How to Consolidate Debt

Combine your debts into one payment with a lower interest rate

Fact checked by Betsy Petrick

You can consolidate your current debts in a variety of ways, often obtaining a lower overall interest rate in the process. Debt consolidation methods include transferring multiple debts to one credit card, getting a debt consolidation loan, using some of your home equity, or borrowing from your retirement accounts. Setting up a debt management plan or negotiating a debt settlement is also possible, although the latter could hurt your credit score. 

Key Takeaways

• There are several ways to consolidate your existing debts, including credit cards, loans, and debt management plans.
• The higher your credit score, the more options you are likely to have and the better the interest rates that might be available to you.
• Every debt consolidation method has some pros and cons.
• There are also alternatives to debt consolidation that can be worth considering.

Ways to Consolidate Debt

If your debt has become hard to manage, there are ways you can retake control and start paying off your creditors through debt consolidation. 

Get a Balance-Transfer Credit Card

Many credit card companies offer zero- or low-interest balance transfer credit cards you can use to move multiple debts to one account. In addition to credit card balances, you may be able to transfer other types of debt, such as medical bills and student loans.

Because there is little or no interest on a balance transfer credit card, your monthly payments will go toward the principal balance, allowing you to pay the debts off faster.

Typically, that special interest rate is only for an introductory period, ranging between nine and 21 months. Paying off your balance before the promotional rate expires will save you a lot of money. However, if you don’t pay the balance off within that period, the interest rate could greatly increase, meaning you will start paying hefty interest charges that could make it more difficult to pay off the card.

Other considerations for a balance transfer card include:

• If your credit is poor, you may not get approved. Zero- or low-interest cards typically are available to individuals with at least good credit scores. If you have a low credit score, you may not be approved for the card.
  
• The credit limit might not be adequate to consolidate all of your debt. While you may get approved for a balance transfer credit card, the credit limit you’re assigned might not be high enough to cover all of your debt. So you may need to use more than one debt consolidation method. 
• Balance transfer cards typically include a fee. While the card might not have an annual fee, you will likely be charged to transfer debt to it. Balance transfer fees are often between 2% and 5% of the amount you transfer.
• You could owe interest on new purchases. Even if the card charges low or no interest on balance transfers it may impose a high interest rate on any new purchases that you make with it. It may also continue to charge interest on those new purchases until your entire balance, including the transferred debt, is paid off.
• If you make late payments, you could lose your promotional rate. The credit card company can raise your interest rate if your payments are more than 60 days late.

Take Out a Debt Consolidation Loan

A debt consolidation loan is a type of personal loan used to pay off several debts, resulting in one loan payment. This can not only make debt repayment easier to budget for, but it may also reduce how much you pay in interest or late fees to other creditors. 

Debt consolidation loans often have lower interest rates than credit cards, which could save you a lot of money if much of your existing debt is on one or more cards. In addition, unlike credit cards these loans have fixed monthly payments for a set term, so you’ll know exactly how much you have to pay each month and when the loan will be paid off. Having a light at the end of the tunnel could provide motivation to keep making your payments. 

However, there are some things to consider before applying:

• You will probably need good credit to be approved for a low-interest debt consolidation loan. The higher your credit score, the better the interest rate should be, maximizing your monthly savings. 
• You may pay origination fees for the loan. Many lenders charge these fees when you take out a loan. However, if you have good credit, you may find a lender that will waive them. 
• You could pay more in interest over the loan term. While you may receive a lower interest rate on a debt consolidation loan than you have on your current debts, but if the loan term is long, you could end up paying more interest in total by the time you’re done. 

Get a Home Equity Loan or HELOC

If you own a home and have sufficient equity in it, you could use that as collateral for a home equity loan or home equity line of credit (HELOC). Both tend to have lower interest rates than other types of loans or credit cards. But there are some risks.

For a home equity loan, lenders may approve you to borrow up to 80% of the equity you have in your home. For a HELOC, how much you can borrow depends on your own creditworthiness.

Either a home equity loan or a HELOC could be a good choice for consolidating debt, but there are some possible downsides to be aware of. 

• You may have to pay fees and other charges. Lenders often charge fees, closing costs, and points when financing a home equity loan. Points, which can be optional, allow you to reduce your interest rate by paying more upfront on your loan.
• The interest rate on a HELOC may change. While a home equity loan comes with a fixed rate, the interest rate on a HELOC is often variable, so your payments could increase.
• You could lose your home. Because you’re using your home as collateral, if you fail to pay the loan or HELOC back as agreed, the lender could foreclose on your home. 

Borrow From Retirement Accounts

If you have a 401(k) or similar plan at work, you may be able to take a loan from it if your employer’s rules allow that. Under current rules, you could borrow up to $50,000 or 50% of your account balance, whichever is less. Plus, when you pay interest on the loan, that money goes back into your 401(k) instead of to a lender. 

Unlike most other debt consolidation methods, you won’t have to undergo a credit check, so you don’t have to worry if you have bad credit. Even so, you should heed the following cautions before taking a 401(k) loan: 

• You will pay fees. For 401(k) loans, you’ll often have to pay a set-up fee and possibly service fees.
• You’ll earn less on the money in your 401(k). The money you take from your 401(k) won’t enjoy the tax-deferred compounding that it would have if it had remained in the account. That loss could be more than what you’d pay in interest using other debt consolidation methods. 
• You may have to repay the loan earlier than expected. If you part ways with your employer, you may have to pay the loan off in full within a relatively short period. If you can’t repay, the money will be treated as a distribution from the account and subject to income taxes and possible early withdrawal penalties.

