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An in-depth guide to debt consolidation

Main Points

Debt consolidation refers to taking out a new loan to pay off two or more loans.
A debt consolidation loan should have more favorable payoff terms, such as lower interest rate, lower monthly payment or both.
It's important to understand your spending problems, if you are spending more than you're earning, a debt consolidation loan won't help you and you could end up deeper in debt.

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Debt consolidation may help you simplify your financial life, with fewer bills to pay each month and fewer due dates to worry about. If you approach it correctly, it can improve your credit score and save you money. But you may want to think twice about debt consolidation, since it can leave you in a much worse financial position. This guide to successful debt consolidation can help you decide whether debt consolidation is the right way to pay off your loans.

What Is Debt Consolidation?

Debt consolidation is a “type of loan that collects many of your debts into one loan with one loan payment” as defined by the Consumer Financial Protection Bureau (CFPB). But as the CFPB explains, debt consolidation does not eliminate or reduce any of your debts. It works by merging all of your debt into one loan. Suppose you have a $2,000 credit card debt and you also owe $3,000 on a line of credit, if you consolidate those debts with a $5,000 debt consolidation loan, you still owe $5,000.

How Can Debt Consolidation Help You?

Most people choose debt consolidation to get one or more of these benefits:

Lower their interest rates.
Lower their payments.
Simplify their debt management.

The best consolidation loans may successfully achieve all three goals. Imagine that the interest rates on your credit cards go from 17% to 27% and you pay them off with a 7% home equity loan. In that case, you can lower your monthly expense, lower your interest rate, and combine several payments into one.

Optimize Your Loan Term

In order to reduce your interest rate and lower your payment, you need a loan with a lower interest rate and a longer term. However, if you take a new loan with lower monthly payments but a longer repayment term, you may end up paying more in total interest over time.

For example, if you have a debt of $5,000 on a credit card with a 17% interest rate, and your minimum payment is $100 per month, it will take you 79 months to pay off that debt and cost you $2,896 in interest. If you consolidate it to a 15-year home equity loan at 10% interest, you need to pay %53 a month, and your interest charges would total to $4,671.

In order to optimize the term of your new loan, you need to take some factors into consideration. The loan term should be short enough to pay off your debts within a reasonable period. But it should not be so short that you´ll struggle to make monthly payments. One way to solve this is to take a loan with a payment that you can make easily but then pay it down as fast as possible.

Prepayment Penalties

Few loans come with prepayment penalties nowadays, but there are still a few left. Make sure to check your loan agreements for any debts you plan to consolidate. Usually, store or credit cards don't have these types of penalties.

Dont assume that you can't consolidate an account because it has a prepayment penalty. These penalties, although not always, can be very small sometimes. You should call your tender and ask how much you'll have to pay for penalties. Depending on the amount, you can decide whether it would make that particular debt uneconomic or not.

When Does Debt Consolidation Make Sense?

Debt consolidation is not the solution if you are overwhelmed by debt, it's best to undergo debt consolidation before you experience real debt problems.

Don't wait until you start skipping payments or making them late, because your credit score could take a hit, and that could result in paying a higher interest rate on your debt consolidation loan. It's best to act earlier.

Get Better Results Success with a consolidation strategy should include the following benefits:

Lower interest rate: You should decrease your overall rate by consolidating debts, get a rate on your new loan that's lower than the ones you're currently paying to save money over the life of the loan.
Reduce monthly payments: your overall payment is likely to decrease, this can be advantageous from a monthly budget standpoint.
Make payoff faster: With good cash flow and a lower interest rate, you could consolidate to a loan with short term.

Most people can accomplish at least two of these goals.

Address Overspending Before Debt Consolidation

Debt consolidation is only a good idea if you have addressed the underlying problems that led to your current debts, like overspending. It may not be your fault, especially if you have no choice but to pay for necessities with a credit card due to facing medical bills or having experienced a period of unemployment.

