Debt consolidation: How it works and ways to do it

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In a Nutshell

Debt consolidation combines multiple debts into a single new debt that you repay with one monthly payment. You may be able to do this with a debt consolidation loan, balance transfer credit card or home equity loan. Debt consolidation can simplify your finances and may even help save you money. But because you’re opening a new account, you’ll need to meet the lender’s requirements to qualify.
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If you want to reduce or eliminate debt, debt consolidation could help streamline your finances by rolling multiple balances into a new account with a single monthly payment.

Consolidating debt can be a convenient alternative to juggling multiple payments each month. And it might help you save money if you’re able to qualify for a rate that’s lower than the combined rate you’re paying on your existing accounts.

But debt consolidation may not make sense in every situation. To decide if it’s right for you, here’s what you need to know about how it works, what some of your options are and how it can affect your credit.



How does debt consolidation work?

Keeping track of multiple debt payments each month can be overwhelming. Debt consolidation could make managing your payments easier by combining multiple debts into a new loan or credit card.

The funds from the new account are used to pay off your existing balances. Instead of making multiple debt payments each month, you make one payment according to the terms of the agreement of the new loan.  

Since you’re applying for a new account, you must meet the lender’s eligibility requirements to qualify. If you’re not eligible for an interest rate that’s lower than the combined rate you’re paying on your existing accounts, you could end up paying more in interest charges — so consolidating your debt may not be worth it.

But if consolidation is the right solution, it’s important to have a plan for repaying your debt before you get started. When you consolidate debt into a new loan or credit card, you free up space on your existing credit cards that can be used to buy even more stuff. If you don’t change your spending habits, you could end up deeper in debt than when you started.

What’s the best way to consolidate debt?

There are multiple ways to consolidate debt. The solution that’s right for you depends on various factors, including how much debt you have to repay, your credit history and the interest rates on your current accounts.

Debt consolidation loan

A debt consolidation loan is a personal loan that’s used to combine multiple balances into a single new account. It can be used to pay off all kinds of debt — including credit card balances, medical bills and more.

Unlike credit cards, which are a form of revolving credit, debt consolidation loans are installment loans. You borrow a set amount of money and pay it back — with interest — typically in equal installments throughout the life of the loan.

Debt consolidation loans are available from banks, credit unions and online lenders. Loan amounts vary by lender but often range from $1,000 up to $100,000. Interest rates typically don’t exceed 36% (though you should be wary of a rate that high). The amount and rate you may qualify for depends on your credit.

Balance transfer card

A balance transfer lets you move balances from one or more credit cards to a card with a lower rate. Some balance transfer cards have limited-time, 0% APR or low-interest introductory offers that are available as long as you make your payments on time. But if you’re late with a payment, the credit card company may revoke the offer and apply interest to your card balance.

If you decide on a balance transfer, it’s important to make sure you can pay off the amount you transfer before the promotion expires to avoid racking up additional interest charges. If you don’t repay the amount you transfer before the introductory period ends, the remaining balance will typically accrue interest at the card’s regular APR.

Plus, some cards charge a balance transfer fee, which adds to the amount you owe. If you opt for a balance transfer, the amount you transfer plus fees can’t exceed your credit limit, which means you may not be able to consolidate all of your debt, depending on how much you owe.

It’s important to note that some card companies don’t allow customers to transfer balances between cards they issue. If you want to complete a balance transfer, look for cards offered by different companies than the cards you already have.

Check out our balance transfer calculator to find out how much — if anything — you might save with a balance transfer.

Home equity loan

Home equity loans let you borrow money against equity you have in your home. If you can get a lower mortgage rate than you currently have, you might also consider a cash-out refinance loan. With a cash-out refinance, a new loan replaces your existing mortgage, and you get cash back from part of the equity you’ve built up over time.

You can use the funds from a home equity loan or cash-out refinance to pay off existing debt. 

You may be able to get a lower interest rate on a home equity loan or cash-out refinance than a personal loan or credit card since it’s secured by your house. But these types of loans are risky because if you can’t make your payments, your lender may have the right to start foreclosure proceedings, and you could lose your house.

It’s important to carefully consider all your options before you convert unsecured debt to secured debt.

