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Personal Finance

What is Debt Consolidation and How Does It Work?

Updated Jun 16, 2023   |   7-min read

If you’re concerned about your debt management, you aren’t alone. Nearly eight in ten Americans maintain some level of debt, with a collective bill of approximately 3.9 trillion dollars as of September 2018.

Of course, all debt is not created equally. The largest portion of U.S. consumer debt—2.9 trillion dollars—is made of loans like mortgages, auto loans, and student loans. Student loan debt is unique from other types of debt in many cases as far as how it can be managed and repaid.

The rest—about 1 trillion—is made up of credit card debt, frequently referred to as revolving debt.

For some, managing that debt is a natural part of their everyday life, fitting seamlessly into their finances. Unfortunately, for many others, managing debt and multiple payments can become a burdensome balancing act.

Furthermore, those struggling to repay their debts often find that multiple balances and due dates, when paired with high interest rates, make it nearly impossible to get ahead. Sometimes having a single payment could be advantageous, and there are ways to do this.

On this page:

What is Debt Consolidation?

There are numerous ways that consumers can take control of their debt including credit counseling and working with a credit counselor, and a debt management plan. There are various forms of debt relief, including debt relief companies, that may be available to a person, depending on the specific situation. 

Debt consolidation is also frequently an option. Through debt consolidation, an individual can replace numerous debts—and therefore payments, due dates and possible late fees, and interest rates—by taking out a new loan or consolidating their debt onto a credit card. Once the debts are consolidated, the consumer is responsible for a single monthly payment with one fixed interest rate rather than trying to keep up with multiple minimum payments. 

Typically, debt consolidation is limited to unsecured debt and unsecured loans, like credit card balances, medical bills, or personal loans, though there are some cases where secured debt, like a car loan, can be included in consolidation efforts.

>> Read More: Does Debt Consolidation Hurt Your Credit?

How Does Debt Consolidation Work?

If you’re considering consolidating your debt into a single loan payment, you typically will be able to do so using one of these two methods:

Balance Transfer Credit Card

When consolidating debt through a balance transfer credit card, you can transfer numerous balances to a single credit card, securing one monthly payment and a single interest rate. Transferring balances to a credit card can be beneficial if you have good or excellent credit or have a received a balance transfer offer with a 0% or low-interest rate.

Though debt consolidation through a balance transfer can be beneficial for qualified cardholders, there are a few things to consider. Typically, balance transfers include a fee of 3% to 5% of each balance transferred, the sum of which is added to the principal balance and will accrue interest either immediately or after the promotional date.

Further, because balances are being transferred to a single credit card bill, the total amount of the transfer cannot exceed the credit limit of the card. This may limit the number of debts you can combine.

Also, even though you will receive a lower monthly payment than your total payments in many cases because of a low interest rate, it doesn’t erase the interest you owed previously. 

Fixed-Rate Debt Consolidation Loan

Another option that you may want to consider depending on your financial situation is a fixed-rate debt consolidation loan. A debt consolidation loan a personal loan that is used to pay off multiple debts and tackle a variety of debt problems. When consolidating debt through a loan, you will secure fixed monthly payments and a designated pay-off date.

In addition to predictability, fixed-rate debt consolidation loans may allow you to consolidate more debt payments since lenders may issue loan limits that are higher than the credit limits that accompany a credit card balance transfer. 

Though a fixed-rate debt consolidation loan does have benefits, those with excellent credit and minimal debts may find that a balance transfer is more affordable, though this varies from person to person.

Who Should Consider Debt Consolidation?

In some cases, debt consolidation can be a logical move, particularly if you can secure a low-interest loan or if you have a balance transfer offer with a low or 0% interest rate. Additionally, it’s important that any efforts to consolidate debt are accompanied by a sustainable repayment strategy, as failure to pay can land you further into debt and, in many cases, damage your credit score and credit report history. 

Though a credit score and a low debt-to-income (DTI) ratio are not required, they are often beneficial in helping you obtain the best interest rates and loan terms and limits. As such, it’s helpful to enter into debt consolidation efforts with a good credit score and a low DTI.

When Should Debt Consolidation Not Be an Option?

Though debt consolidation does present a means to take control of your debt, it’s not always the best idea, and in some cases, it can further hinder your efforts to relieve yourself from debt. This is particularly the case if you are unable to secure a loan or balance transfer with lower interest rates than the those currently attached to your existing debts. The same may be true for those who have debts that exceed half of their income.

Conversely, borrowers who have minimal debts, particularly those that can be paid off within six to 12 months, may also want to refrain from debt consolidation, particularly if the new interest rate doesn’t result in significant savings.

Bottom Line

Debt has become a common factor in the lives of many Americans, and if you’re one of them, then debt consolidation may offer relief from debt and a pathway to financial freedom beyond simply making minimum monthly payments on multiple forms of debt. However, consolidation is not right for everyone.

If you have poor credit, debt that exceeds half of your income, or if you can pay down your debt in a year or less, debt consolidation may not be the best option. However, if you have good credit and can secure low interest rates or 0% financing on a balance transfer, debt consolidation can help you take control of your debt, making it simpler and more affordable.

For someone with poor credit or who might not be a good candidate for debt consolidation, they might consider an alternative.

Alternatives include working with a credit counseling agency or participating in a debt management program, or negotiating with debt settlement companies, although these can have pros and cons as well. There are also specific repayment plans a person can follow, such as a debt snowball. 

If you are dealing with debt problems, deciding on the right course of action is based on your individual financial situation, your ability to change your spending habits, and your current credit history.