Some people have problems managing their money, and may be in this position because of trying to maintain an unsustainable lifestyle. It's not always your fault, some people are just better at managing money than others.

But you can't just leave things the way they are. If you consolidate your debt and then continue spending beyond your means, it can lead to more substantial financial issues down the line. Because you'll be paying off your debt consolidation loan and all the new borrowing you accumulate afterward.

The CFPB has a good article about this, here are a few suggestions from the federal regulator:

Take time to understand your spending: the best start is to take a good look to find out where your money is going in order to find ways to cut back in the least painful areas. Take a month to track where every cent you spend goes.
Budgeting: make a budget to reduce spending on costs that vary each month. After setting a limit, track how you are doing. You may find you can increase your budget for something you genuinely value and reduce the amount you spend on something less important to you.
Contact your creditors: According to the CFPB, “Some creditors might be willing to accept lower minimum monthly payments, waive certain fees, reduce your interest rate, or change your monthly due date to match up better to when you get paid, to help you pay back your debt.”

If you find yourself overwhelmed, consider credit counseling and/or a debt management plan (DMP). A DMP usually requires you to close your credit cards and make a single monthly payment into the plan and that payment is later distributed to your creditors. You can't run balances back up when your cards are closed, and a credit counselor can teach you how to budget.

Does Debt Consolidation Hurt Your Credit Score?

Yes, your credit score can take a hit when you decide to consolidate your debts. But it's likely to be a temporary, minor fall. However, debt consolidation can also improve your score in a number of ways.

The temporary dip in your credit score may be caused because of the hard credit inquiry, lenders pull your credit report when you apply for a debt consolidation loan. Every inquiry causes your score to drop a few points, that's why it is better to prequalify first, and only authorize a credit report when you are ready to apply for a loan.

Making consistent, on time payments, and paying off the debt can improve your score over time. Once you zero out your credit cards and other unsecured accounts, your score could drastically rise. Because this reduced your credit utilization rate reflected in your report. Credit utilization is 30% of your score. This is not your total debt but the proportion of your credit limits that your card balances makeup. Ideally, you should keep your balance under 30% of your credit limit.

For instance, you have credit cards with a total spending limit of $10,000, and your balance is a total of $8,000. That would mean an 80% utilization, which is relatively high. But that rate would drop to 05 if you pay them off with an $8,000 personal loan or home equity loan. This is because installment loans don't count in the utilization calculation, but you still owe $8,000.

How Do You Consolidate Debt?

Here are some of the ways in which you can consolidate your debts:

Credit card balance transfers
Personal loans for debt consolidation
Cash-out mortgage refinances and second mortgages (home equity loans) – Only for some homeowners
401 (k) loans
Debt management plans from credit counseling firms

Here is what you need to know about each one.

Credit card balance transfers

A new card can help you reduce your credit card debt if it offers a lower interest rate. Some credit cards offer an introductory interest-free period when you transfer your balance to them.

This period can range from six to twenty one months, so it's best to pay off as much of it as you can, as soon as possible.

These are for creditworthy borrowers, so it's no use applying if you don't have a decent credit score.
Note that these cards may impose balance transfer fees, which typically run between 1% and 5% of your transfer amount.
The goal of taking a balance transfer card is to save what you´d otherwise pay in interest and put it toward paying your debt faster.
You should avoid carrying credit card balances in the future, doing it routinely can mean you're spending too much.

These credit card balance transfers are for people with healthy finances who need to accelerate their debt repayment.

Personal Loans

Many people who aren't homeowners chose a personal loan to consolidate their debts. A personal loan is an unsecured loan to which you apply to your bank or an online lender, and use the lump sum provided to pay down your existing debts.