Does debt consolidation hurt your credit?

The impact debt consolidation will have on your credit depends on your financial situation and credit history. There are five major factors that can affect your credit scores. Here’s a look at each of them and how debt consolidation may affect them.

Payment history

Your payment history is a critical factor used in the calculation of your credit scores. If you’re struggling to make multiple debt payments each month, consolidating your debt into a single monthly payment — simplifying your budget — could lead to more on-time payments, which may improve your scores. On the flipside, if a consolidated debt payment is more than your budget can handle and you miss payments, your credit scores may suffer.

Amounts owed

Your credit utilization is the ratio of your available credit compared to the amount you’re using. Experts typically recommend keeping this ratio below 30%. If you’ve maxed out — or are close to maxing out — your credit cards, consolidating your balances could help lower your credit utilization, which may have a positive effect on your credit scores.

Length of credit history

The longer your credit history, the better. When you open a new account, it decreases the average age of your credit history, which may lower your scores slightly.  

Credit mix

The types of accounts you have — including credit cards, installment loans, mortgages and more — also help determine your credit scores. Having a variety of accounts typically has a favorable impact on your credit scores. 

Hard inquiries

Hard credit inquiries come about when you apply for new credit and usually lower your credit scores by a few points — but the effect on your scores doesn’t usually last very long. Consistently making your payments on time and lowering your credit utilization will likely have a bigger impact on your scores than a single inquiry.

Our picks for debt consolidation loans

If you’re tired of juggling multiple debt payments each month, here are our top picks for debt consolidation loans that can help you simplify your finances and reduce or eliminate debt.

Marcus by Goldman Sachs

Why Marcus stands out: If you’re approved for a personal loan with Marcus, the company will send direct payments to up to 10 credit cards, making it simpler to pay off multiple debts. Since the loan funds are sent directly to your creditors, you won’t be tempted to use the money for something other than becoming debt-free.

Marcus offers competitive rates, but keep in mind that you’ll likely need fairly strong credit to qualify. 

  • No-fee promise — Marcus doesn’t charge origination, application, prepayment or late fees on its loans. But if you miss a payment, more interest will accrue on your loan.
  • On-time payment reward — If you make your loan payments on time and in full for 12 consecutive months, Marcus will let you skip a payment without accumulating extra interest. (But remember this means your personal loan term will be extended by one month.)

Read our full Marcus personal loan review to learn more.

Payoff

Why Payoff stands out: Payoff’s personal loan is designed to help people eliminate high-interest credit card debt. Payoff members receive individualized support that includes welcome calls and quarterly check-ins for the first year their accounts are open. Plus, you can monitor your credit scores with free monthly FICO® score updates.

Payoff’s lowest interest rates are much lower than the average APR for credit cards that are assessed interest. Qualifying for a lower rate can help reduce the amount of interest you owe while you pay down your debt. But if you aren’t eligible for a lower rate, you could pay an APR that’s similar to what your credit cards charge.

  • Eligibility requirements — On its website, Payoff notes that you need a minimum FICO score of 640 and no current delinquencies to qualify for a loan.
  • Fees — Payoff charges an origination fee of 0% to 5%, which gets deducted from the amount you receive when your loan is funded. The company doesn’t charge application, late, prepayment, returned-check or check-processing fees.

Read our full review of Payoff personal loans to learn more.

Wells Fargo

Why Wells Fargo stands out: Unlike some personal loan lenders that cap loan amounts at $40,000 or less, Wells Fargo offers unsecured debt consolidation loans of up to $100,000 and secured loans of up to $250,000.

Wells Fargo offers competitive personal loan rates that could include a relationship discount of 0.25%. But keep in mind that you’ll need to be a bank customer to apply online for a personal loan.

  • Direct debt payments available — Wells Fargo can send payments directly to your creditors or you can receive your loan funds by direct deposit or check. 
  • No prequalification option — Some lenders use a soft credit inquiry that allows you to check your estimated rate and loan term without affecting your credit scores before you formally apply, but Wells Fargo doesn’t. To find out your rate and loan term, you must submit a loan application, which will generate a hard credit inquiry that may affect your credit scores.
  • Minimal fees — There’s no origination fee for unsecured loans, but if you choose a secured loan, there’s a one-time origination fee of $75. There are no annual fees or prepayment penalties on either type of loan.

