What Is Debt Consolidation and When Is It a Good Idea?

Debt consolidation refers to taking out a new loan or credit card to pay off other existing loans or credit cards. By combining multiple debts into a single, larger loan, you may also be able to obtain more favorable payoff terms, such as a lower interest rate, lower monthly payments, or both. Here's how to decide whether you should consolidate your debts and how to go about it if you do.

How Debt Consolidation Works

You can roll old debt into new debt in several different ways, such as by taking out a new personal loan, a new credit card with a high enough credit limit, or a home equity loan. Then, you pay off your smaller loans with the new one. If you are using a new credit card to consolidate other credit card debt, for example, you can transfer the balances on your old cards to your new one. Some balance transfer credit cards even offer incentives, such as a 0% interest rate on your balance for a period of time.

In addition to the possibility of lower interest rates and smaller monthly payments, debt consolidation can be a way to simplify your financial life, with fewer bills to pay each month and fewer due dates to worry about.

An Example of Debt Consolidation

Suppose you have three credit cards and owe a total of $20,000 on them, with a 22.99% average annual interest rate. You would need to pay about $1,048 a month for 24 months to bring the balances down to zero, and you'd pay about $4,601 in interest during that time.

If you consolidated those credit cards into a lower-interest card or loan at an 11% annual rate, you would need to pay about $933 a month for the same 24 months to erase the debt, and your interest charges would total about $2,157.

With a 0% credit card, your payments would be even lower, at least while the promotional period was in effect.

Risks of Debt Consolidation

Debt consolidation also has some downsides to consider. For one, when you take out a new loan, your credit score could suffer a minor hit, which could affect whether you qualify for other new loans.

Depending on how you consolidate your loans, you could also risk paying more in total interest. For example, if you take out a new loan with lower monthly payments but a longer repayment term, you may end up paying more in total interest over time.

Types of Debt Consolidation Loans

You can consolidate debt by using different types of loans or credit cards. Which will be best for you will depend on the terms and types of your current loans as well as your current financial situation.

There are two broad types of debt consolidation loans: secured and unsecured loans. Secured loans are backed by an asset like your home, which serves as collateral for the loan.

Unsecured loans, on the other hand, are not backed by assets and can be more difficult to get. They also tend to have higher interest rates and lower qualifying amounts. With either type of loan, interest rates are still typically lower than the rates charged on credit cards. And in most cases, the rates are fixed, so they won't rise over the repayment period.

With any type of loan, you'll want to prioritize which of your debts to pay off first. It often makes sense to start with the highest-interest debt and work your way down the list.

Here are a few more details about the most common ways to consolidate your debt.

Personal Loans

A personal loan is an unsecured loan from a bank or credit union that provides a lump sum payment you can use for any purpose. You repay the loan with regular monthly payments for a set period of time and with a set interest rate.

Personal loans generally have lower interest rates than credit cards, so they can be ideal for consolidating credit card debt.

Credit Cards

A new card can help you reduce your credit card debt burden if it offers a lower interest rate.

As mentioned earlier, some credit cards offer an introductory period with 0% APR when you transfer your existing balances to them. These promotional periods often last from six to 21 months or so, after which the interest rate can shoot up into double digits. So it's best to pay off your balance, or as much of it as you can, as soon as possible.

Note that these cards may also impose an initial fee, often equal to 3% to 5% of the amount you are transferring.

Home Equity Loans

If you are a homeowner who has built up equity over the years, a home equity loan or home equity line of credit (HELOC) can be a useful way to consolidate debt. These secured loans use your equity as collateral and typically offer interest rates slightly above average mortgage rates, which are generally well below credit card interest rates.

Student Loans

The federal government offers several consolidation options for people with student loans, including direct consolidation loans through the Federal Direct Loan Program. The new interest rate is the weighted average of the previous loans. Consolidating your federal student loans can result in lower monthly payments by stretching out the repayment period to as long as 30 years. However, that can also mean paying more in total interest over the long term.

Private loans don't qualify for this program, although you may be able to consolidate them with another private loan.

Debt Consolidation and Your Credit Score

A debt consolidation loan may help your credit score in the long term. By reducing your monthly payments, you should be able to pay the loan off sooner and reduce your credit utilization ratio (the amount of money you owe at any given time compared to the total amount of debt you have access to). This, in turn, can help boost your credit score, making you more likely to get approved by creditors and for better rates.

However, rolling over existing loans into a brand new one may hurt your credit score. Credit scores favor older debts with longer, more consistent payment histories.

Qualifying for Debt Consolidation

Borrowers must meet the lender's income and creditworthiness standards to qualify for a new loan. For example, for a debt consolidation loan, you may need to provide a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.

The Bottom Line

Debt consolidation can be a useful strategy for paying down debt more quickly and reducing your overall interest costs. You can consolidate debt in many different ways, such as through a personal loan, a new credit card, or a home equity loan.