What Is Debt Consolidation, and Should I Consolidate?

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With the U.S. economy officially in a recession and historic unemployment numbers, many people are feeling the squeeze. According to a recent NextAdvisor survey, more than half of all Americans have felt anxiety over their personal finances in recent months, with debt being a significant contributor.

While debt is an everyday part of life for many, it can snowball into big problems when you fall behind on payments. But there are things you can do before you fall too behind on your debt. Debt consolidation may be a way to lower the interest rate or monthly payments of your current obligations. But this isn’t a solution for everyone, and with so many different ways to consolidate debt, you should be thoughtful about what might make sense for you.

What is Debt Consolidation?

Debt consolidation is the process of combining all of your debts into a single payment, often with a loan or balance transfer credit card. 

“Typically with debt consolidation, you’re also looking to lower your interest rate. So it would be [to] save money and save hassle,” says Ted Rossman, a credit card analyst with Creditcards.com. When done well, debt consolidation can help you get out of debt faster and save, or rebuild, your credit.

Debt consolidation shouldn’t be confused with debt settlement, which all of the experts we talked to said to avoid if possible. “When you settle for less than you owe, it’s a bad thing for your credit score,” Rossman says. “And also, a lot of those companies will try this tactic where they tell you to stop paying for a while.” Debt-settlement companies will use the fact that you aren’t paying back your debt as leverage to negotiate a smaller payback, says Rossman. However, there is no guarantee this strategy will work, and even if it does, an account that is settled for less than you owe will negatively impact your credit report for seven years.

How to Consolidate Debt

There are six different ways to consolidate debt, but the financial tools you can use fall into two main categories: secured and unsecured.

A secured loan is backed by something of value you own, like your home or car. An unsecured debt has no underlying asset or collateral attached to it. With secured debt, if you default, the lender can take your home or other physical property. For that reason, unsecured debt, like that of a balance transfer credit card, is a preferable and safer way to consolidate.

Secured loans are less risky for a lender than unsecured loans, so they can have better interest rates and terms. But that doesn’t mean a secured loan is always the best option. A home equity line of credit (HELOC) may have a better interest rate than your current debt — but if you can’t pay, your house is on the line. 

Choosing the right debt consolidation strategy depends a lot on your financial situation. The catch-22 is that to qualify for the best interest rates, you’ll need to have a high credit rating. And those in dire financial situations may not even be able to qualify for some of the better debt consolidation options, like 0% APR credit cards or low interest personal loans. 

Lenders are worried about the future of the economy, so they are implementing higher standards for balance transfer credit cards, home equity lines, and personal loans, says Rossman. “Unfortunately, it’s a tough time right now for debt consolidation because a lot of the normal avenues have either dried up or they’re just harder to qualify for,” Rossman says. 

How to Consolidate Debt

1. 0% APR balance transfer credit cards

While they are increasingly tough to come by right now, some credit cards have introductory offers of 0% APR on balance transfers for a set time period, usually 12 to 18 months. If you can qualify for these card offers, you can save on interest. For a balance transfer card to make sense, you’ll need to be able to pay off the debt during the 0% period. Just keep in mind the balance transfer fee (3 to 5%) which can eat into your savings. If possible, apply for a card with no balance transfer fee and 0% APR.

2. Debt-consolidation loan

Taking out a personal loan with a bank or credit union is another potential option for consolidating debt. A personal loan will have a fixed interest rate, which is an advantage over a credit card with a variable rate. Your credit score, income, and debt will determine what interest rate you can qualify for. So before you apply, shop around to ensure you will actually be saving money by getting a personal loan with a better interest rate — and be aware of up-front origination fees which can be as high as 8% of the loan amount. Finally, if you have federal student loans you’re interested in consolidating, you may not want to use a personal loan since you’d be losing certain protections that private loans don’t offer, such as forbearance options or income-based repayment plans.

3. Credit counseling agency

Working with a nonprofit credit counseling agency is a great way to get free or low-cost help with your debt. Credit counselors can give you free advice on budgeting or money management and even set you up with a debt-management plan (DMP) for a small fee. A DMP is similar to debt consolidation, but instead of taking out a loan to pay off your debts you make one payment to the counseling agency, and they pay your creditors. Under a DMP, your credit counselor also negotiates with the lenders for reduced interest rates or fees. Just know that if you choose to go with a DMP, there will be fees. Typically a setup fee is around $50 to $75, and monthly administrative fees range from $25 to $50. Also, you are generally required to close your credit card accounts as part of the DMP.

Pro Tip

If you don’t have the credit score to qualify for 0% APR balance transfer credit cards or low-interest personal loans, consider credit counseling. You may be able to save without dipping into your retirement funds or putting your house on the line.

4. Secured loans

Consolidating debt with a secured loan is an option you’ll want to consider carefully, and probably as a last resort. Securing a loan with collateral is less risky for the lender, so you might be able to get a better interest rate. But it comes with a significant downside for you if you default. So you should consider this route only if you have a secure source of income.

5. HELOC (Home Equity Line of Credit)

The most common type of secured loans are those attached to a retirement account or a home. If your home is worth more than you owe, you could take out a home equity loan, set up a HELOC (home equity line of credit), or do a cash-out mortgage refinance to turn that value into cash to consolidate your debt. When mortgage rates are low, like they are now, this can be an excellent opportunity to save. But don’t miss any payments: If you default on a loan that’s backed by your home the lender could foreclose on your property.

6. Retirement accounts

If you have money invested in a retirement account, you can either take out a loan or withdraw the money early (aka take a distribution), depending on the type of account. This is generally a big no-no, because it can throw your retirement plan offtrack, result in penalties, and leave you more vulnerable in the long term. Money in your retirement account is typically protected from bankruptcy.

When Consolidating Debt Makes Sense

Consolidating debt makes sense if you have multiple loans or credit cards at high interest rates. Combining these under one interest rate could save you money in the long run. It also helps the day-to-day management of debt. If you’re juggling multiple payment deadlines, then it’s easy for a payment to slip through the cracks and damage your credit score. Debt consolidation also makes sense for those who already have a payoff plan and a sustainable budget.

When Consolidating Debt Isn’t Worth It

It’s not worth it to consolidate debt if you cannot get a lower interest rate than what you are already paying. Taking out a new loan or initiating a balance transfer requires fees, and if the interest rate isn’t competitive, then potential savings could be lost from the fees. Debt consolidation also isn’t beneficial when you don’t have a plan to pay off that debt. It’s not a silver bullet — you’ll still need to be diligent with your budget and make your payments on time and in full.