How does debt consolidation work and can it help you?
Consolidating debt can often help you save money on interest and pay off debt faster.
Contributing Writer at Tally
June 25, 2020
When you're dealing with debt problems, it's easy to feel stuck. Fortunately, there's a wide range of options to help you if your consumer credit has gotten a little out of control. One popular solution is debt consolidation.
With so many companies advertising different debt consolidation options, you may wonder just how does debt consolidation work. Below we outline what debt consolidation is, how it works, the various consolidation options and the alternatives if consolidation isn't right for you.
How debt consolidation works
Debt consolidation rolls two or more debts into one loan. The most common reasons to consider a debt consolidation loan are to:
Combine multiple debts into a single payment
Get a lower interest rate
Lower your monthly payment amount
Get out of debt quicker
Types of debts you can consolidate
Most debt consolidation focuses on credit cards, which is generally one of the highest-interest consumer debts. However, a debt consolidation loan can work on nearly any type of debt.
Some types of debt commonly paid off using a debt consolidation loan include:
Old collections accounts
State and federal taxes
Common debt consolidation loans
Depending on the type of debt consolidation loan, you can pay off virtually any type of secured or unsecured debt. Some debt consolidation loans have strict rules about which types of debt can be consolidated, such as unsecured debt only, credit cards only or student loans only.
Debt consolidation comes in several forms, giving you added flexibility to choose the one that works best for you. The three common types of debt consolidation include a debt consolidation loan, 0% balance transfer credit card and a line of credit.
Debt consolidation loan
A debt consolidation loan is generally a fixed-rate, lump-sum personal loan that allows you to pay the same interest rate and monthly payment amount throughout the life of the loan. In some cases, though, you may get a variable-rate loan, meaning the interest rate and monthly payment will fluctuate periodically.
With a debt consolidation loan, you take a personal loan for an amount that can pay off most or all of your high-interest debts. Then, you use the money from that loan to pay off your existing debts. This leaves you with a single monthly loan payment, which can often save you money on interest and help you pay off your debt faster.
You can get debt consolidation loans from a wide range of sources, including traditional banks, credit unions or online lenders that specifically work on helping consumers get debt free.
The downsides to a debt consolidation loan are that you generally need a good credit score and, depending on the loan terms, you could end up with a significantly higher monthly payment.
Line of credit
There are several types of lines of credit that you can use as a form of debt consolidation. The first is a traditional line of credit, like Tally's line of credit. These are revolving credit accounts, meaning you can use them multiple times to pay off several high-interest debts.
The Tally line of credit generally offers an interest rate lower than most credit cards, so it may reduce the total amount you pay over time. Plus, with the flexibility to use it multiple times, you can pay off all your high-interest credit card debt over time.
Another option is a home equity line of credit. You use the equity, which is the difference between how much you owe on the mortgage and how much the home is worth, to secure this line of credit.
Because a home equity line of credit is secured by your home, it generally comes with a lower interest rate and longer repayment terms than other debt consolidation options. This makes it a great way to save on monthly payments if you have a lot of high-interest debt.
The downside to a home equity line of credit is it’s secured by your home, so if you miss a payment, the lender may foreclose on your home.
0% balance transfer credit card
It's common to receive offers for new credit cards with promotional interest rates, like 0% APR for 18 months. If you receive a credit card with a promotional APR and a credit limit high enough to consolidate your high-interest credit cards and other debts, this can save you a lot of money in a short amount of time.
During the promotional period, which is usually 12-18 months, you’ll save tons on interest payments. But keep in mind, these balance transfer cards generally charge a 3% to 4% balance transfer fee.
For example, if you’re aiming to pay off $10,000 in credit card debt with a 19% interest rate in 12 months, you would have to pay $921 per month, plus it would cost you $1,058 in interest.
If you transferred that $10,000 to a 0% APR balance transfer credit card with a 4% balance transfer fee, you would pay $0 in interest, a $400 balance transfer fee and only $866.67 per month for 12 months.
