Debt Consolidation: What It Is and How It Works

The average person has $101,915 of debt in 2023, according to Experian data. If you’re one of the many people drowning in debt, there’s a solution that can help — debt consolidation. This action lets you combine all your debts into a single one. Instead of dealing with multiple debts with different due dates and interest rates, you can simplify things by merging them into a single loan. 

Before taking out a consolidation loan to pay off debt, read on to learn more about debt consolidation and a suggested offer from Accredited Debt Relief.

MoneyLion offers a service to help you find personal loan offers based on the info you provide, you can get matched with offers for up to $50,000 from our top providers. You can compare rates, terms, and fees from different lenders and choose the best offer for you. You can also use the loan funds to pay off other existing debts. MoneyLion is here to help.

Understanding debt consolidation

Debt consolidation is a strategy that helps you simplify the task of repaying multiple debts. Instead of keeping track of various debts like credit card balances, personal loans, or car loans separately, debt consolidation brings them all together into one package. You’ll have only one loan to deal with, one monthly payment to make, and one interest rate to keep in mind.

Why is this helpful? Well, imagine you have debts with different due dates and interest rates. It can get overwhelming trying to remember when each payment is due and how much interest you’re paying for each debt. Debt consolidation solves that problem by combining everything into a single loan.

Not only does debt consolidation make things simpler, but it can also save you money. How? By potentially getting you a lower interest rate on the consolidated loan. When you have multiple debts, each with its own interest rate, you might end up paying more in total interest. But with debt consolidation, you have a chance to secure a better interest rate, which can reduce the overall amount of interest you’ll pay over time. It’s like getting a discount on your debts.

How debt consolidation works

Here’s how it works. Instead of making separate payments for each debt, you take out a new loan or credit card specifically for consolidating your debts. This loan or card has a fixed interest rate and a set repayment period. With this new loan or card, you pay off all your other debts, leaving you with just one monthly payment to make.

Debt consolidation can have positive and negative effects, depending on how you manage it.

Positive impact on credit: If you consistently make your debt consolidation payments on time, it shows that you’re responsible with your finances and can have a positive impact on your credit score. A good credit score can make it easier to qualify for future loans, credit cards, or better interest rates.

Potential negative impact on credit cards: When you consolidate credit card debts, you might close credit card accounts. Closing credit card accounts can reduce your credit score because it reduces your overall available credit limit and if you have had the card open for a long time, it could affect the length of credit history. 

Debt consolidation alone does not magically fix your credit. You’ll want to practice good financial habits, such as making payments on time and not accumulating more debt, to maintain a healthy credit profile.

Example of debt consolidation

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There are different methods available for debt consolidation, depending on individual circumstances. One common approach is obtaining a personal loan from a financial institution to pay off existing debts. By doing so, all the debts are consolidated into a single loan with a fixed interest rate and monthly payment.

Another method is through balance transfer credit cards. You transfer the balances from multiple credit cards onto a single card that offers a lower interest rate or an introductory 0% interest period, consolidating your credit card debts and simplifying payments.

5 Benefits of debt consolidation

Debt consolidation offers several benefits that are worth exploring. 

1. Chance to simplify repayment

One of the primary benefits of debt consolidation is that it simplifies the repayment process. Managing multiple debts with different due dates and interest rates can be confusing and stressful. By consolidating your debts, you combine them into a single loan or payment. You only need to keep track of one due date and one interest rate, which can make it easier to stay organized and avoid missed payments.

2. Possible lower interest rates

The potential to nab a lower interest rate for your debts is a huge perk, especially if you’re dealing with high-interest credit card debt or payday loans. These types of debts often come with sky-high interest rates, which means you end up paying more money in the long run. But with debt consolidation, you have a chance to renegotiate and get a better deal.

3. Possibly reduced monthly payments

Consolidating your debts can potentially lower your monthly payment amount. This goal can be achieved through a few different mechanisms. For example, you may secure a lower interest rate on the consolidated loan, resulting in a reduced monthly payment. Extending the repayment term can spread out the payments over a longer period, which can make them more affordable each month. Lower monthly payments can provide immediate financial relief and free up some of your budget for other expenses or savings.

4. Debt payoff strategy

Debt consolidation allows you to simplify your debt repayment strategy. Instead of feeling overwhelmed by multiple creditors, due dates, and varying interest rates, you can focus on a single loan. You can create a clear plan to pay off your debt systematically. You can allocate your resources more effectively, potentially paying down the debt faster and regaining financial control.

5. Opportunity to improve your credit score

Debt consolidation can have positive effects on your credit score. It can lead to a lower credit utilization ratio by increasing your available credit, potentially counteracting the negative impact of opening a new account. Making timely payments on your new loan can gradually improve your payment history, which is a significant factor in credit scores. However, responsible financial behavior and consistent payment management are key to experiencing these benefits, and it’s important to note that initially, opening a new account may cause a slight decrease in credit scores. 

5 factors to consider before consolidation

By considering a few important factors, you’ll be better equipped to make an informed decision about debt consolidation.

1. Assessing total debt

Take a look at all the amounts you need to consolidate, including credit card balances, personal loans, student loans, or other debts you have. Knowing the exact total will help you figure out if consolidation is a feasible option for you.

2. Evaluating current interest rates

Compare the interest rates on your current debts with the rate offered on the consolidation loan. Debt consolidation makes sense when you can secure a lower interest rate. But if the new rate is higher or similar, consolidation may not bring you the financial benefits you’re looking for.

