How to Consolidate Debt

Quick Answer

You can consolidate debt by completing a balance transfer, taking out a debt consolidation loan and tapping into home equity. Additional options include a debt management plan or debt settlement, though these option may hurt your credit score.
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If you're trying to keep up with all your debt payments but are increasingly feeling overwhelmed, it may be time for a new strategy. One way to get your debts under control is through debt consolidation. To consolidate debt, start with researching various methods to understand which might work for you.

When done right, debt consolidation can save you money and help you pay off your debt faster. However, some approaches present certain risks to be aware of. That's why, before you decide to consolidate your debt, it's important to understand how each method works and if it's indeed the right choice for you.

How Debt Consolidation Works

When you consolidate debt, you combine multiple debts, such as credit cards, medical bills and other unsecured loans, into one monthly payment with a lower interest rate. It can be an effective financial strategy if you have debt that carries high interest and you are ready to stick to a plan to pay off that debt.

There are several methods you can use to merge and pay down your debts using debt consolidation. Read on to understand your options and choose the one that works best for you.

Balance Transfer Credit Card

Balance transfer credit cards usually come with a promotional 0% annual percentage rate (APR) on balance transfers for a set period, typically between 12 and 20 months. The idea is to transfer your debts to the new card and pay off that debt during the introductory period to avoid paying interest.

When considering using a balance transfer card to consolidate debt, make sure the combined amount of debt you're transferring is lower than your credit limit. And don't forget to account for transfer fees and read the card's fine print. You may find that the APR for new purchases is different from the balance transfer rate, which could end up costing you if you make new purchases on the card. Typically it's best to use a balance transfer card only to pay your existing debt without incurring new debt.

If you don't think you'll be able to pay most of the balance before the promotional period ends, check to see whether your new card's ongoing APR is lower than the rates you're currently paying on your other cards. If it's not, this option might not be the best way to deal with your debt.

Debt Consolidation Loan

Another option is to get a debt consolidation loan that offers a lower APR than you're paying on your current debt. If your credit score is in good shape, this type of personal loan can help you reduce your total debt by hundreds or even thousands of dollars by decreasing the amount you owe in interest.

For example, let's say you owe $10,000 in credit card debt with an average APR around 22%, and you're currently paying $400 every month to meet the minimum payments. It would take you a whopping 184 months to pay off this debt, and you'd end up paying $8,275.44 just in interest. Now suppose you got approved for a $10,000 consolidation loan with an interest rate of 11%. With a fixed monthly payment of about $217, you'd be able to pay off this loan in only 60 months and save over $5,200 in interest.

That said, if you have less than stellar credit, you might not qualify for terms that would make a debt consolidation loan worthwhile. Before you get discouraged, however, shop around so you know all the available options to you.

Debt Management Plan

Debt management plans (DMPs) are programs offered by nonprofit credit counseling agencies. They are designed to help those struggling with a large amount of unsecured debt, such as personal loans and credit cards. They don't cover student loans or secured debts such as mortgages or auto loans.

Before signing up for a DMP, you'll go over your financial situation with a credit counselor to see if this option is a good choice for you. If you decide it is, the counselor will contact your creditors to negotiate lower interest rates, monthly payments, fees or all of the above, and they will become the payer on your accounts. Once they reach an agreement with your creditors, you'll start making payments to the credit counseling agency, which will use the money to pay your creditors.

When you agree to a debt management plan, you may have to close your credit cards per your credit counselor's requirements. You should also avoid applying for more credit, as your creditors will likely withdraw from the program if they see new debt on your credit report.

Debt Settlement

While debt settlement might seem similar to a debt management plan, this option could present a much bigger risk to your credit. You can try settling the debt yourself or hire a debt settlement company to do it for you for a fee (typically between 15% and 25% of the settled amount).

The goal is to negotiate a payment with your creditors that is lower than your full outstanding balance. Paying less than you originally owed may seem like a great deal—until you consider the consequences to your credit, which could be substantial. Additionally, the forgiven debt may be reported as income to the IRS, which means you may have to pay taxes on it.

If you work with a debt settlement company, it will usually require you to stop paying your bills while it negotiates your new settled amount, which is typically 50% to 80% of the total balance. Late payments will be reported to the credit bureaus (Experian, TransUnion and Equifax) and will stay on your credit report for seven years. These accounts could even go into collections as you wait for your debt settlement company to complete negotiations. All of these actions will have a substantial negative impact on your credit.

That's why you should only consider debt settlement as a last resort. For instance, it may make sense if you already have accounts that are severely delinquent or in collections. Otherwise, look into other methods to consolidate debt.

Borrowing From Home Equity or Retirement Accounts

These two methods of debt consolidation are associated with potential risk not just to your credit score, but also to your assets. They include borrowing against your house and borrowing from your retirement account.

If you have equity in your house, you may be able to use a home equity loan or line of credit (HELOC) to get the cash you need to pay off your other debts. This method is popular because home equity loans and lines of credit offer low interest rates, as they use your home as collateral for the loan. But that's also where the danger lies: You risk losing your home if you default on your payments.

As for borrowing from your 401(k), you could get up to 50% or a maximum of $50,000 from your retirement funds. There's no credit check, the interest rate is low and repayment is deducted from your paycheck. However, once you pull out the funds from your 401(k), they will lose the power of compounding interest that allows your account to grow. Furthermore, if you do not pay back the amount in full, you may have to pay an early withdrawal penalty and income taxes on the amount withdrawn.

Because of the risks associated with these methods of debt consolidation, you might only want to consider them in a financial emergency or when other alternatives are exhausted.

How Debt Consolidation Affects Credit

In the long run, sticking to your debt payment plan can help your credit scores. However, as you begin to consolidate debt, you might see your scores drop. How long it will take your scores to recover will depend on the consolidation method you've chosen.

