How Does Debt Consolidation Work?

Debt consolidation is taking a new loan to be able to pay off your other debts and liabilities.

You combine more than one debt into each other with better terms like reduced interest rates and monthly payments.

It could be just one of them or both together; it depends on your consolidation.

Debt consolidation can help you manage your student loan debts, credit card debts, and other expenses.

In fact, according to Lending tree, in the year 2019, 35.7% of loan applicants were looking to consolidate debt.

So what is the reason behind people choosing debt consolidation over other debt relief options? Let’s find out!

How Does Debt Consolidation Work?

Key Takeaways

  • Most customers start their debt consolidation through a bank or some credit union.
  • If you get rejected, you can go to mortgage businesses and lenders.
  • Debt consolidation can be done for both secured and unsecured debts.
  • To qualify for debt consolidation, you need to have a decent credit score and income.

Debt Consolidation Work

Debt Consolidation Work

Debt consolidation is the act of repaying high amounts of debts and liabilities by using various types of funding.

If you have many types of debt, you have the option to opt for a new loan to consolidate them into a single debt to reduce your monthly payments or interest rate and pay them off.

Once you do this, you make your new payments to the new debt until you pay all of it.

To start off the process, the majority of customers start their debt consolidation through either a bank or some credit union.

If you have a good connection with the institution you work with and you have a good payment history with them, this is an excellent place to start.

If you get a rejection, look into private mortgage businesses or lenders. Creditors are prepared to do so for a variety of reasons.

Debt consolidation increases the chances of collecting debt from a debtor.


Read: Our Recommended Debt Relief Companies For Debt Consolidation

Example of How Debt Consolidation Works

Suppose you have three credit card debts, and you owe $20,000 in total with a monthly compounded interest rate of 22.99%.

To bring the balance down to zero, you will have to make a monthly payment of $1,047.37. And during this time, you will have $5,136.88 in interest.

Now if you had opted for debt consolidation with a monthly compounded rate of 11%, then you would have to make monthly payments of $932.16 for 24 months. Over time your total savings would come down to $2,765.04.

Is It Good For You?

Types of Debt Consolidation

Types of Debt Consolidation

Secured Loans

Secured loans are loans that have some sort of security behind the loan by the borrower’s assets. This could be a home or a car.

The main point of it is that in case of a default, these assets can help to pay for the loan after the institution seizes them. They are a security for the loan.

Unsecured Loans

However, unsecured loans are loans that have no type of security behind them, and it is way harder to get them than secured loans.

These types of unbacked loans generally have higher interest rates, and not everyone can get them.

Interest rates on both of these loan types are often lower than those on credit cards.

These loans have fixed rates and do not change in most situations, so they do not fluctuate over the payback time.

Ways to Consolidate Debt

Ways to Consolidate Debt

Here are some ways to consolidate your debts:

1. Credit card balance transfers

A lot of credit card companies offer low-interest or zero-interest balance transfers to consolidate your debt.

What to know:

Credit card promotional periods only last for a limited time. After the promotional period ends, your credit card interest rates rise, increasing your monthly payments.

Another thing that you should know is that many credit card companies charge a balance transfer fee which is a certain percentage of the amount you transfer.

Associated risks:

If you decide to go for credit card debt consolidation, then you shouldn’t use this same card to make new purchases.

This is because you are not going to get any grace period for the new purchases, and you will also have to bear interest until you pay the whole balance in full.

2. Home Equity Loan

In this type of consolidation loan, you borrow money against your home’s equity. You will then use this money to pay off your creditors and then pay back this home equity loan.

What to know:

Although home equity loans offer low-interest rates, they can be very risky. If you do not repay the home equity loan, then it can result in losing your home in foreclosure.

Also, in this loan, you might have to pay closing costs, which can be hundreds or thousands of dollars.

Another risk associated with a home equity loan for debt consolidation is that if your home’s value falls, it can put you at risk of being “underwater.” This whole thing can make it very hard for you to refinance or sell.

