What Is Debt Consolidation and How Does It Work?

Do bills from credit card companies, doctors, your cable provider, and your cell phone company stuff your mailbox? Are you struggling to pay all these bills, and are past-due notices sprinkled in with these bills?
Consolidating your debt might provide financial relief.
As the name suggests, in debt consolidation you combine several of your monthly debts into one new loan. The goal is to leave you with a single monthly payment that you can afford and to reduce the interest you are paying on your debt.
It’s not surprising that many consumers might consider debt consolidation. Statistics show that credit card debt is rising across the United States. The Federal Reserve Bank of New York reported that U.S. households added $26 billion in credit card debt in the fourth quarter of 2018. And a survey from CNBC released in May found that 55% of U.S. adults have credit card debt, with one in 10 carrying a balance of more than $5,000.
Debt consolidation might help you tackle your debts. But this solution isn’t for everybody. If your credit score is too low, your debt consolidation will come with a high-interest rate that might significantly boost the amount you’ll pay overall to eliminate your debts. And if you owe so much debt that a single monthly payment won’t be enough to realistically pay off your creditors, you might do better to pursue a debt settlement plan, in which your debt isn’t just consolidated but is also reduced.
And what happens if you don’t figure out a way to change your negative spending habits? Then debt consolidation won’t prevent you from running up new debt in the future. Some financial experts say that debt consolidation can make it easier to overspend again.
Tanner Dodson, co-owner and marketing manager of Ashley Dodson, CPA, in Columbia, Missouri, says that many people take out new loans or credit cards once they have a bit of spare cash from the lower monthly payment that comes along with their debt consolidation loan. These same consumers then run up new debts on these accounts.
“Without connecting the underlying issue, a debt consolidation loan will not break the cycle of debt,” Dodson adds. “It can actually make it easier to increase your total amount owed since most lenders only care about a debt-to-income ratio rather than the total amount you owe.”
How can you determine if debt consolidation is right for you? It helps to understand how the process works when it makes financial sense and what debt can and cannot be consolidated.

How Debt Consolidation Works

The goal of debt consolidation is to leave you with a monthly payment that you can afford at a lower interest rate, which will save you money as you pay down this debt. This usually requires working with a lender or debt consolidation service that will negotiate a repayment plan with your creditors. These lenders or services will look at what you owe and how much you can afford to pay each month when crafting your debt consolidation plan.
There are several different ways to consolidate your debt, though, and not all follow this exact formula. No one way is right for everyone, and each method of debt consolidation comes with its own pluses and minuses.
Todd Christensen, education manager with Money Fit by DRA, a Boise, Idaho, non-profit debt relief agency, says that credit counseling agencies work to secure better repayment terms for their clients, anything from lower interest rates on existing debt to lower monthly payments or the elimination of late fees.
Christensen says that debt consolidation can help consumers overcome their debt problems. But it won’t work if these same consumers aren’t willing to then change their spending habits.
“It does not make sense for anyone consolidating their debts if they have not addressed the cause of the debt,” Christensen says. “If the debt resulted from overspending or uncontrolled credit card spending, consolidating the debt onto one card or account will, more often than not, lead to a return to overspending on the newly paid-off accounts.”

What Debt Can You Consolidate?

Not all debt can be consolidated. Only unsecured debt – debt that does not come with collateral – can be consolidated.
Secured debt includes mortgage and auto loans. If you don’t pay your mortgage loan, your lender can take your home through the foreclosure process. If you don’t pay back your auto loan, your lender can take your car. In these cases, your home and car are your collateral.
Unsecured debt is any debt that isn’t backed by collateral. This includes most personal loans and credit card debt. These are the debts you can consolidate.
Examples of unsecured debt that you can consolidate include:

  • Credit card debt
  • Student loans
  • Unsecured personal loans
  • Payday loans
  • Medical bills
  • Cell phone bills
  • Utility bills

Types of Debt Consolidation

0% Interest Balance Transfer

One of the simplest ways to consolidate your debt is to transfer the balance from a credit card with a high-interest rate to one with a 0% introductory rate. These 0% rates don’t last forever, with most lasting from six months to a year. But by swapping debt that comes with a far higher interest rate – 20% or more on some credit cards – to a 0% card, you can dramatically reduce the amount of interest you pay on your debt.
The downside of this approach? You can only use it to pay off existing credit card debt. You can’t transfer medical debt, utility bills, cell phone bills or other debts to a 0% credit card. You also must be certain you can pay off your debt before that introductory offer ends. Once the 0% offer ends, the interest rate on the debt that remains will revert to your new card’s rate. That could, again, be 20% or higher.

Fixed-Rate Debt Consolidation Loans

You can also work with a lender or debt-relief organization to take out a debt consolidation loan. In this scenario, your existing debts will be rolled into one personal loan with one monthly payment. For this to make financial sense, the interest rate on your debt consolidation loan should be lower than the average rate on your existing debts.

