What Is Debt Consolidation?

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Updated on Tuesday, April 28, 2020

Debt consolidation is the process of rolling several debts into one easy-to-manage payment. It’s a strategy you can use to simplify the debt payoff process and save some money on interest. If you’re overwhelmed with multiple high interest debts, it may be just what you need to become debt-free faster.

What is debt consolidation and how does it work?

If you have many unsecured debts to pay off, you can turn them into a single monthly payment through debt consolidation. When you consolidate your debt, you won’t have to manage different payments, interest rates, payment dates and payback periods. You’ll eliminate confusion and make the process of repaying debt more manageable.

While there are several debt consolidation strategies at your disposal, a debt consolidation loan is a popular option. A debt consolidation loan is a personal loan you use to combine multiple debts with a new one, ideally with a lower interest rate and more favorable terms. You’ll receive a lump sum of cash to pay off your debts, and then make a single monthly payment on your new loan. (Some lenders can pay off your creditors directly, however.)

You can use debt consolidation to pay off consumer debt such as:

  • Credit cards
  • Medical bills
  • Utility bills
  • Payday loans
  • Taxes
  • Collection bills

Once you figure out all the unsecured debt you owe, use our debt consolidation loan calculator to get an idea of how long it will take you to repay them. The calculator compares the cost of all your debts versus the cost for a debt consolidation loan. It can help you determine how much money you can potentially save.

Pros and cons of debt consolidation

Pros:

Cons:

  • One monthly debt bill: Since you’ll only have to make one monthly debt payment rather than several, you’ll find the debt payoff process to be much easier.
  • May save money on interest: If you have high interest rates on your existing debts, consolidating them to a lower interest rate can allow you to save money over time.
  • Lower monthly payments: With debt consolidation, you can reduce your monthly payments through a lower interest rate and, if you choose, a longer repayment term.
  • Can pay off debt faster: A lower interest rate and a single debt bill can allow you to become debt-free faster than if you were to keep your multiple debt payments.

  • Potential fees: Some lenders charge an origination fee to take out a loan. Others may charge you a prepayment penalty if you pay off your debt early.
  • Can be hard to qualify: Traditional debt consolidation loans are unsecured personal loans, which require great credit to receive the best interest rates.
  • Does not solve an overspending problem: While debt consolidation can be a helpful strategy, it won’t help you control your spending and stay out of debt.

Where to find debt consolidation loans

Banks, credit unions and online lenders all offer debt consolidation loans. You might start your search for a loan with your current bank or by looking up lenders in your area who offer debt consolidation loans. But don’t overlook online lenders. They have lower overhead costs compared to lenders with brick-and-mortar locations and can pass those savings on to borrowers.

Loan marketplaces such as LendingTree can be especially helpful when you’re exploring lenders. By filling out a simple form, you can be matched with up to five lenders. You might also check out MagnifyMoney’s personal loan marketplace. Here are a few options you’ll find there.

Debt consolidation loan lenders
 

FreedomPlus

Learn more

Peerform

Learn more

SoFi

Learn more

APR

7.99%-29.99%

5.99%-25.05%

5.99%-18.28%

Terms

24 to 60 months

36 or 60 months

24 to 84 months

Borrowing limits

$7,500 to $40,000

$4,000 to $25,000

$5,000 to $100,000

Origination fee

1.99% - 4.99%

1.00% - 5.00%

No origination fee

Minimum credit score requirement

Varies

600

680

How to compare debt consolidation lenders

To understand your loan options, you’ll want to prequalify with several lenders. This process only requires you to provide basic information about yourself, your finances and the loan you want. Prequalifying will give you an idea of the kinds of loan terms you may get when you formally apply.

As you review lenders and offers, pay attention to such factors as:

  • Interest rates
  • Borrowing limits
  • Repayment terms
  • Fee structures
  • Minimum credit score requirements

Is debt consolidation worth it?

Debt consolidation may be a good idea if…

  • You have good credit: Lenders reserve their best loan terms, such as low interest rates, to borrowers with strong credit profiles. A lower rate could translate to a lower overall cost of borrowing.
  • Consolidating would make repayment cheaper: Debt consolidation is generally used to make repayment cheaper. That means accessing a loan with fewer fees and a lower interest rate. However, you might also choose a shorter-term loan to minimize interest charges.
  • You have other bills to worry about first: Debt consolidation may also make sense if you want lower monthly payments, such as by picking a longer-term loan. Although this would increase your total borrowing costs, it could allow you to focus on other financial priorities by freeing up some cash each month.
  • You’re tired of juggling multiple loans: If you have several credit card and loan bills to worry about, debt consolidation could make your life easier. By combining your debts, you’ll only have one monthly payment to worry about.

Debt consolidation may be a bad idea if…

  • You have bad credit: Borrowers with poor credit may find it difficult to find an affordable loan to consolidate debt. However, if you’re facing super-high interest rates, such as those offered on payday loans, a debt consolidation loan may yet be more affordable.
  • You’ll only rack up more debt: Debt consolidation can be a great way to wipe out credit card debt. But if freeing up your credit lines only means you’ll rack up more credit card debt, then consolidation may not make sense. You don’t want to bury yourself deeper into debt.
  • It wouldn’t save you money: Lenders commonly charge an origination fee equal to 1% to 8% of your loan amount. Tack on potential prepayment penalties from your old creditors, and you may find debt consolidation won’t save you money after all. Take these factors into account when exploring your options.