3. Debt consolidation loan

Banks, installment loan lenders, or credit unions might offer debt consolidation loans. In this, all your debts are consolidated into one that too with a lower interest rate.

What to know:

Many Debt consolidation loan lenders may have “teaser rates” which last only for a while. After this, they increase the rates again.

This means you will end up paying more overall, including interest rates, fees, and other charges.

Pro tip:

Before choosing a debt consolidation loan, make sure you compare the interest rate and loan terms of all the options and choose the one that benefits you the most.

4. Student Loan Program

The federal government offers many loan consolidation options to those who owe student debt.

The interest rate on this is calculated as the weighted average of the previous loans. Also, note that only student loans qualify for this and not private loans.

5. Home Equity Line of Credit

A home equity line of credit (HELOC) is also a loan secured by your home that gives you a revolving credit line to pay high-interest debts or cover hefty expenses.

It lets you withdraw funds at a variable interest rate, and as you repay your outstanding balance, the amount of the available credit is replenished, much like a credit card.

The loan term is usually longer, lasting up to 10 years. 

Interest Rates on Debt Consolidation Loan

Interest Rates on Debt Consolidation loans range between 5.99-35.99%, and to make the most out of this option, you need to be able to qualify for a lower interest rate loan.

Otherwise, taking a debt consolidation loan with a high-interest rate wouldn’t solve the purpose and would put you even further down in debt.

So here are what lenders look for when deciding your interest rate:

  • Income: This is obviously the first thing they will check to ensure that you earn enough to be able to make monthly payments.
  • Your DTI ratio: DTI ratio shows how much of your monthly income goes toward your debts. The lower your DTI ratio is, the better chance you will have at qualifying for a lower-interest debt consolidation loan.
  • Credit score: Lenders look for a credit score of more than 600 to qualify for this loan. And having an even higher credit score can qualify you for a lower interest rate.

Advantages of a Debt Consolidation Loan

Advantages of a Debt Consolidation Loan

If you want to streamline monthly payments toward your debt, then you should opt for debt consolidation.

Here are some other advantages of debt consolidation loans:

  • Save on interest: Did you know the average interest rate for credit cards is 19.04%, and for personal loans, it is 13.5-15.5%? So debt consolidation gives you an opportunity to roll all your debts into one for a lower interest rate. So you will end up saving a lot of money on interest.
  • Simplified monthly payments: Having multiple debts makes it difficult to track monthly payments. Debt consolidation simplifies your monthly payments and eliminates the possibility of missing out on them.
  • Fixed schedule: Because debt consolidation loans have a fixed tenure, it offers you clarity as to when you will get free.
  • Get debt free quickly: Repaying credit card loans can take years, especially if you keep making minimum payments on them. However, a debt consolidation loan can get you debt-free quickly. 2

Disadvantages of a Debt Consolidation Loan

While there are benefits of a debt consolidation loan, you cannot ignore the drawbacks it entails.

Here are some disadvantages of debt consolidation:

  • It comes with upfront costs: In a debt consolidation loan, you may be required to pay fees such as prepayment penalties, annual fees, origination fees, balance transfer fees, etc. which can make it hard for you to pay your balances.
  • You might end up making more interest: Debt consolidation can only save you money on interest if you keep the repayment term shorter. A longer repayment would eventually take a lot of money out of your pocket. 3

The Verdict

The main point of debt consolidation is to make it easy to pay your debts off and not default on them with lower interest rates and lower monthly payments.

However, not everyone can qualify for debt consolidation, and you need to make sure that you will be able to pay off your new debt after debt consolidation.


How to know if debt consolidation is for me?

If you are having a hard time making multiple monthly payments towards your debt and would like to roll all your debt into one that, too with a lower interest rate, then you can go for debt consolidation.

How is debt consolidation different from debt settlement?

In debt consolidation, your aim is to reduce the time and interest of your overall debt. However, in a debt settlement, your aim is to reduce the overall debt itself.

Will debt consolidation damage my credit score?

In the long run, debt consolidation does not damage your credit score.

You can see an initial decline in your credit score, but it will start rising right back up once you start making monthly payments. 4

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