Home Equity Loans

If you own a home, you can also tap the equity in it to consolidate your debt. Equity is the difference between what you owe on your mortgage and the current value of your home. If your home is worth $200,000 and you owe $130,000 on your mortgage, you have $70,000 worth of equity. You might then be able to take out a home equity loan of, say, $30,000, which you would receive in a lump sum and then pay back in regular monthly installments, usually at a fixed interest rate. You could then use that money to pay off your high-interest rate debt.
You could also opt for a home equity line of credit, better known as a HELOC. This home equity product works more like a credit card in which your credit limit is based on your equity. With a HELOC, you only pay back what you borrow. If you have a HELOC with a maximum spending limit of $20,000 and you spend $10,000 to pay off your credit card debt, you only have to pay back that amount.
The benefit of home equity loans is that they come with low-interest rates, so you’ll usually save money when swapping home equity debt for higher-interest-rate credit card debt. The downside? If you don’t make your payments on time, you could lose your home.

A 401(k) Loan

If you need cash to pay off high-interest rate debt, you might be able to borrow against your 401(k) plan. There are drawbacks here, though: Not all companies let their employees borrow against their 401(k) plans. And if you don’t pay your 401(k) loan back in time, it will be considered a distribution that you’ll have to pay taxes on. You will also pay a 10% early withdrawal penalty if you’ve withdrawn that money before the age of 59-and-a-half.
There’s another drawback here, too: When you take money out of your 401(k), it reduces the number of dollars you’ll have at retirement. You’ll have to determine whether paying off your debt is worth this cost.

Pros and Cons of Debt Consolidation

The main advantage of debt consolidation is to save money. If you can consolidate your debts into a loan with a lower interest rate, you’ll pay less to eliminate that debt. Making just one monthly payment instead of several can also make it easier to tackle your debt.
Taking out a debt consolidation loan or transferring your existing debt to a credit card with 0% interest, though, could cause a slight initial dip in your three-digit credit score. First, the lender or credit card provider that approves your loan will run your credit. This is known as a hard inquiry and will cause your credit score to dip slightly, usually about five points.
Your score might also fall because you are taking on a new account, whether you’ve applied for a debt consolidation loan, new credit card or home equity loan to consolidate your debt. Opening new accounts will cause another temporary dip in your credit score.
Chane Steiner, chief executive officer of Crediful.com, a personal finance website based in Scottsdale, Arizona, says that debt consolidation will save you the time and frustration of juggling several payments every month. But it won’t reduce the amount of money you owe.
The key, then, is to change your spending habits so that you won’t run up your debt again.
“Remember to avoid making the common mistake of failing to control the spending habits that caused the debt in the first place,” Steiner said.

When You Should and Should Not Consider Debt Consolidation

Are you a good candidate for debt consolidation? This process works best if your credit score is strong. You need a high credit score to qualify for the lower interest rates that would make debt consolidation make financial sense. If your credit is weak and you’ll only qualify for high-interest personal loans, then you won’t save the money necessary to make debt consolidation worthwhile. If your credit is too low, you might also not qualify for 0% credit cards or home equity loans.
If your debt is too high, it might not make sense, either. The monthly payment you’d have to make would have to be so high that you might not be able to afford it. In general, your total monthly debt should be no more than 40% of your gross income for consolidation to make sense.
If you’re struggling with secured debt – such as your monthly mortgage or auto payment – debt consolidation also won’t work. You can’t consolidate secured debt.
Finally, debt consolidation won’t work if you don’t have a plan in place to pay down your debt and change your spending habits. Make sure before you sign up for any type of debt consolidation that you know how much you can afford to spend on a monthly payment. You’ll need to create a household budget showing how much money you earn each month and how much you spend. Once you know how much you can afford, you can determine if the plan will work for your budget.

Alternatives to Debt Consolidation

 If debt consolidation won’t work for you, there are other ways to pay down your debt. You can pay off debt the old-fashioned way, by allocating more money to it each month, or by taking one of two approaches, the debt avalanche or debt snowball methods.
With the debt avalanche approach, you organize your debts by interest rate, and then pay more each month on the one with the highest rate, while making the minimum payment on your other debts. Once the debt with the highest rate is paid off, you start paying more on the debt with the second highest interest rate until you eventually pay off all your debts. This method will save you the most money.
In the debt snowball method, you pay off your debts not according to the interest rate but to balance, paying off those debts with the smallest balances first. This is useful if you need the satisfaction of crossing off debts at a faster pace.
You can also explore debt settlement, in which you work with a company that tries to convince your creditors to forgive some of your debt. If successful, this will leave you with less debt to pay back. There is no guarantee, though, that your creditors will agree to forgive any of your debts.

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