What is Debt Consolidation — And Should I Consider It?

Managing multiple debts often feels like a juggling act, but did you know you can consolidate debt? This guide will explain how debt consolidation works, the different methods, and its pros and cons. Financial experts will also give tips on how to decide if debt consolidation is a good idea and how to choose the right plan. 

What Is Debt Consolidation?

Debt consolidation is a way to combine all those pesky debts — credit cards, loans, you name it — into one payment. Then you have only one due date each month. You might also lower your interest rate, monthly payment or both. 

How Does Debt Consolidation Work?

How exactly does this whole debt consolidation thing work? It’s pretty straightforward. You take out a new loan that covers all your existing debts. Once you square away those debts, you’re left with just one loan to focus on. Ideally, this new loan comes with better terms — like a lower interest rate and less total interest paid — and your monthly payments become more manageable.

To explain how debt consolidation works, here are the basic steps:

1. Total Your Debts: List all your debts, including the amount you owe, the interest rates, and the amount you pay each month.
2. Research a New Loan or Card: Talk to a financial advisor or do research to see if you might do better with a personal loan, a balance transfer, a home equity loan or something else.
3. Apply: Talk with a few reputable lenders and apply for the best loan or card you can find. If you’re approved, use it to pay off your other debts.
4. Start Paying Off Your New Loan or Card: Now you have just one debt to worry about. Make sure you stay on top of it!
5. Stay Focused. As you pay off this new loan, make sure you’re not racking up new debt on the side.

“The key to effective loan consolidation lies in carefully reviewing your liabilities, managing your budget, and negotiating lower interest rates,” says attorney Jonathan Feniak, MBA, who serves as general counsel and head of finance at LLC Attorney. “Establish a payment strategy that aligns with your income and lifestyle without causing unnecessary financial strain. Always prioritize debts with higher interest rates.”

Types of Debt Consolidation Methods

There’s more than one way to tackle debt consolidation, so it’s good to know your options. Here are the main methods:

• Personal Loans: These are fixed-rate loans often used for loan consolidation. Personal loans don’t require collateral, but you will need an adequate credit score (typically at least 660) and debt-to-income ratio (usually under 40-43%). You make regular payments over a set period, normally two to seven years, and then the debt is paid off. However, you may never get ahead if you continue accumulating other debt, like credit card debt. 
• Home Equity Loans or HELOCs: If you’ve built up enough equity in your home, you can borrow against it with a home equity loan or line of credit. This often gives you a lower interest rate, but your home is on the line if you can’t keep up with payments. To qualify, you need to have enough equity in your home, typically under a 70-80% loan-to-value (LTV) ratio. You’ll also need an adequate credit score and debt-to-income ratio (DTI). 
• Balance Transfer Credit Cards: This method enables you to transfer your credit card balances to a new, lower-interest card. The best balance transfer cards might even have a 0% introductory period typically lasting up to 21 months. However, you’re unlikely to qualify without a good credit score. 
• Debt Management Plans (DMPs): DMPs involve working with a credit counselor who negotiates lower interest rates and payments with your creditors, creating a more manageable plan.

Pros and Cons of Debt Consolidation

Debt consolidation sounds pretty good, right? But, like anything, it has its upsides and downsides:

Is Debt Consolidation a Good Idea?

Debt consolidation can be a smart move, but it’s not for everyone. It can be good if you’re dealing with high-interest debt, have multiple payments to juggle and your income is stable enough to handle a new loan. But you should think twice if your debt is overwhelming or if you’re not prepared to change your spending habits.

“The decision to consolidate loans greatly depends on individual circumstances,” Feniak says. “It tends to be beneficial when individuals struggle with managing multiple payments or if they’re capable of securing lower interest rates. However, it could potentially be detrimental if the consolidation loan extends the term of the debt or if it encourages further irresponsible spending habits.” 

Best Way to Consolidate Debt

The best way to consolidate debt depends on your situation. Here’s who might benefit from each method.

How to Choose the Right Debt Consolidation Option

Choosing the right way to consolidate debt takes some careful thought. You’ll want to weigh your financial situation, set your goals, and consider the ins and outs of each consolidation method. Here’s a simple guide to help you make the best choice:

1. Assess Your Financial Situation

• Take Stock of Your Debts: Start by listing all the debts you owe. This includes credit cards, personal loans, medical bills—anything you need to pay off. Write down the interest rates, what you pay each month and how much you still owe.
• Review Your Budget: Look at your income and expenses to figure out what you can realistically afford to put toward debt repayment each month. This will help you decide which consolidation option is a good fit for your budget.
• Calculate Your Debt-to-Income Ratio (DTI): This is a key number lenders look at. To find it, add up all your monthly debt payments and divide by your gross (before-tax) monthly income. A lower DTI makes it easier to qualify for better loan terms.

2. Check Your Credit Score

• Understand Your Credit Profile: Your credit score plays a big role in what debt consolidation options you’ll qualify for and the interest rates you’ll get. Grab a copy of your credit report and take a close look at your score.
• Identify Ways to Improve: If your credit score isn’t as high as you’d like, think about steps you can take to boost it. This could include paying down some debts, correcting any errors on your credit report, and avoiding new credit inquiries.

