What is debt consolidation and how does it work?

Whether you owe more or less than the average, managing your debt can feel overwhelming, especially if you’re juggling multiple monthly payments.

Debt consolidation can make it easier to deal with your debt, and it might enable you to get out of debt sooner or save on interest costs. Here’s how debt consolidation works and the different methods you can use to consolidate multiple balances.

• What is debt consolidation and how does it work?
• Common ways to consolidate debt
• When debt consolidation makes sense
• When debt consolidation doesn’t make sense

What is debt consolidation and how does it work?

Debt consolidation is the process of combining two or more debts into one account. You can usually do this with a single loan, which you’ll then use to pay off your current balances. A debt consolidation loan can pay off a handful of select accounts or even satisfy all the debt that you currently hold.

Any paid accounts will be cleared or closed out, and you’re then responsible for repaying the debt consolidation loan as agreed.

With a debt consolidation loan, you can:

• Lock in a lower interest rate
• Reduce your monthly payment amount
• Get out of debt sooner
• Simplify your repayment schedule

In some cases, you might be able to accomplish all of the above.

Common ways to consolidate debt

You can consolidate your debt in several different ways. Here are a few of the most common options.

Personal loan

You can find personal loans offered by banks, credit unions, and online lenders. They provide a single lump sum of cash, which you can then use to pay off existing debt (or whatever else you need). Personal loans are installment products, so you repay them over a set period of time with fixed monthly payments.

Pros

• Some of the best personal loans allow you to borrow up to $100,000, making it easier to consolidate multiple debt balances.
• Funding can be as soon as the same or next business day.
• Interest rates can be competitive for good credit borrowers.

Cons

• You’re responsible for using the funds to pay off existing balances (though some lenders offer to do this for you).
• To get the lowest available interest rates, you’ll need good to excellent credit.
• You may need to meet a lender’s minimum income requirements to qualify.

Balance transfer credit card

Balance transfer credit cards allow you to move balances from one credit account to a new credit card account. If a new card offers a lower interest rate — or even an introductory 0% APR for a certain period of time — shifting balances over can save you a lot of money on your credit card debt.

Pros

• Introductory or promotional offers may reduce or even eliminate interest charges.
• If you already have a balance transfer credit card, you can consolidate your debt at any time without needing to apply for a new card.
• Some balance transfer cards may come with additional rewards or perks for using the card.

Cons

• Some issuers charge balance transfer fees, which can often be between 3% and 5% of the amount you transfer.
• You can only transfer balances up to your card’s credit limit. If your current debts exceed your credit limit, you won’t be able to consolidate all your debt onto the card.
• After the card’s promotional period ends, your remaining balance is subject to the typical interest rate on the card, which can be higher than personal loan interest rates.

401(k) loan

Your retirement account might be the single largest pool of savings you own. Accessing these funds with a 401(k) loan may be one quick way to consolidate and clear out some debt. But it’s rarely the best choice, and not all employers permit 401(k) loans.

Pros

• Retirement accounts may offer more funds than you can get with a personal loan or credit card.
• Any interest is paid directly back into the account, so you’re essentially paying yourself interest on the loan.
• You won’t have to undergo a credit check to borrow the money.

Cons

• If you leave your job, you may have to repay the loan in full.
• You’ll miss out on potential growth on the amount that you withdraw, which can affect your long-term savings goals.
• If you don’t repay the loan as agreed, you’ll default; defaulted loans are considered early withdrawals and will be subject to penalty fees and taxes.

Debt management plan

A debt management plan (DMP) is a strategy put in place by a nonprofit credit counseling agency. A credit counselor will negotiate with your creditors on your behalf. You’ll make one monthly payment to the credit counseling agency, and the agency will pay your creditors for you. A debt management plan isn’t a loan, but it can make getting out of debt more manageable.

Pros

• You’ll only have one monthly payment to keep track of.
• Credit counselors will work with your lenders and creditors to create a debt repayment strategy that’s manageable for you.
• Depending on the plan, you may be able to reduce your monthly payment amount and interest charges.

Cons

• Creditors may report debt management plans to the credit bureaus, which may affect your credit score.
• Plans often charge a monthly fee, which can increase your overall costs.
• It can take up to five years to fully pay off your debt under a debt management plan.

When debt consolidation makes sense

Here are some situations when debt consolidation can make the most sense.

You want to reduce your number of monthly payments

Rather than juggling multiple payments and due dates each month, consolidating your balances can result in one single payment with one single due date.

You have a decent credit score

If you have good credit, you could qualify for a low-interest loan with a competitive rate, which may be much lower than you’re paying on other debts, such as credit cards. This can save you a lot of money in interest over time.

You’re focused on controlling your spending

Debt consolidation can clear out balances on your revolving accounts, which could make it tempting to begin spending again and racking up additional debt. If you’re committed to getting out of debt and focused on meeting your financial goals, then debt consolidation can be a solid strategy.

When debt consolidation doesn’t make sense

As with any financial strategy, debt consolidation doesn’t make sense for everyone. Here are some times when you might want to reconsider consolidating your debt.

You have a small amount of debt that can be repaid quickly

Debt consolidation is a great strategy for repaying various balances, but it can come at a cost. If you only have a small amount of debt, consider whether another strategy (such as the debt snowball or debt avalanche) could be better, rather than paying personal loan origination fees or balance transfer credit card fees.

Your credit score may prevent you from qualifying for a lower interest rate

If you’re trying to get a credit card or personal loan with bad credit, you might not qualify for an interest rate that’s lower than the one you’re paying on your existing debts. If you can’t snag a lower interest rate or introductory balance transfer offer, consolidating your debt might not be worthwhile.

You can’t change your spending habits

When you’re in debt, you may dream about clearing out your outstanding balances. But once you do, the temptation of that $0 balance can sometimes prompt new spending.

If you feel that you might be tempted to rack up those balances again, reconsider whether or not you should consolidate.