What Is Debt Consolidation, and How Does It Work? - Slimmer Payments

What Is Debt Consolidation, and How Does It Work?

Debt consolidation piles debt from multiple sources and puts it in one place, which makes the repayment process a bit simpler. Consolidating your debt can also allow you to reduce the interest rate or total amount of what you owe.

Rather than keeping track of multiple lenders, due dates, or interest rates, debt consolidation gives you one lump sum. One loan means one lender, one due date, and one interest rate — and only one set of login credentials to keep track of. This strategy can be very helpful in the long run — as long as it’s done right.

Here’s everything you need to know about debt consolidation and whether it’s the right move for you.

What is debt consolidation?

Debt consolidation is combining multiple debts (like loans or credit card balances) into one single monthly payment. There are several ways this can be done, which we will cover later on.

Whichever ever route you choose, the idea is for the new, consolidated balance to have a lower interest rate than the individual debts. A reduced overall interest rate can save you a bundle in the long run, and can make your debt easier to manage during the repayment process.

If you are someone who has several high-interest debts that they struggle with, this can be a great option — as long as you’re fully committed to the plan, and it’s a good fit.

How to consolidate your debt

Regardless of what type of debt you’re looking to consolidate, you have a few different options to choose from:

Debt consolidation loan: These are personal loans that consolidate multiple loans into one fixed monthly payment. Debt consolidation loans typically let borrowers consolidate up to $50,000 and have repayment terms between 1 and 10 years. You’ll want to make sure that your new loan’s interest rate is lower than the interest rates of your original loans.

Best for: Those who want a fixed repayment schedule.

Balance transfer credit card: Much like debt consolidation loans, these take multiple high-interest credit card balances and put them onto one credit card with a lower interest rate. Most balance transfer credit cards offer a 0% APR introductory rate, which usually lasts anywhere from 12 to 21 months. However, if you continue to carry a large balance once the 0% APR period expires, you can end up in even more debt. These typically have higher interest rates than the other debt consolidation methods.

Best for: Those who can afford to pay off credit cards quickly.

Student loan refinancing: If your debt comes from high-interest student loans, refinancing can help you snag a lower interest rate. Student loan refinancing allows borrowers to consolidate their student loans — both private and federal — into one fixed monthly payment, and often better repayment terms. Keep in mind that you’ll lose federal protections and benefits i.e. income-driven repayment and deferment options if you choose this option.

Best for: Those who have high-interest private student loans.

Home equity loan: A home equity loan (aka second mortgage) lets borrowers tap into their home’s existing equity. Most of these loans allow homeowners to borrow up to 85% of their home’s value, less any outstanding mortgage balance, and typically offer repayment periods between 5 and 30 years. Home equity loans are secured by your home, so that means your home is at risk of foreclosure if you do not repay the loan, but the plus side is they tend to boast lower interest rates personal loans or credit cards.

Best for: Those who have a generous amount of equity in their home and a stable stream of income.

Home equity line of credit: Home equity lines of credit, or HELOCs, is a long-term home equity loan that acts as a revolving line of credit. HELOCs allow homeowners to withdraw funds as needed with a variable interest rate. Like home equity loans, these tap into your home’s equity, so the amount you can borrow correlates with the amount of equity you have in your home. The repayment period can typically last up to 20 years, during which time you’ll be unable to continue accessing your line of credit.

Best for: Those who want a long repayment timeline and have a lot of home equity.

Do consolidation loans adversely affect your credit score?

Any time you apply for a new loan or credit card means that there will be a hard inquiry on your credit report which will remain there for 1 year, but usually stops affecting your score after 6 months. Hard inquiries result in a slight drop in your credit score (typically by 10 points or less).

So if you have good credit or better, one hard inquiry probably won’t have a huge impact on your score. But if you’re straddling the line between poor and good credit, a hard inquiry may knock you back into the bad-credit arena. The good news is that your score can bounce back quickly if you maintain good financial habits, like making all of your payments on schedule and maintaining a low balance on your credit cards.

Is it a good idea to consolidate your debt?

Debt consolidation can help you save money in the long run by lowering your interest rates and enabling you to repay debt faster, but it doesn’t address the root causes that originally put you into debt. Before putting any ink to paper, make sure to spend time examining the factors that led to your current situation, and give yourself the tools you need to avoid similar problems in the future.

What are some alternatives to debt consolidation?

Maybe you reviewed your options and came to the conclusion that consolidating your debt isn’t the best way to go. What are your options? Two popular payoff strategies for paying off debt are the “snowball” and “avalanche” methods. Both of these methods revolve around paying off one debt at a time. The “snowball” method focuses on paying off your smallest balance first, and then rolling that amount you were paying into paying off the next-biggest balance, and so on. The “avalanche” method works basically the same way, but instead tackles the balances with the highest interest rates first.

If your situation is more on the complicated side, consider a debt relief program. Just be aware that debt settlement should be a last resort, because it is an involved process that can take years. And since it involves stopping payments and working with a firm while they negotiate with your creditors, this can have a huge negative impact on your credit score. 

The takeaway

If debt consolidation is something that you’d like to pursue, give yourself plenty of time to consider all of your options. Be sure to get quotes from several lenders and compare interest rates, fees, and terms in order to find the best deal for you.

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