Here are some ways debt consolidation can affect your credit:

  • New credit applications: When you apply for a debt consolidation loan or balance transfer credit card, the lender will check your credit, resulting in a hard inquiry on your credit report. Hard inquiries lower your score by a few points; however, your score should recover fairly quickly.
    Adding new accounts to your credit file also reduces the average age of your credit, or how long you've maintained open accounts. This can impact your credit score and is one reason to consider keeping your paid accounts, which contribute to a longer credit history, open. Instead of closing the accounts, put the cards in a drawer or somewhere you won't use them.
  • Change in credit utilization: Your credit utilization ratio, or percentage of available credit you're using, also affects your credit score. The lower your ratio, the better for your credit because this shows you're not using up all of your available credit. If you keep your old credit cards open after a balance transfer, your credit utilization will likely decrease, benefiting your score. However, keep in mind that even a single card with a high utilization rate—in this case, the balance transfer card you used to consolidate debt—might still have a negative effect on your credit. That's another reason to avoid incurring new debt on your balance transfer card and putting your old cards away so you're not tempted to use them.
  • Debt management plan requirements: Signing up for a DMP may have a negative effect on your credit score as well. Even though the enrollment itself has no impact on credit scoring, your report will show less available credit as a result of closing your credit cards, which is often required by DMP counselors. Your score might experience an initial drop, but will likely recover if you follow the plan.
  • Settled debts: Of the methods we've discussed, debt settlement presents the biggest risk to your credit score because you're paying less than the full balance on your accounts. The settled debt will be marked as "paid settled" and will remain on your credit report for seven years. The more debts you settle, the bigger hit your credit score could take. In addition, late payments and even collections, which often occur when you use this method, will bring your score down.

Whichever debt consolidation method you choose, the most important step you can take is to maintain a positive payment history by making all your payments on time. This can help your scores recover from short- and medium-term negative effects and even improve in the long run.

Is Debt Consolidation the Right Choice for Me?

Whether debt consolidation is a good option for you depends on your financial circumstances and the type of debt you wish to consolidate. Carefully consider your situation to determine if this path makes sense for you.

When Debt Consolidation Is a Good Option

Consider debt consolidation in these situations:

  • When you have a good credit score. Having a high credit score can make it possible for you to qualify for 0% balance transfer cards and low interest loans. On the other hand, if your score could use some work, you might not get the terms that would make debt consolidation effective.
    But even if your credit score is not perfect, it might still be worth a shot to shop around for debt consolidation loans, as their terms may be better than what you currently have. In the end, what matters is whether it will help you pay down your debt before it gets overwhelming.
  • When you have high interest debt. Debt consolidation is a good option if you have high interest debt because it allows you to save money by reducing the interest you're paying.
  • When you're overwhelmed with payments. If it's becoming hard to keep track of your debt payments, debt consolidation can solve that by helping you merge multiple payments into one, making it easier for you to pay on time.
  • When you have a repayment plan. Having a plan and following it is essential to successful debt consolidation. Before taking the first step to consolidate debt, it's a good idea to decide on the payment strategy and make sure you'll be able to stick to it. This may include reviewing your budget and changing some of your spending habits.

When Debt Consolidation Might Not Be the Best Idea

Debt consolidation may not be the best approach in these situations:

  • When your debt amount is small. Debt consolidation doesn't make much sense if you can pay off your debt in less than a year. It might not be worth your effort if you'd only save a small amount by consolidating.
  • When you're considering federal student loan forgiveness. It's true that consolidating your student loans can simplify your monthly payments. But if your loans are currently in the direct loan program, consolidation would reset the clock on the 10-year repayment requirement since your original loan wouldn't exist anymore.
  • When you're not planning on changing your spending habits. Debt consolidation isn't always easy, as it involves finding new ways of saving money and getting rid of the old spending habits. If you don't think you're ready to commit, it might not be the right approach to getting out of debt for you.

What Are Debt Consolidation Alternatives?

Debt consolidation can be an effective tool when managing debt, but it's not a magic bullet. There are other solutions you can try that don't involve taking out new credit or potentially damaging your credit score.

Create a Budget

Sometimes all it takes to get out of debt is making a budget and following it. To create a budget, start by calculating your monthly expenses and comparing them with your income. Once you determine how much extra money you have after paying necessities, set realistic debt payoff and savings goals and commit to the plan. Make sure to record your spending to track your progress.

Take a financial inventory and see if you can battle your debt without using methods like debt consolidation. The main thing here is to stay disciplined and not spend more than you truly can afford.

Consider the Debt Avalanche Method

Another approach to eliminating debt is the debt avalanche method, which focuses on paying off the revolving debt with the highest interest rates first as you work to pay off all your accounts.

For this approach, list all your debts from the highest interest rate to the lowest and pay the minimum balances on all of them. Then, use whatever your budget allows to pay more toward the debt with the highest interest rate. When you're done paying it off, move on to the debt with the second-highest interest rate on your list, and so on.

High interest debt is the most expensive to you, so eliminating it first saves you the most money.

Consider the Debt Snowball Method

This approach is similar to the debt avalanche method, but in this instance, you'd order your debts by balance starting with the lowest.

After paying the minimum balance on all your debts, use any extra money to put more toward the debt with the lowest balance. Once that's paid, move on to the debt with the next lowest balance, and so on. This way you can reduce the number of debts faster, which can motivate you to keep going since you'll see progress quickly.

The Bottom Line

If you're considering debt consolidation, it's best to carefully evaluate your financial situation and research your options to determine if it's the right solution for you. Before you begin, take a look at your free credit score to see where you stand and make sure to monitor it to track your progress and any changes as you work to pay off your debt.