3. Research Different Consolidation Methods

• Compare Interest Rates and Terms: Look into the interest rates, repayment terms, and any fees that come with different consolidation methods. Whether it’s a personal loan, a balance transfer credit card, a home equity loan or a debt management plan, each has its own perks and pitfalls.
• Weigh the Pros and Cons: Each method offers something different. For example, personal loans give you fixed rates and predictable payments, while balance transfer cards might offer an interest-free period but usually require excellent credit and may have hefty fees.
• Consider the Impact on Your Assets: If you’re thinking about a secured loan, like a home equity loan, remember that your home is on the line. Balance the risk of losing your home against the benefit of a lower interest rate.

4. Shop Around for Lenders

• Compare Offers: Don’t just jump at the first offer you see. Shop around and compare deals from different lenders—banks, credit unions and online lenders. Look for competitive rates, reasonable fees and good repayment terms.
• Negotiate Terms: If your credit is solid, you might get even better terms by negotiating. Don’t hesitate to ask for a lower interest rate or reduced fees, especially if you’ve found a better deal elsewhere.
• Check Lender Credibility: Make sure your lender is trustworthy and has good customer reviews. Be wary of predatory lenders who might hide fees or hit you with high penalties.

5. Read the Fine Print

• Understand All Terms and Conditions: Before signing anything, know exactly what you’re agreeing to. This includes the interest rate, repayment schedule, and any penalties for things like paying off the loan early or missing payments.
• Spot Potential Pitfalls: Watch out for any clauses that could cause trouble later, like interest rates that could rise or fees that aren’t immediately obvious.

6. Seek Professional Advice

• Consult Financial Experts: If you’re unsure which option is right for you, it might help to talk to a financial advisor or credit counselor. They can offer personalized advice based on your situation and guide you through the process.
• Consider Legal Advice: In some cases — especially if you’re dealing with a lot of debt or thinking about a home equity loan — it could be worth getting advice from an attorney to fully understand the legal side of things.

Alternatives to Debt Consolidation

Not sure if debt consolidation is right for you? There are other ways to tackle and manage your debt. Each alternative has its pros and cons, so it’s important to figure out what might work best for your situation.

• Debt Settlement
  Debt settlement is all about negotiating with your creditors to reduce the amount you owe. Either you or a debt settlement company will approach your creditors to see if they’re willing to accept a lump-sum payment that’s less than what you owe. Creditors often prefer getting something rather than nothing, so they might agree to cut you a break. Debt settlement can be a good option if your debt feels overwhelming and you don’t see a clear path to paying it off entirely. But be aware — there are risks involved, like a debt settlement company charging fees.
• Budgeting
  Sometimes, the simplest approach is the best one. Budgeting means making a detailed plan for your income and expenses, figuring out where to cut back and using those savings to pay down your debt faster. Budgeting can be a solid strategy if your debt isn’t too overwhelming and you have the income to cover your expenses. It’s also a great first step before diving into more drastic options like debt settlement or consolidation.
• Debt Snowball and Debt Avalanche Methods
  These two strategies are popular for a reason — they work! With the debt snowball method, you focus on paying off your smallest debt first. Once that’s done, you roll that payment into the next smallest debt, and so on. It’s like building a snowball that gets bigger as it rolls.The debt avalanche method, on the other hand, has you target the debts with the highest interest rates first, which can save you more money over time. Both methods are great if you’re ready to make consistent payments and want a clear, step-by-step plan to get rid of your debt.

• Bankruptcy
  Bankruptcy is a legal process that can either wipe out or help you repay your debts under court protection. There are two main types: Chapter 7, which can discharge most of your debts, and Chapter 13, where you set up a plan to pay off your debts over three to five years. Bankruptcy should be your last resort after you’ve tried other debt-relief options and are still drowning in debt you can’t repay.
• Debt Forgiveness Programs
  Some types of debt, like student loans, might qualify for forgiveness programs. These programs can wipe out some or all of your debt if you meet certain requirements, like working in public service for several years. If you have federal student loans or another type of debt that might be eligible, it’s worth checking out these programs to see if you qualify.

Tips for Successfully Managing Debt After Consolidation

So, you’ve consolidated your debt — great start! But that’s just the first step. Here’s how to keep things moving in the right direction:

• Stick to Your Budget: Make sure you’re sticking to a budget that puts paying off your debt front and center. It’s all about making sure your spending aligns with your goal of getting debt-free.
• Avoid New Debt: It can be tempting to swipe that credit card or take out a new loan, but try to resist until your consolidated debt is paid off. The last thing you want is to pile on more debt.
• Build an Emergency Fund: Life happens, and having some savings set aside for those unexpected expenses can keep you from sliding back into debt. An emergency fund is your safety net.
• Monitor Your Credit: Keep tabs on your credit report. Make sure your payments are being recorded accurately and watch your progress. It’s motivating to see your efforts paying off!

“After a loan consolidation, I always advocate for disciplined spending behavior to avoid falling back into debt,” Feniak says. “Establish an emergency fund, adhere to a budget, and if possible, aim to make extra payments toward the loan to get out of debt faster.”

With the right approach, you can simplify your debt and start working toward a brighter financial future.