How does debt consolidation work? Consolidating debt can help manage finances and lower interest rates. Here's what to know before you consolidate debt.
You may have seen debt consolidation advertisements promising to make your debt disappear on TV, or read success stories of people who finally dug out of debt by consolidating it. While debt consolidation can be a tactic that helps you better manage and take control of your debt, it’s not necessarily the best—or only—solution you can use to manage what you owe.
Here’s a closer look at what debt consolidation really entails, and four facts you need to understand before deciding it’s right for you.
Fact 1: Debt consolidation is really a refinanced loan with an extended repayment term.
Debt consolidation is the process of paying off several higher interest rate debts—like balances you might owe on a few different credit cards—with money from a lower interest loan you've secured with a bank, or a similar type of lender. To use this approach, you’ll first need to apply and be approved for a new loan that’s large enough to cover the debts you want to pay off. Lender policies for loan approval vary, but some may require that you have a good credit score, history of paying bills on time as agreed and meet other criteria like a certain income, debt to income ratio and proof of employment.
If you are approved for a new loan, it will have its own unique terms—like interest rate, length of the loan and required monthly loan payment. Once you have access to funds from your new loan, you’d pay your other debts off with that money. Then, you’d make one monthly payment to your new loan, until it’s paid off in full.
Fact 2: Debt consolidation will not eliminate or lower the amount of your debt.
Debt consolidation should not be confused with debt settlement, which Experian explains involves a third party negotiating with your creditor to reduce what you owe, and typically results in closing your credit accounts. Additionally, debt settlement could negatively impact your credit for some time. Because of this, it should be considered a last resort if you are otherwise in danger of defaulting on your credit card payments entirely.
Fact 3: You must be sure you can make the new monthly loan payment in full.
Other than the convenience of paying one monthly bill instead of many, debt consolidation may lower the interest rate(s) you pay on your monthly debt. However, the loan you use to pay off other debts will likely be an installment loan. That means you agree to make a monthly payment in a specific amount in full, for a specific period of time at an agreed-upon interest rate, until the loan is paid off. An installment loan is completely different than revolving credit, which is what credit cards usually offer. It does not allow you to make a minimum payment like a credit card does; the amount you can borrow with an installment loan does not increase as you pay the loan down, as it might with a credit card.
Fact 4: Debt consolidation won't correct problem spending.
Debt consolidation may help you spend less money on your debt if it helps you take advantage of a lower interest rate loan, but it won't address how you got into credit card debt in the first place. Use debt consolidation as an opportunity to take control of how spend and use credit cards so you don't find yourself balancing new debt from the loan you opened to consolidate, along with new credit card balances.
Make these simple financial habits part of your money management routine to reduce the chances that debt consolidation will leave you with more unintended debt:
- Track everything you spend so you know where your money goes
- Consider paying only with cash or prepaid debit cards until you're confident you won't accidentally overspend with a credit card
- Create a budget to balance your income, basic living expenses and the new monthly debt consolidation loan payment you'll have, so you know you don't have to rely on credit cards
- Once you're in the habit of paying off your monthly installment loan, establish automatic contributions to an emergency savings account from each paycheck; aim to build the balance to at least three to six months worth of your monthly expenses. When you do have unexpected financial emergencies, this money can be a safety net you can tap into to pay for them, instead of turning to credit cards or loans.