How Debt Consolidation Works
6 MIN READ
Published April 07, 2023 | Updated October 30, 2023
Keeping track of balances and payments can be difficult between multiple credit cards, auto loans, and student loans. Debt consolidation can help streamline your repayments and save money on interest charges.
Debt consolidation can combine multiple high-interest debts, such as credit card bills, into a single monthly payment.
Consolidating these debts into a single loan can simplify your finances, but it won’t fix the underlying issues that led to debt in the first place.
If you can find a loan at a lower interest rate, debt consolidation might be a good way to reduce your debt and pay it off faster. If you’re dealing with multiple debts and simply want to reorganize your debts, debt consolidation is an effective approach.
What Is Debt Consolidation?
Debt consolidation is the process of rolling multiple debts into a single balance transfer credit card or consolidation loan at a lower interest rate.
The process involves using the proceeds of the new loan to pay off individual loans.
Many lenders offer debt consolidation loans, but you can always use regular personal loans for the process.
Some lenders may even pay off the debts on your behalf, while others may disburse the loan amount to borrowers’ bank accounts so they can pay off lenders themselves.
You can then set up autopay to ensure timely payments toward your new loan.
If you qualify for a balance transfer credit card, you’ll have a 0% APR introductory period of six months to two years.
Transfer your existing balances to the new card and then pay off the balance within this introductory period to save money on interest charges.
When Is Debt Consolidation a Good Idea?
Debt consolidation can be a sound financial decision if:
- You have a large amount of debt. If you have small enough debt that you can pay off on your own within a year, it may not be worth the credit check and fees.
- You have a good credit profile to qualify for a debt consolidation loan at the lowest rates.
- You have enough income to pay the monthly payment. Although your overall debt payments will go down once you consolidate your loans, it may not be a good option for you if you are unable to cover your new loan payment.
- You have plans to address financial habits that led to debt in the first place. Spend some time evaluating your spending habits and making a budget to get your financial life in control.
How To Consolidate Your Debt
There are two main ways debt consolidation options and a debt relief company can help you determine which option is right for you:
Debt Consolidation Loan
Once your loan is approved, use the funds to pay off your existing debt. You’ll only have to deal with one monthly installment for a fixed term to pay back the loan.
Typically, you’ll need to have a good credit history to qualify for a loan. The higher your credit score, the more likely you are to qualify for better loan options.
If your credit score is 689 or below, you may still qualify for a loan but at a higher annual percentage rate.
Loan applications are usually approved within one business day.
Financial institutions and credit unions will check your debt-to-income ratio, your creditworthiness, credit utilization, and other criteria before deciding on the interest rate and the loan amount you qualify for.
Compare different loan offers to see which one offers the lowest loan rates and best repayment terms.
Balance Transfer Credit Card
You can also apply for a 0% balance transfer credit card if you qualify.
Once you are approved, you can transfer all your existing debts to the new card. Most credit cards have an introductory promotional period of up to two years, based on your eligibility.
If you go for this option, it is important to ensure that you pay off the balance in full during this promotional period to avoid incurring interest charges.
You should also know that you’ll need excellent credit of 690 or higher if you want to qualify for a balance transfer credit card.
While there are other ways to consolidate debt, such as through a home equity loan and borrowing against your retirement funds, these are not recommended because they are very risky.
Since HELOC is a secured loan, failing to make payments can put you at risk of foreclosure. A home equity line of credit should only be considered if you do not have any other options to tackle your debt.
Two Examples of Debt Consolidation
Here are two practical examples of how debt consolidation works:
Let’s say you have three credit cards with a total balance of $8,000 at an APR of 25%. If you pay off this balance over a period of twelve months, you’ll pay $1,124 in interest charges.
If you apply for a personal loan for $8,000 for a twelve-month term at an APR of 10%, you’ll pay only $440 in interest charges. Your total savings in interest costs in this example will be $684.
If you have $5,000 in credit card debt at 25% APR and pay off the balance in 36 months, you’ll end up paying $2,157 in total interest costs.
If you were to consolidate these balances in a loan with a loan term of 36 months and a 17% APR, you’d only pay $1,417 in interest. In this example, you will save $739 in total interest costs.
How Debt Consolidation Affects Your Credit Score
When you apply for a debt consolidation loan, your lender may run a hard credit inquiry with credit bureaus.
This will be reflected on your credit report, and you may see a small dip. This is usually a small and temporary dip. As long as you continue to pay your loan installments on time, your credit scores will not be negatively impacted.
Downsides of Consolidating Debt
Although there are several benefits of debt consolidation, there are a few downsides that you should be aware of:
- There are added costs involved in debt consolidation, such as balance transfer fees, loan origination fees, closing costs, and annual fees.
- Debt consolidation will not address the underlying reasons for debt accumulation. You’ll have to address these issues to stay out of debt in the future. For example, a smart idea is to put your credit cards away or cut them up until you can build appropriate money management and spending habits.
- If you fail to pay your debt consolidation loan before the due dates, it will negatively impact your credit score.
- If you have bad credit, it may be difficult to qualify for debt consolidation.
Debt consolidation can simplify debt repayment and help you save money on interest costs. However, this option may not be right for everyone. Fortunately, there are many other debt relief programs available such as debt management and debt settlement.
Regardless of your financial situation or your needs, TurboDebt can help you pay off your debts, so you can start building your savings.
With our counseling, consultation, and planning services, we can help you identify the right debt relief option for your needs. Connect with us today for a free consultation.