the interest rate.

401(k) loan: Using a 401(k) loan for debt consolidation 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 may initiate a foreclosure on your home if you default on the loan, after your first mortgage is paid off. 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.

Should I Consolidate My Debt?

Debt consolidation can be instrumental in helping you pay off your debt faster, but it can also be a huge problem if you're not prepared to stay on top of your bills. It's best to explore all your options to make sure you're getting the best deal and doing what works for your finances.

Is Debt Consolidation a Good Idea?

Debt consolidation can be a good idea, depending on your financial situation. If you have good credit but you want to simplify paying off your debts and lower your interest rate, debt consolidation can be a great option for you. However, if you are struggling to pay off your debt in general and have bad credit, consolidating may be an option for you, but you should consider talking to a certified credit counselor to help you figure out the best way to pay off your debts.

If you are going to consolidate your debt, make sure that doing so will help you effectively pay down your debt in some way, whether it will save you money, time or lengthen the period you have to pay off your debt. You don't want to burden yourself with a higher interest rate just to only have one bill each month. If you need help figuring out the cheapest option for you, use a debt consolidation calculator to help you decide.

Pros and Cons of Debt Consolidation

Debt consolidation does not work for everyone so, we've listed some of the pros and cons for those still figuring out whether it the best option for them.

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.

Alternative Ways to Pay Off Debt

If you are having trouble paying off your debt and don't think you'd be able to handle a debt consolidation loan or a balance transfer credit card by the time the promotional period is up, you should consider alternative ways to pay off your debt, including talking to a certified credit counselor. If you are in desperate need, you can also look at your debt settlement options, though we don't recommend settling your debt as it can ruin your credit score and cost a lot upfront.

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, it signals to them that you need help paying off your loans.

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.

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.

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