3. Understanding repayment terms

Extending the repayment period might lower your monthly payments, but keep in mind that it could increase the overall interest you end up paying. Shorter terms can save you money on interest, but you’ll have higher monthly payments. Take some time to evaluate how the repayment term will fit into your budget and financial goals.

4. Understanding fees and charges

Get a good understanding of fees associated with debt consolidation. These can include origination fees, balance transfer fees, or early repayment penalties. Crunch the numbers and calculate the total cost of the consolidation loan, including those fees, to see if it outweighs the potential benefits.

5. Consider your credit score and credit history

Take a moment to evaluate how debt consolidation might impact your credit score. Keep in mind that consolidation itself doesn’t harm your credit, but certain actions like closing credit card accounts or opening new ones can affect your credit utilization ratio or credit history length. It’s important to think about the short-term and long-term effects on your credit before making a decision.

5 Different methods of debt consolidation

There are other methods available to help you tackle and pay off your debt.

1. Personal loans

You can get a personal loan from a bank or online lender to consolidate your debts. This loan is used to pay off your existing debts, and then you make regular payments on the personal loan instead.

2. Balance transfers

Some credit card companies offer balance transfer options. This involves transferring your existing credit card balances to a new credit card with a low or 0% introductory interest rate for a specific period. You make payments on the new card to consolidate your debts.

3. Home equity loans

If you own your home and have some equity in it, a home equity loan may be an option to explore. These loans use your home value as collateral but do have credit and income requirements to qualify. 

4. Debt management programs

These programs are typically offered by credit counseling agencies. They work with your creditors to negotiate lower interest rates or reduced monthly payments. You make one monthly payment to the credit counseling agency, which distributes the funds to your creditors.

5. Debt consolidation loans

Similar to personal loans, debt consolidation loans are specifically designed for consolidating debts. You apply for a loan from a bank or lender, and if approved you use the funds to pay off your existing debts. Then you make regular payments on the consolidation loan.

Remember, these options have their pros and cons, so you’ll want to consider which one aligns best with your needs and goals. Take your time to explore each method and compare interest rates, fees, and eligibility requirements. 

Potential drawbacks of debt consolidation

Debt consolidation is not a magical solution that automatically solves all your financial problems. It requires careful consideration and planning to ensure its effectiveness. Here are a few risks to be aware of.

Temptation to accumulate new debt

One drawback is the temptation to continue using credit cards or taking on new loans without addressing the underlying spending habits and financial discipline. If you fall into this trap, you might end up with even more debt than before, defeating the purpose of debt consolidation.

Extended repayment period

Debt consolidation can sometimes result in a longer repayment period compared to your original debts. While it can lower your monthly payments, it may mean that you end up paying more overall due to the extended duration of the new loan. Evaluate the trade-off between lower monthly payments and the total cost of the extended repayment period.

Potential for higher total interest paid

Depending on the interest rates and terms of the consolidation loan, there is a possibility that you may end up paying more in total interest compared to your original debts. This is particularly true if you extend the repayment period or opt for a consolidation loan with a higher interest rate. It’s crucial to compare the total interest costs of your current debts with the projected interest costs of the consolidation option. 

Should you consolidate your debt?

Before deciding to consolidate your debt, it’s important to ask yourself some questions. 

Will consolidation save you money or cost you money?

Many consumers, especially younger adults just beginning to live independently, often have at least one credit card with a high interest rate — sometimes these rates can be well above 20 percent. The more of these types of cards you accumulate, the harder it can be to keep up with the minimum payments.

At that point, it might make sense to jump on offers to consolidate your credit card accounts onto one lower-interest-rate card. Many credit cards offer zero-percent or low-interest balance transfers to let you consolidate. This lets you make one payment at a lower interest rate for an introductory time.

Many of the low rates these new cards offer are only good for a set period. After that, the interest rate on your new card will probably move higher. And if you haven’t paid off your entire transferred balance before your teaser rate expires (usually 12 to 18 months), your new finance charges could jump as high as the old cards you just paid off. If you don’t think you can pay your entire balance within the introductory period, try to hold out for a card with a low fixed rate.

Does consolidation help you make timely payments?

One of the biggest advantages of consolidating debt is that, with fewer creditors to pay, you’re more likely to pay on time, which is one of the most important ways to maintain or build a good credit score. Having just one payment to make can simplify your debt paydown strategy.

Is consolidation helping you get out of — or getting you into even more — debt?

It may sound like common sense, but it’s important to remember that debt consolidation is still debt — you’ve only transferred the amount of debt you already have to lower your payments and make the payments easier to make. And while it might seem like you’re on your way to paying off your debt, you technically haven’t reduced any of what you owe.

And while it’s a good first step, it’s not a cure-all. The reality is that most consumers who choose to consolidate their debt end up with more debt a few years later, in some cases maxing out the credit cards that were freed up by the consolidation. 

So should you consolidate your debt? The verdict — it really depends on you

There’s no question that debt consolidation could save you money and help you make timely payments, but the most important factor to consider when consolidating debt is you: don’t let debt consolidation provide you a false sense of security — or permission to yourself — to take on additional debt. You’ll need the discipline and grit to pay off your consolidated debt as quickly as possible.

Taking Charge of Your Finances 

Debt consolidation can be a game-changer for getting your financial ducks in a row. It simplifies the tangled mess of multiple debts, lowers interest rates, and gives you a clear roadmap to paying it all off. But don’t dive in headfirst. Consider all the options and weigh the pros and cons before you decide on a method. 

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