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Debt Consolidation 101: A Comprehensive Guide

Simplifying your finances is possible, especially when you consider bundling your debt together.

February 16, 2021

Most Americans have multiple credit cards. If you’re one of them, you know how tricky it can be to keep track of your various payment amounts, due dates, interest rates, and fees. Juggling it all could make anyone’s head spin. If you’re looking for a way to simplify your finances, debt consolidation can help you do just that.

Below, we’ll explain how to consolidate credit card debt. We’ll also break down the ins and outs of debt consolidation, so you can decide if it’s right for you.

What is debt consolidation?

Debt consolidation is the process of paying off all of your debts with one consolidated loan or credit card. By bundling your debt together, you can simplify your finances and possibly even lower your interest rate.

Once you’ve consolidated your debt, you’ll only have to worry about making one debt payment each month, rather than several payments for varying amounts on different due dates.

You may also be able to lock in a lower interest rate on your monthly payment, depending on your eligibility. If you qualify for a lower interest rate on your new loan or credit card, you may be able to save money on credit card interest and get out of debt faster.

How does debt consolidation work?

Debt consolidation works by using a new loan or credit card to pay off all of your existing debts.

Here are some of the financing options you can use to consolidate your debt:

  • Personal loans – You can use personal loans to pay for a variety of personal expenses, including debt consolidation. To qualify for a personal loan with a low interest rate, you’ll generally need to have a good credit score. Personal loans are an attractive credit consolidation option, due to their fixed interest rates, fixed loan terms, and predictable monthly payments. If you want to have a set date for becoming debt-free, a personal loan can offer you that. Personal loans also rarely require any collateral. As a result, you won’t need to put your most valuable assets on the line when you take out a personal loan.

  • Balance transfer credit cards – Balance transfer credit cards allow you to transfer all of your debt onto one credit card. They’re a popular credit card consolidation tool because they often feature an interest-free introductory period. If you can pay off your entire debt balance within this time frame (usually 6 to 18 months), you could save a ton of money on interest. However, once the introductory period is over, you’ll have to start paying interest again. If your new interest rate is high, it could counteract your interest savings from the introductory period. You may also have to pay a balance transfer fee of 3% to 5% of your total transfer amount.

  • Home equity loans – If you’re a homeowner, you can borrow money from your home’s equity, rather than borrowing from a lender. Equity is the portion of your home that you own outright. To get a home equity loan, you’ll have to use your home as collateral. Home equity loans offer many of the same benefits as personal loans, like fixed interest rates and fixed loan terms. They often come with lower interest rates than personal loans, since they are secured by collateral. Best of all, the interest you pay on your home equity loan may be tax-deductible. Despite these advantages, this type of consolidation loan is arguably the riskiest, since you have to use your home as collateral. If you stop making your loan payments on time, you could lose your home through foreclosure.

  • 401 (k) loans – If you have a 401 (k) retirement account, you can use a 401 (k) loan to consolidate your debt. Since you borrow your own money with this type of loan, your 

     go directly back into your 401 (k) account. Despite this benefit, 401 (k) loans come with many restrictions. For example, you can only borrow 

     of your account’s balance, up to $50,000. You may also face tax penalties for borrowing this money if you’re under the age of 59½. Another downside of borrowing money from your 401 (k) is that you could set back your retirement goals. Any money you remove from your 401 (k) account will miss out on time that it could have been earning compound interest.

How do debt consolidation loans work?

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No matter what type of loan you use to consolidate your debt, they all work in a similar way.

Once you’re approved for your loan, you can use it to pay off all of your other debts. After that, you’ll have to start paying back your loan according to the terms laid out in your loan agreement.

How to get a debt consolidation loan

You can apply for a debt consolidation loan with a bank, credit union, or state-licensed lender. It’s important to research your potential lenders carefully. Each one will have different credit score requirements and loan terms.

