What is debt consolidation?

Searching for a way to simplify your payments? Interested in saving on the interest you pay on your debts? If yes, debt consolidation might be worth considering.

But what is debt consolidation, and how does it work?

This article shows you the basics of debt consolidation, highlights its benefits, and helps you decide if it aligns with your financial goals.

Understanding debt consolidation

Debt consolidation is a popular method of simplifying your debt by combining all your eligible debts into a single loan.

Debt consolidation can help the following:

Make it easier to manage your payments
Lower the interest rates you’re paying monthly
Reduce your monthly payments
Ultimately paying off your debt more quickly

You can consolidate debt using several different methods, including:

Home equity loans
Home equity lines of credit (HELOCs)
Personal loans
Balance transfer credit cards

Each method has advantages and drawbacks, so choosing the one that best suits your financial situation and goals is important.

Debt consolidation—how does it work?

Debt consolidation involves obtaining a new loan or line of credit to pay off your debts.

The aim is to replace multiple payments with a single monthly payment, ideally at a lower interest rate, to simplify your finances and reduce interest costs over time.

Here are the most common methods of debt consolidation.

Personal loans

With a personal loan, you borrow a certain amount to pay off all your current debts.

You then repay the loan every month, with a fixed interest rate and a set time to finish.

The interest rate on a personal loan is usually better than standard credit card rates, especially if you have a good credit score.

Balance transfer credit cards

Another common debt consolidation method is using a balance transfer credit card.

This involves transferring your current balances to a new card with a lower interest rate, sometimes at 0%, for 6 to 18 months.

This can help you save on interest while paying off debt faster. However, paying off the balance before the promotional period ends is important, as the rate will revert to the standard—usually much higher—rate.

Home equity loans or lines of credit

If you’re a homeowner, you can leverage your home’s value to consolidate or pay off debts through a home equity loan or line of credit (HELOC).

While HELOCs typically have variable rates, home equity loans have fixed interest rates.

Since these options use your home as collateral, they often offer lower interest rates than other loans.

However, it’s fundamental to remember that these debt solutions use your home to secure the loan—meaning that foreclosure becomes a risk.

Debt management plans

Another way to combine your debts is through a debt management plan (DMP), often offered by credit counseling agencies.

With a DMP, the agency works with creditors to lower interest rates or remove specific fees. You then make one monthly payment to the agency, and they divide the money among your creditors.

DMPs can help you handle your debt effectively, but they usually require you to close your credit card accounts and stick to a strict payment plan, often lasting 3 to 5 years.

The benefits of debt consolidation

Simplified payments: The simplicity of debt consolidation is often seen as the most attractive of its many benefits. Instead of dealing with multiple payments with different due dates, interest rates, and minimum amounts, you only have to worry about one. This can make it easier to keep track of your payments and reduce the stress of managing debt.
Lower interest rates: If you can secure a lower interest rate through debt consolidation, you can save on interest over time. This is particularly beneficial if you’re consolidating high-interest credit card debt. A lower interest rate means more payment goes toward the principal balance, helping you pay off your debt faster.
Lower monthly payments: Consolidating your debt into a single loan with a longer repayment term and lower interest rates (or both) can lower your monthly payments, making them more affordable. While this may extend the time it takes to pay off your debt, it can provide immediate relief if you struggle to keep up with your current payments.
Improved credit score: Another popular benefit of debt consolidation is its impact on your credit score. When you pay off your debts, you reduce your credit utilization ratio, which can improve your credit score over time. Additionally, making consistent, on-time payments on your consolidated loan will further boost your credit score.

The drawbacks of debt consolidation

Debt consolidation is a powerful strategy for managing finances; however, every aspect must be considered.

Potential for higher total interest costs

While debt consolidation can mean smaller monthly debt payments, it may also extend your repayment period, meaning you could pay more in interest over the life of the loan.

It’s important to carefully consider the terms of your consolidation loan and weigh the potential savings against the total cost of the loan.

Risk of accumulating new debt

Debt consolidation can offer many consumers a fresh start, but you must avoid slipping back into old habits.

Accumulating new debt on your credit cards after consolidating your existing debts can add to your financial burden and create a difficult-to-break debt cycle.

Fees and costs

Some debt consolidation methods, such as personal loans and balance transfer credit cards, can have administrative or other processing fees, such as

Origination fees
Balance transfer fees
Penalties for paying off the loan balance early

These extra expenses can impact the total amount you’ll need to pay and should be considered when evaluating your options.

Risk of losing assets

Any asset you use as collateral—whether it’s your home or other property—will mean you risk losing it in the event of non-payment.

Before using your home as collateral, you must ensure you can afford to repay the loan.