The downside to a balance transfer credit card is you must pay off the balance within the promotional APR period, or you'll get stuck with a higher interest rate once the promotion expires. Also, the credit card company may cancel the promotional period if you're ever late on a payment.
Other debt consolidation programs
Outside of the common types of debt consolidation loans, there are a few less common loan options to consider that require special circumstances, including 401(k) loans and federal Direct Consolidation Loan for student loans.
Most people think of a 401(k) as a vehicle for retirement only, but it can also help when a financial need arises. One such financial need may be unmanageable debt.
With a 401(k) loan, you borrow from your 401(k) retirement account and use the cash to pay off your debt. These generally come with relatively low interest rates, so you may see plenty of savings. But the real benefit is you pay the interest back to your 401(k) account, not a lender. So, you're basically paying interest to yourself.
The downside to using a 401(k) loan is you're eliminating the benefit of compound interest on the amount you borrowed, which can affect you in retirement. Compound interest is when you earn interest on top of previously earned interest.
For example, if you have $1,000 in a 401(k) and earn 10% in interest one month, you now have a $1,100 balance in your 401(k), a gain of $100. If you earn the same 10% in the following month, that applies to the new $1,100 balance, netting you a $110 gain instead of $100.
Federal Direct Consolidation Loan
Federal student loans are unique in that they generally have a low interest rate. As of June 2020, federal student loan interest rates range from 4.53% for direct subsidized and direct unsubsidized loans to 7.08% for direct PLUS loans.
These relatively low rates mean many debt consolidation loans don't have low enough interest rates to help you save money or pay off the loans faster.
This is where the Federal Direct Consolidation Loan can help. It consolidates your student loans into one payment and bases the interest rate on the weighted average of all your federal student loan interest rates.
The downsides of the Federal Direct Consolidation Loan program are:
Longer payment terms can increase the total interest payments over time.
You may lose certain benefits, including interest rate discounts and some loan-cancelation benefits.
Weighted average interest rate may be higher than your lowest student loan's interest rate.
Debt consolidation loans impact your credit score
When considering your credit score, debt consolidation is a mixture of positive and negative — but the positives usually outweigh the negatives.
Starting with the negative impacts on your credit score, debt consolidation generally includes a hard inquiry on your credit report when you apply for the loan. Hard inquiries result in a negative mark in the "New Credit" portion of your FICO credit score, which accounts for 10% of your score.
Each hard inquiry deducts roughly five points from your credit score, according to myFICO. Taking out a new loan also counts against the "New Credit" portion, further impacting your credit score.
Also, if you use a balance transfer credit card and max it out to pay off high-interest debt, this may increase your credit utilization ratio, which makes up 30% of your FICO credit score.
On the positive side, if you take out a traditional debt consolidation loan and pay off several high-interest credit cards with it, your credit utilization ratio will fall sharply. This credit utilization reduction may result in an increase in your credit score.
Adding a debt consolidation loan to your credit report can also improve the "Credit Mix" portion of your FICO score. This only makes up 10% of your FICO credit score, but it can still give it a slight boost.
Determining if a debt consolidation loan is right for you
Debt consolidation is a great idea on the surface, but it's not for everyone. You must look closely at your goals to determine if it's right for you. These goals generally include:
Reducing the number of monthly payments
Reducing the monthly payment amount
Lowering the amount of interest paid
Getting out of debt quicker
Here's a look at how debt consolidation can impact each goal.
Reducing the number of monthly payments
If your goal is simply to reduce the number of monthly payments you make each month, there's a good chance a debt consolidation loan is right for you. The only time it won't be is if you can't get approved for a loan large enough to pay off most or all of your debts.
Reducing the monthly payment amount
When your goal is to reduce your monthly payment amount, you must carefully review the terms and verify whether you can stretch the debt consolidation loan’s payments out long enough to reduce your monthly payments. If you can’t, a debt consolidation loan may not be the right choice for you. Keep in mind that a longer repayment term often comes with a higher interest rate, resulting in additional interest fees paid over time.