By applying with a lender that can offer you a low interest rate, you can optimize your interest savings. During the application process, you’ll be asked to provide your:

  • Government-issued ID

  • Social Security number

  • Proof of address

  • Proof of income

  • Employer’s contact information

  • List of recurring monthly debts

If your application is approved, the last step is to review your loan agreement and sign the contract. Once you do that, you can start using your new financing to pay off your debts.

Which is better: Debt consolidation or personal loan?

Many people wonder if they should take out a personal loan or consolidate their debt. As you now know, personal loans are just one method you can use to consolidate your debt. Personal loans may be the best debt consolidation option for you, but that depends on your financial situation.

What is the smartest way to consolidate debt?

The best debt consolidation method depends on your financial circumstances. Ideally, you want to choose the method that offers you the lowest interest rate and the best repayment terms.

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How does debt consolidation affect your credit score?

Debt consolidation may cause your credit score to drop temporarily. Here’s why:

  • It adds a new credit account to your credit report. Your credit score may drop by a few points any time you apply for a new credit account with a lender. That’s because new credit applications result in a hard inquiry into your credit report. Applying for a new debt consolidation loan or credit card is no exception.

  • It may reduce your credit mix. Credit mix is another factor that impacts your credit score. Your credit mix looks at how many different types of credit accounts you currently have open. If you close some of your old credit accounts after paying them off, your credit mix may be negatively affected.

  • It may increase your credit utilization temporarily. Credit utilization is another influential factor that impacts your credit score. You can calculate your credit utilization by dividing your current credit balances by your total credit limit. Ideally, you want to keep your credit utilization below 30% to maintain a good credit score.

If you close your old credit accounts after paying them off, your overall credit limit will decrease. Meanwhile, your current credit balances will remain the same. This shift can cause your credit utilization to skyrocket, reducing your credit score.

Even though these factors may cause your credit score to drop temporarily, debt consolidation may improve your credit score in the long run.

Not only can it make it easier for you to make all of your payments on time (improving your payment history—the most important credit score factor), but it may also help you pay off your debt faster (reducing your credit utilization over time).

Is it smart to consolidate debt?

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After reviewing how debt consolidation works, you may be wondering if it’s the right choice for you. Generally, debt consolidation is only a good idea if you:

  • Have a manageable amount of debt (your debt payments only make up 40% or less of your monthly income)

  • Can qualify for a low interest rate

  • Have a steady income

  • Can stop using credit to pay for your monthly expenses

What are the risks of debt consolidation?

Even though debt consolidation may be a good idea for some people, it doesn’t come without risk.

For instance, if you have a lot of debt, consolidating it could cause your monthly payment to become unaffordable. If you’re unable to make your new loan or credit card payment on time, you could end up harming your credit score.

Debt consolidation may also be a bad idea if you have a bad credit score. Since it’s unlikely that you’ll be eligible for a low-interest rate, debt consolidation could increase your total interest charges in this scenario for people with bad credit. You'll also want to check in with your lender on prepayment penalties, which can also be a factor in some cases.

What is the catch with debt consolidation?

It’s important to remember that debt consolidation is not debt elimination. No matter how you choose to consolidate credit card debt payments, you still have to repay the full amount of money that you owe, including its annual interest rate and fees.

As a result, it’s important to do the math and find out if consolidating your debt will actually help you accomplish your financial goals—whether that’s to:

  • Save money on interest

  • Get out of debt faster

  • Make your monthly payments more affordable

Additionally, if you don’t stop spending outside of your means, debt consolidation won’t solve the root problem that got you into debt in the first place.

Manage your debt easily with Tally

Now that you know the ins and outs of debt consolidation, the choice is yours. If you’d like to simplify your debt with the help of an easy-to-use debt consolidation app, look no further than Tally.

At Tally, we make credit card management easier. Our app allows you to monitor all of your credit cards effortlessly from one place. In turn, you can enjoy the convenience of debt consolidation without the hassle or risk. Our Tally Advisor will suggest what payment amounts you can make each month to save the most money on interest and get out of debt faster.

Simplify your finances by downloading the Tally app today!