The interest rate will mainly depend on two things:

Credit report and score
Choice of lender

Your choice of lender is important, you should do your research because some lenders offer the same borrower a much better interest rate than others. And many personal loans come with fees, so you should compare fees and interest rates before applying. Lenders have to disclose by law the annual percentage rate, which incorporates both the interest rate and the costs to obtain a loan so that you can compare offers more easily. But applying to multiple lenders could be damaging to your credit score. The loans that you can apply for many times with a minimal effect on your score are “mortgage, auto and student loans,” according to FICO, and personal loans are not among those. Before choosing your lender and applying, research which personal loans allow consumers to prequalify without pulling their credit.

Cash-Out Refinances And Equity Loans You have this option if you are a homeowner whose home is worth more than their mortgage valances. Some lenders will offer loans against more than 85% of your home's value, with a cash-out refinancing or with your existing mortgage plus a new home equity loan. Home equity financing comes with some of the lowest interest rates available, as long as you are eligible. Since loan terms are longer than those of most personal loans, Monthly payments are smaller. There are some drawbacks to home equity loans:

Equity loans come with charges that are specially high with a cash-out refinance.
Borrowing for a long time can become expensive in the long run, even if your interest rate is low.
Equity loans are secured on your home, if you fail to pay, you could pay foreclosure.

If you qualify, these loans offer interest rates slightly above average mortgage rates, which are generally well below credit card interest rates. But even with the lowest monthly payment you can find, that might cost you over the long term.

401(k) loans Your 401(k) plan may allow you to borrow from your account balance. It might make sense to do so if your employer allows it.

Bad credit isn't an issue because you are essentially borrowing from yourself.
You could take as much as 50% of your account balance, up to a maximum of $50,000.
You'll never be late because repayment comes out of your paycheck.

But many financial advisors don't recommend this course of action because of the significant disadvantages.

You can't contribute to your account as long as you have a loan against it. So if your company matches contributions, you lose that benefit.
If you leave the company, whether voluntarily or involuntarily, you have to pay off the loan, otherwise it becomes a distribution for tax purposes. But if you are not eligible to withdraw from your account, you'll owe both a 10% penalty, and the unpaid loan balance also becomes taxable.

Although attractive, this form of debt consolidation is potentially dangerous and costly.

Debt management plans from credit counseling firms Debt management plans don't make your debts disappear, but they may ease the burden by reducing your monthly payments, A certified counselor will work with you, looking into your financial situation in depth. You will work with your counselor to create a customized plan, and your counselor may be able to negotiate lower rates (“concession rates”) with your creditors. You make a monthly payment into the plan covering your enrolled debts, and its distributed among your creditors. The payment also includes a fee that goes to the counseling firm. This works to get you out of your enrolled debts in a reasonable time as long as you can afford the payment. However, if you enter a Debt Management Plan, you should make sure you can afford it. According to the Federal Trade Commission, “The traditional Debt Management Plan (DMP) supported by creditors is not sufficient to help many consumers…these inflexible full principal programs will work for only about 25 percent of consumers who seek credit counseling assistance because they require a payment beyond a consumer’s ability to manage over the life of a program.”

Debt Consolidation Mistakes Debt consolidation can have a number of advantages if you do it correctly. However, you may want to think about it twice since it can lead to more substantial financial issues down the line. Don't make the mistake of taking debt consolidation lightly, and avoid these common errors.

1
Choosing the wrong method – the right program or loan should provide clear benefits while helping you achieve your goal better than other methods.
2
Thinking debt consolidation “wipes out” debt – because it doesn't. It just helps you have a much easier time managing your finances and strategizing how to pay off your debt. But it's only a means to an end, not a solution. You need to get your financial house in order or else you'll be worse off than when you started.
3
Getting caught in a circle of debt – it's tough, but don´t rack up a balance while still paying down your consolidation loan. Commit to your long-term financial wellness by building healthy spending habits that last, or you'll end up right where you started.
4
But the worst mistake is waiting too long to take action – if you're facing financial difficulties, there's a good chance your credit score is already falling. Your credit score can negatively affect the interest rate you'll pay when you finally get around to consolidating. So don't waste any time!