What Is Debt Consolidation?

young couple sitting on the floor going over finances

If you're feeling overwhelmed by debt, there are several ways to get your finances under control. One method is debt consolidation, which allows you to consolidate multiple debts into just one loan or credit card. This can make your debt easier to manage and might also allow you to pay less interest and lower your monthly payments.

What Does It Mean to Consolidate Debt?

Say you have several forms of debt: credit card debt, and maybe an unsecured loan or medical bill. You're struggling to keep track of them, and the interest rates are sky-high. Debt consolidation allows you to merge them, or consolidate them, into a single loan or credit card, ideally at a lower interest rate. This means you'll owe one creditor instead of several, and your monthly payment might be lower due to the lower interest rate.

There are a few debt consolidation methods, but these are the two most common:

  • Balance transfer credit card: With this method, you obtain a credit card with an introductory 0% annual percentage rate (APR) for a set period that's typically anywhere from 12 to 20 months. You then transfer your high-interest debts to this new credit card, where you temporarily will not owe any interest. The goal with a balance transfer card is to pay off all or as much of your balance as possible during this time before the higher ongoing interest rate kicks in.
  • Debt consolidation loan: If you have good credit, you may be able to get a debt consolidation loan with a lower interest rate than your existing debts. You'll pay off your other debts with this loan, simplifying payments and ideally paying less over the life of the loan. When you qualify for a loan with a lower interest rate than your previous debts, more of your payment goes to the principal debt, allowing you to potentially pay down your debt much faster.

Is Debt Consolidation Different from Debt Settlement?

Another way to tackle debt overload is debt settlement, but this is not the same as debt consolidation and can seriously damage your credit. With debt settlement, you negotiate to pay a lower amount of debt with your creditors than you originally owed. You can either try doing it yourself, or you can hire a debt settlement company to do it for a fee.

Debt settlement doesn't lower your interest rates, as a debt consolidation loan or balance transfer credit card does—just the balance. And settling your debt can have major negative consequences on your credit scores, since you're not paying the debt as agreed. In addition, debt settlement companies typically have you stop making payments on your debts, which can cause your credit scores to plummet even further.

Debt consolidation, on the other hand, shouldn't negatively impact your credit if you make all of your payments on time—in fact, if it helps you avoid late payments and you pay the loan as agreed, debt consolidation could even help your credit.

What Are the Benefits of Debt Consolidation?

Debt consolidation has several potential benefits:

  • Better interest rates: If you have a credit card or loan with a steep interest rate—say 20%—a big chunk of your monthly payment is going toward interest rather than paying off your balance. Finding a debt consolidation loan or credit card with a lower interest rate can significantly lessen how much interest you pay over the life of the loan. In the case of a balance transfer credit card with an introductory offer, you can even pay 0% for a set amount of time. This can save you hundreds, or even thousands, of dollars in the long run.
  • Shorter term lengths: When you consolidate your debt, you can also choose a shorter term length than what you originally had, allowing you to pay off your debt even faster.
  • Easier to manage: If you have multiple debts all due at different times, you may have a hard time keeping track of payments, increasing the likelihood of making late payments. When you consolidate your debts into one account with one due date, it's much easier to manage and make on-time payments. Payment history is the most important component of your credit score, so if you have a track record of missing payments or making late payments, consolidating your debts and paying your bill on time can help give your credit a boost.

What Are the Disadvantages of Debt Consolidation?

While debt consolidation can be hugely beneficial for some people, it's not for everyone. First, keep in mind that there's no guarantee you'll be able to qualify for a balance transfer credit card or debt consolidation loan with a lower interest rate than that of your existing debt. If you have good credit, it will be easier to qualify. But if your credit needs improvement, it's possible you won't be able to get the lower rate needed to consolidate your debts and save money.

Also, be aware that if you extend the term of your original loan, it can actually become a more expensive proposition. Even if your interest rate is lower, it can still cost you more over time if you take longer to pay off the debt.

Some debt consolidation methods, such as an unsecured loan, require no collateral. Other options, such as consolidating your debt with a home equity line of credit (HELOC), can put your assets at risk. Before you go down that road, make sure you can stay on top of the payments so you don't find yourself at risk of losing your home.

What Credit Score Do You Need for Debt Consolidation?

There isn't a magic number you need to consolidate your debt, but your credit does play a big role. You can potentially qualify for debt consolidation loan if you have a fair credit score (above 580), but be aware that the interest rate might be even higher than the one on your original loan. In this case, it might not save you money at all, and could even cost you more.

While you might be able to get a debt consolidation loan with bad credit, keep in mind that the higher your credit score, the better your interest rate will be. If your credit score needs some work, you might consider taking efforts to improve it before you apply for a debt consolidation loan.

Weigh Your Options

If you're struggling with multiple forms of high-interest debts, debt consolidation can help you make them more manageable and potentially lower your interest rate and monthly payments. Whether this method works for you will be contingent upon the state of your credit and whether you can qualify for debt consolidation with a lower interest rate than you're currently paying.

If your credit needs work, work on improving it before you apply for a debt consolidation loan or balance transfer credit card. Also consider trying Experian Boost®ø, which could help give your score a lift by giving you credit for your on-time utility and telecom payments.