Debt Consolidation

By Mike G.

Debt consolidation means taking out one new loan or credit line to pay off several existing debts, so you make one payment instead of many. It saves money only if the new rate, after fees, is lower than what you’re paying now.

How it works

There are three common ways to consolidate:

• Personal loan. A bank, credit union or online lender lends you a fixed amount, often at a fixed rate, for a set term of a few years. Some low advertised rates last only for a set time.^[1] You use it to pay off your cards or other debts, then repay the loan in equal monthly payments.
• Balance transfer card. A credit card with a low or 0% introductory rate lets you move existing card balances onto it. There’s usually a transfer fee, and the low rate ends after the promotional period.^[1]
• Home equity loan or line of credit. These use your home as collateral. Rates can be lower, but if you can’t repay you could lose your home.^[1]

In every case the debt doesn’t go away. It moves. Consolidation changes the rate, the payment and the number of bills. It doesn’t change how much you owe on day one.

Who it fits

Consolidation tends to work for people who:

• Carry high-interest debt, mostly credit cards
• Have credit good enough to qualify for a meaningfully lower rate
• Can afford the new monthly payment with room to spare
• Have stopped adding new charges

If debt has already hurt your credit score, the offers you get may not be low enough to save anything.^[1]

The Debt Audit points here when paying off on your own would take roughly three to five years and your average rate is high. It only does so when its own estimate, fees included, shows a real saving. The exact rules and the rate it assumes are on How the audit works.

Pros and cons

Pros

• A lower rate means more of each payment goes to the balance
• One payment is easier to manage than several
• A fixed-term loan has a clear payoff date

Cons

• Fees can wipe out the savings, especially on smaller balances
• A longer term can lower the payment but raise the total interest^[1]
• Promotional rates end, and the rate after that can be high
• Paid-off cards are open again, which makes it easy to run them back up
• Home equity options put your house at risk

What it costs

Look past the monthly payment to the total cost:

• Origination fees and other charges add to a personal loan’s cost. The loan’s disclosure lists them.^[2]
• Balance transfer fees are usually a percentage of each amount moved, or a flat minimum, whichever is more.^[1]
• The rate after the promotion on a transfer card, if any balance is left when it ends.
• Closing costs on some home equity loans.

A fair comparison is total interest plus fees under the new loan against total interest on your current debts, paying the same amount each month. That’s how the Debt Audit’s estimate works.

How it affects your credit

Applying usually means a credit inquiry, which typically has a small negative effect on your credit scores.^[3] After that, paying off cards with a loan can lower how much of your card credit you’re using, and on-time payments on the new loan build your history. The damage usually comes later, if the old cards fill back up or payments on the new loan slip.

Red flags

• A “consolidation” offer that’s really debt settlement. If a company tells you to stop paying your creditors, it isn’t a loan. See debt settlement.
• Fees charged before you get anything.
• A payment that’s lower only because the term is much longer. Check the total cost.
• Pressure to borrow against your home to pay off unsecured debt like credit cards.
• A promotional rate with a short window you can’t realistically pay the balance off within.

Frequently asked questions

Sources