Read our full Wells Fargo personal loan review to learn more.

Avant

Why Avant stands out: You don’t need to have perfect credit to qualify for a debt consolidation loan with this lender. Avant says most of its customers have credit scores between 600 and 700.

Because Avant considers people who have less-than-perfect credit, its interest rates are higher than those offered by some other lenders. If you have good credit, you’re probably better off applying with a lender that offers lower rates.

  • Multiple fees — Avant charges late and insufficient funds fees, plus you could be charged an administration fee of up to 4.75% that’s deducted from your loan when it’s funded. Avant doesn’t charge a prepayment penalty if you want to repay your loan early.
  • Potentially fast funding — Avant says it’s often able to fund loans by the next business day after your application is approved. (But keep in mind it may take longer to receive your cash depending on your bank.)

Read our full review of Avant personal loans to learn more.

Our picks for balance transfer cards

If you want to eliminate high-interest credit card debt, combining multiple balances with a balance transfer could help minimize the amount of interest you have to pay. Here are our top picks for balance transfer cards that can help you get out of debt.

Citi Simplicity® Card

Why the Citi Simplicity® Card stands out: Many balance transfer cards give you only 60 days from your account opening date to complete a transfer with a 0% intro offer. But if you qualify for the Citi Simplicity® Card, you’ll have up to four months to transfer a balance to this card.

  • Intro offer — The Citi Simplicity® Card has a 0% APR introductory offer for 21 months on balance transfers (starting on the date of the transfer). If there’s a balance remaining at the end of the promotional period, it will accrue interest at the card’s regular balance transfer APR of 14.74% - 24.74%.
  • Balance transfer fee — You must pay a balance transfer fee of 5% (minimum $5) for every balance you transfer to this card.

U.S. Bank Visa® Platinum Card

Why the U.S. Bank Visa® Platinum Card stands out: The U.S. Bank Visa® Platinum Card comes with one of the longest 0% intro APR periods of any card available — the offer lasts for 20 billing cycles. When it expires, any unpaid balance will accrue interest at the card’s regular balance transfer APR of 14.49% - 24.49%.

  • Time limit — Balance transfers must be completed within 60 days of account opening.
  • Balance transfer fee — When you transfer a balance to this card, you’ll have to pay a balance transfer fee of 3% (minimum $5) of the transfer amount.

HSBC Gold Mastercard® credit card

Why the HSBC Gold Mastercard® credit card stands out: The HSBC Gold Mastercard® credit card has a 0% introductory APR for the first 18 months your account is open. When the intro offer expires, your remaining balance — if you have one — will accrue interest at the card’s regular balance transfer APR of 13.99% – 23.99%.

If you qualify for the HSBC Gold Mastercard® credit card, you’ll get your FICO score every month for free. With monthly FICO score updates, it’s easy to see how reducing your debt is affecting your credit scores.

  • Balance transfer fee — This card’s balance transfer fee is 4% (minimum $10) of the transfer amount per transaction.
  • Time limit — You must complete all balance transfers within 60 days from the date your account is open.

What’s next: What are my other options?

If you want to pay off debt but you don’t think debt consolidation is your best bet, there are some other options to consider.

  • Debt settlement — Debt settlement companies work with creditors to settle your debt for less than what you owe. But they often advise clients to stop making their payments, which can add interest charges and late fees to your balance. Plus, missing payments can negatively affect your credit scores.
  • Negotiating with creditors — Your creditors may be willing to work with you by waiving late fees, decreasing your interest rate, extending your repayment period or reducing the total amount you owe.
  • Debt management plan — A debt management plan is a tool that’s often used by nonprofit credit counseling agencies. The agency negotiates a repayment plan with your creditors, which may include reduced interest rates and fee waivers. You make one monthly payment to the credit counseling agency, and the agency pays your creditors.
  • Loan forbearance — If you’re experiencing a financial hardship, you may qualify for loan forbearance, which temporarily suspends or reduces your payments.


About the author: Jennifer Brozic is a freelance financial services writer with a bachelor’s degree in journalism from the University of Maryland and a master’s degree in communication management from Tow… Read more.