Reducing the amount of interest paid
If your goal is to minimize the amount of interest you pay while becoming debt free, verify the debt consolidation path you take has an interest rate lower than your lowest-interest-rate debt. For example, if you’re consolidating credit cards, and your lowest-rate card carries an 18% interest rate, you must find a debt consolidation loan with an interest rate lower than 18% to make it worth the effort.
Getting out of debt quicker
If you just want to get out of debt as quickly as possible, determine how much extra money you can put toward paying off your debt, then calculate how long it’ll take to pay off your debts without a consolidation loan. Compare that amount of time to the time it would take to pay off a debt consolidation loan using the same extra money you plan to put toward your debts. If the consolidation loan takes less time, then it’s the correct path for you.
In many cases, your financial goals will be a combination of the four aforementioned goals.
In this case, you must prioritize the goals. Then, carefully review your finances and the loan terms to determine if a consolidation loan meets all or at least the most important of your goals.
You may have to make a few compromises to make this work. For example, you might have to stretch your budget to handle a higher payment so you can get out of debt earlier or accept a higher interest rate to get a longer repayment term and a lower monthly payment.
Alternatives to debt consolidation
Consolidation isn't your only path to getting debt free. There are several other options, including a debt management plan with a credit counseling agency or debt settlement.
Debt management plan
A debt management plan is a way to get debt free by working with a nonprofit credit counseling agency. The agency works with your creditors to create agreements that'll reduce your interest rates and fees as long as you agree to pay off the debt in a specific period.
The credit counselors also work to get late fees and finance charges removed, saving you more money.
Once you agree to a debt management plan, you will make a single monthly payment to the credit counseling agency. The agency will then distribute 100% of those funds to your creditors.
The downsides to debt management plans are few but important to note. First, if you miss a single payment, it can derail the entire process. Second, the credit counseling agencies are nonprofit, but they still generally charge a one-time setup fee and a monthly maintenance fee.
Debt settlement is similar to a debt management plan, but it doesn't involve a credit counseling agency and can have a negative impact on your credit score.
In debt settlement, you negotiate with your credit card company and other creditors to reduce your fees and amount owed.
If the credit card company agrees to the reduced fees and credit balance, you make the agreed-upon lump-sum payment to the credit card company, and the credit card company closes your account. After closing the account, the credit card company forgives the remaining balance.
You may also choose to bring in a third-party debt settlement company if you're not confident in your negotiation skills. These companies add a whole new set of variables. According to the FTC, they tend to charge high fees and may make lofty promises they sometimes can't deliver on.
The FTC suggests doing thorough research on any debt settlement company and avoiding those that make bold promises of eliminating mass amounts of debt.
Wiping out tons of credit card debt in one swoop may sound great, but there are serious potential downsides to debt settlement, including:
Creditors aren't required to offer a settlement
Creditors may not consider a settlement until you're delinquent, resulting in a negative mark on your credit report
The IRS charges income tax on any forgiven debt over $600
Closed credit card accounts can negatively impact your credit score
Accounts are marked as "Settled" on your credit reports, which may negatively impact your credit score
Choose your best path to becoming debt free
You now grasp that debt consolidation is a way to combine multiple debts into one payment. You can do this through a loan, a 0% APR balance transfer credit card, a line of credit or various other means. It can also help you meet a wide range of goals, including simplifying or reducing your monthly payments, lowering your interest rate, getting out of debt more quickly, or a combination of several goals.
Debt consolidation may not be for everyone looking to solve their debt problems, but it's worth considering. If it isn't right for you, there are several alternatives, including using a credit counseling agency's debt management plan or taking advantage of debt settlement options.
No matter which route fits you best, now's the time to get started on your path to living debt-free. The sooner you start, the sooner you'll solve your debt problems.