How Does Debt Consolidation Work?

Americans are no strangers to debt. In fact, U.S. consumer debt hit a record in the fourth quarter of last year, $16.9 trillion according to the Fed's latest Quarterly Report on Household Debt and Credit. Credit card balances jumped $61 billion to $986 billion. Add on student loans and mortgages, and many of us have some pretty hefty monthly debt payments.

If you have a mix of debts, sometimes making loan payments can feel like a game of debt whack-a-mole, funneling money toward multiple bills with different due dates, interest rates and minimum payments. And with some debts, even when you make the minimum payment, it barely dents the actual loan balance.

It doesn’t have to be this difficult. If you feel like you’re juggling too many loans, it might be time to set the balls down and consider debt consolidation. While consolidating your debts can sometimes help lower your interest rates, the real benefit is that it can simplify your payments, making it easier to manage.

What is debt consolidation?

When you consolidate debt, you take out a single loan and use the money to pay off multiple debts. The result is a single monthly payment where you may previously have had several.

As a result, you take high-interest debt, like credit cards or student loans, and bundle them into a single loan, hopefully one that carries a lower interest rate. So, not only does debt consolidation simplify your monthly budget; it could also save you thousands in interest charges.

Suppose you owe $10,000 on a credit card at 17 percent interest and $10,000 on another card at 20 percent interest. Right now, you’re just paying the minimum, or a little more than $500 a month total. At that pace, you’ll eliminate your credit card debt in just over five years — and pay about $11,000 in interest.

With a great credit score, though, you might qualify for a personal loan that covers the entire $20,000 balance at an 8 percent interest rate. If you still pay about $500 a month, now you’ll wipe out your debt in just four years and save yourself about $6,500 in interest.

Ways to consolidate debt

Consolidating debt with a loan

When you take out a debt consolidation or personal loan, you borrow all the money you need to pay off multiple outstanding balances. Then, instead of paying multiple creditors, you pay only the provider of that consolidation loan.

Consolidating debt with credit

Typically, paying credit card debt with another credit card is a risky strategy. However, some providers offer an interest-free promotional rate, typically for a year, if you transfer loan balances to their card. If you’re in a position to pay most or all of what you owe over that first year, this may be a smart strategy. (If you go this route, make sure you watch out for balance transfer fees.)

You could also work with a bank to get a personal line of credit. The bank gives you approval to access a certain amount of money, and you pay interest only on the amount you utilize. You don’t have to put up collateral for the money, but you’ll need to have a good credit score for approval.

Consolidating debt with home equity

Alternatively, you can tap into equity you’ve built in your home with a cash-out refinance, a home equity loan or a home equity line of credit.

With a cash-out refinance you get a new loan. The proceeds will first pay off your existing mortgage balance, and any remaining funds can be used as you wish, such as to pay off other debts. This results in a new mortgage, meaning you may wind up paying longer than you originally planned, paying more on a monthly basis, or both. 

Alternatively, you can take out a home equity loan, in which your equity serves as collateral for the lender. It’s essentially a second mortgage with its own repayment terms.

Finally, you could take out a home equity line of credit. With this type of loan, you are approved to use a certain amount, but you can draw funds as you choose. Repayment is also more flexible for a certain period of time.

What should I know before consolidating my debt?

While consolidation has some real advantages, keep a few things in mind:

You need to qualify. The best consolidation options and lending terms require good credit and steady income. Plus, even if you do qualify, there’s no guarantee that you’ll get a better interest rate.

Consolidating may cost money. You may have to pay for the privilege of consolidation through refinancing fees, closing costs, balance transfer fees, loan origination fees and more. Look at the total cost before consolidating to ensure you’re coming out ahead.

You may be in debt longer. Some consolidation loans ease the burden of monthly payments by extending the term of the loan. That may be a good option for you, but keep in mind that you’ll continue paying interest for all those extra years that you have your loan.

Be careful with secured debt. Credit card debt isn’t tied to any of your assets. But moving that debt to your home, for instance, means that if you can’t pay the loan back, the bank can take your home.

Overall, it’s always good to explore ways to get out of debt faster and more cheaply. Debt consolidation can be an effective way to do that. However, there are pros and cons to each strategy. If you’re feeling a little unsure about next steps, a financial advisor can help you develop a solution that improves your financial health without exposing you to unnecessary risks.