3 debt consolidation alternatives

Balance transfer credit card

A common alternative to a debt consolidation loan is a balance transfer. With this repayment strategy, you’ll take out a balance transfer card and move your existing credit card debt onto it. The benefit of a balance transfer card is that they commonly come with a promotional 0% APR. You can avoid interest charges by repaying your debt in full during the promotional period.

However, if you don’t repay your debt in full, you’ll be responsible for all of the interest that accrued. There’s also a balance transfer fee you’ll typically pay; it’ll be a percentage of the balance you transfer. That said, this strategy is one of the best for consumers who can aggressively repay what they owe and are sure the balance transfer fees they’ll pay will be offset by the amount they save on interest.

Pros

Cons

  • Move your debt to a better credit card: Depending on the card you get approved for, you may be able to move your debt to a card with a lower interest rate and more favorable terms.
  • Interest savings: You can consolidate your credit card debt into a single credit card with a 0% or low promotional APR that can save you money on interest.
  • Can help your credit: If you use your credit transfer card to reduce your credit utilization ratio, pay down debt faster and lower your balance to zero, you can improve your credit.

  • Balance transfer fee: While balance transfer fees vary, most credit cards charge 3% of the balance.
  • Promotional APRs expire quickly: These APRs last about 12 to 21 months. After this period, the card will function like a typical credit card and the interest rate will go back up.
  • Can add to debt: If you have a spending problem, a balance transfer card can make it worse and put you in more debt by freeing up your old credit lines.

Home equity loan

A home equity loan allows you to borrow against the equity you have in your home. Other factors such as your outstanding mortgage balance, home’s value and your credit health will affect your loan eligibility and amount.

Because you use your home as collateral, you’ll find home equity loans come with better terms than you may find on an unsecured loan such as a personal loan. However, you’ll find a longer application process as well as closing costs. You should be able to reliably make payments in full and on time each month, too. Otherwise, you risk losing your property.

Pros

Cons

  • Fixed interest rates: That means predictable monthly payments throughout repayment.
  • Lower interest rates: With collateral, a home equity loan will generally be more affordable.
  • Larger loan amounts: Depending on your available equity, you could access a large loan amount.
  • Your home is collateral: If you fail to repay your home equity loan, you could lose your property.
  • Closing costs: Expect to pay about 2% to 5% in fees.
  • Slow application process: It can take several weeks to receive loan approval and funds.
  • Need home equity: New homeowners, for example, may find they don’t yet have enough equity to qualify.

401(k) loan

With a 401(k) loan, you borrow money from your retirement savings and repay them over time with interest. Your monthly payments, including interest, go right back into your retirement account. Unlike with a 401(k) withdrawal, where you permanently remove money from savings, you won’t have to pay taxes or penalties on a 401(k) loan unless you default.

You can access this type of loan through the retirement plan offered by your employer. Often, you’ll have up to five years to repay the loan amount. If you leave or lose your job, though, you’ll be required to repay the full loan amount within a short period.

Pros

Cons

  • Low-cost borrowing: Since the interest you pay goes right back into savings, a 401(k) loan can be affordable.
  • No credit check: This loan also doesn’t appear as a debt on your credit report.
  • Lost savings: You’ll miss out on the money you would have earned on your borrowed amount.
  • May suddenly need to repay the full loan amount: If you lose or leave your job, you’ll be asked to quickly repay the loan.
  • Taxes and penalty, if you default: If you’re under 59 ½, you’ll pay certain fees for defaulting.

Debt settlement

Debt settlement involves negotiating with your creditors to settle for less than what you owe. You can hire a debt settlement company to negotiate with creditors on your behalf, though that may be a risky move. That’s because some debt settlement companies will ask you to stop making payments in order to starve creditors into negotiating over a payoff amount; you’re also liable to pay fees.

Pros

Cons

  • Potential to reduce your debt: Debt settlement can lower the amount of debt you owe to various creditors.
  • One deposit every month: If you hire a debt settlement company, you’ll deposit money into a special account every month. As your balance goes up, they’ll contact your creditors to negotiate lower settlement amounts.
  • Can pay off debt faster: With debt settlement, you may be able to settle your debt in only 24 to 48 months.

  • No guarantees: Your creditors are under no obligation to negotiate over your debt.
  • Your credit will take a hit: When you settle a debt, your credit report will show that a debt was paid off for less than the full amount.
  • High fee: If you opt for a debt settlement company, you may owe them a fee of 15% of your total debt once it settles.
  • Tax consequences: You may have to pay taxes on the portion of your debt that is forgiven by creditors.

Bankruptcy

Bankruptcy is a legal process where your assets are used to pay off debts (Chapter 7) or you repay debt via a debt repayment plan (Chapter 13). Since bankruptcy comes with long-term legal and financial consequences, it’s wise to consult a bankruptcy lawyer before pursuing it.

Pros

Cons

  • Relief from collection activity: Once you file for bankruptcy, most debt collectors will stop contacting you.
  • Chance to discharge your debts: If you are overwhelmed with debt, bankruptcy can allow you to wipe them out.
  • A short process: Chapter 7 bankruptcy only takes 4 months, on average.

  • May lose some of your assets: If you opt for Chapter 7, you may lose your home and other assets.
  • Negative long-term impact to your credit: While Chapter 7 bankruptcy stays on your credit report for 10 years, Chapter 13 remains for seven years.
  • Strict qualifications: You’ll have to meet certain income criteria if you wish to pursue Chapter 7. If you don’t qualify, Chapter 13 may be your only option.

Debt consolidation can be a great way for you to take control of your debt and improve your finances. However, it is not right for everyone so it’s important to do your research before you take the plunge.