How Does Debt Consolidation Work?

Being in debt isn’t easy. Repayment is challenging enough, but keeping track of multiple loans and lenders can feel downright overwhelming. So how can you simplify your financial situation and stay on top of what you owe?

One solution is debt consolidation. In this article, we’ll discuss debt consolidation, how it works, and how to figure out if a debt consolidation is the right fit for you.

What is Debt Consolidation?

Debt consolidation is a process by which an individual uses a personal loan to pay off various other debts. If you’ve acquired a lot of different debt that’s compounding at high interest rates from various lenders, consolidating can make your life simpler, easier, and may lower your interest rate.

Three main types of debt that might be consolidated include:

Credit Card Debt

Credit card debit is a huge financial burden for many Americans. Indeed, the average credit cardholder in the U.S. had $5,769 in credit card debt in Q1 2022. This is up about 3% from Q1 2021.

If you have a lot of debt on different credit cards, consolidating is a financially savvy option. The average credit card APR is between 16-18%. If you consolidate high-interest debts like these into a loan with a lower interest rate (say, 8%), you’ll save a significant amount of money over the long term.

Student Loan Debt

Many students have taken out multiple loans to cover their undergraduate or graduate degrees. Consolidating student loans can also provide lower interest rates and other benefits like income-based repayment.

Personal Loan Debt

Personal loans tend to come with the most competitive interest rates. However, if you had a lower credit score in the past and it has since improved (or interest rates have significantly decreased) you may be able to secure savings with a better interest rate.

Types of Debt Consolidation Loans

Let’s break down the most common types of loans used to consolidate debt.

Bank Loans/Credit Union Loans

The most traditional way to consolidate debt is to take out a fixed-rate debt consolidation loan from a bank or a credit union. You’ll use this money to pay off the other debts you owe.

Personal Loans

Personal loans aren’t too different from the debt consolidation loan you’d get from a bank or credit union. However, you will need to do your homework. Personal loans tend to vary widely in terms of interest rates and payment plans. Shop around and compare before committing to a personal loan so you can find the one that will best suit your financial situation.

Credit Cards with Balance Transfers

Your third option for consolidating debt involves getting a new credit card with a low interest rate that allows balance transfers. Balance transfers give you the power to move debt from one credit card to another. This means you can put all of your debt in a single location (the new credit card) and you’ll be free of multiple payments over multiple cards with steep interest rates.

How Debt Consolidation Works

Put simply, debt consolidation combines multiple debts into a single manageable debt. When seeking a debt consolidation loan, here are some best practices:

Compare lender terms. Shop around and compare interest rates, fees, loan terms, and repayment plans. Think about your own financial situation. Which lender’s terms will best suit your needs?

Prepare your application information. You’ll need to provide your personal information including address, contact info, date of birth, social security number, housing and income information, and the desired loan amount. You may also need recent pay stubs, bank statements, or tax returns.

Apply. If all goes well, the lender will either send the funds to you or disburse them to your other creditors directly.

Manage your new loan. Once you’ve paid off all your old debts, make sure you pay your new consolidation debt on time. Consider setting up reminders or automatic payments.

Is Consolidating Debt a Good Idea?

Whether or not consolidating your debt is a good idea depends entirely on your personal situation. Generally speaking, consolidating debt is wise if:

You have a strong credit score and can qualify for a lower interest rate. Excellent credit means you’re likely to get a better interest rate on a consolidation loan than you are currently paying on your various other debts.

You need to simplify the management of your finances. If you struggle to juggle multiple debts and payment plans, consolidation will drastically simplify your monthly financial responsibilities. It can be a savvy option for those prone to incurring late fees or penalties.

You want a more predictable financial situation. Most debt consolidation loans have a fixed interest rate. They create consistency and allow for easy budgeting.

FAQs

Is there a difference between debt settlement and consolidation?

Yes. Debt settlement reduces the total debt that you owe, while debt consolidation reduces the total number of creditors whom you owe.