Sign Up for a Debt Management Plan

To create a debt management plan, you meet with a certified credit counselor and review your financial situation. After that, the counselor will speak with your creditors and try arrange for lower interest rates, more time to repay, waived fees, or some combination of those. Credit counselors do not negotiate to reduce how much you owe.

Once the debt management plan is arranged, you will make one monthly payment to the credit counseling organization. The counselor will use that payment to pay your creditors as agreed under the plan. 

There are some drawbacks to entering a debt management plan: 

• Debt management plans are not for all debts. You can only use debt management plans with unsecured debts. Any secured debts, such as a car loan, will not be eligible.
• It could take a long time to pay off your debt. Debt management plans often take many months, 48 or more, to completely pay off debt. You might find that you could pay off your debt faster using other debt consolidation methods. 
• You may be restricted from using or getting new credit. The terms of your debt management plan may prohibit you from taking on additional debt until your existing debt is repaid. 

Opt for Debt Settlement

Unlike debt management plans, debt settlement, or debt relief, aims to reduce the amount you owe by negotiating with your creditors to accept less than they are due. You can attempt debt settlement on your own or hire a debt settlement company to negotiate on your behalf. That can sound appealing, but there are risks involved:

• Debt settlement can be costly. Debt settlement companies typically charge hefty fees. 
• Debt settlement could severely damage your credit. As part of the process, debt settlement companies usually encourage you to stop paying your creditors. This results in late fees, penalty charges, and a major blow to your credit score. 
• Debt settlement may not work. Your creditors may decline to work with the debt settlement company to renegotiate your debt. 
• You may face collection actions or lawsuits. If you stop paying your bills, your creditors may pursue collection through a collection action or by filing a lawsuit. 
• Some debt settlement promoters are scams. While there are legitimate companies offering debt settlement services, there are also many scammers in the field. So if you want to go this route, make sure you know who you’re dealing with.

How Debt Consolidation Affects Your Credit

Consolidating your debt can have both good and bad impacts on your credit.

Negative impacts

• If you close your existing credit card accounts as part of debt consolidation, that could hurt your credit score by raising your credit utilization ratio—the amount of debt you have as a percentage of all the credit available to you. If possible, it’s better to keep those accounts open even if you don’t use them.
• When you apply for a balance transfer credit card or debt consolidation loan, the lender will run a hard inquiry on your credit report. That can lower your credit score by a small amount.
• If you do get approved for a balance transfer credit card or loan, those new accounts could lower your credit score until they have been on your credit report for a while. Your credit score considers how many new accounts you have and how old your accounts are on average, with older accounts being a plus.
• Any debts you eliminate through debt settlement will be reflected on your credit reports for up to seven years. This will also lower your credit score (although it’s better than leaving them unpaid). 

Postive impacts 

• Making timely payments on your new credit accounts will raise your credit score. 
• As you pay off your debt, your credit utilization ratio will decrease, which will boost your credit score. 
• The longer you have a balance transfer credit card or loan on your credit report, the older your accounts will be on average, increasing your credit score. 

Factors to Consider Before Consolidating Debt

Before you proceed with any debt consolidation method, here are some factors and questions to consider:

• Credit score. Is your credit score good enough to qualify for a zero- or low-interest balance transfer credit card or low-interest loan? If you can’t get a rate that’s significantly lower than you’re currently paying, consolidating might not be worth it.
• Income. Do you have sufficient income to make the payments on a debt consolidation solution?
• Budget. Can you stick to your budget to pay off your debt? 

Is Debt Consolidation Right for Me? 

To decide if debt consolidation is the right choice, it’s important to consider all the benefits and drawbacks. 

Pros of debt consolidation

• You could save money by paying less in interest and late fees. 
• You could have just one monthly payment to worry about instead of jugging multiple payments with different deadlines.
• You could get out of debt more quickly. 
• You could improve your credit score. 

Cons of debt consolidation

• You may pay additional fees with certain debt consolidation methods. 
• You might not receive a low enough interest rate to make up for the added costs.
• If you miss payments, your interest rate could increase, you could owe more in late charges, and your credit score could go down. 

Individuals with solid credit and a lot of high interest debt to pay off will benefit the most from debt consolidation. Debt consolidation may not be worth it for individuals with poor credit, who are unlikely to qualify for a better interest rate. However, simply consolidating might benefit anyone who has trouble keeping track of all their monthly bills and making sure they’re paid on time.

Alternatives to Debt Consolidation

While debt consolidation is helpful to many people, there are alternatives that may be a better option in some cases. 

Budgeting

Making a budget, even a relatively simple one, could provide insights into expenses you could cut, leaving you with extra money to pay off your debt. It also could shed light on how much you could reasonably pay each month so that you can plan your payments without a struggle. As you pay down your debt, revisit your budget periodically and see if you can apply even more of it to debt repayment. 

Debt Avalanche Method

In what’s known as the debt avalanche method, you pay off your debts with the highest interest rates first. Start by making a list of all your debts, ranking them by highest to lowest interest rate. Each month, make the minimum payment on all your accounts. Then, take any extra funds and pay those on the account with the highest interest rate. Once it is paid off, apply that account’s minimum payment and any extra funds to the account with the next highest rate. Follow the same approach until every account is paid off.

Debt Snowball Method

The debt snowball ranks debts by their outstanding balances, from lowest to highest. Again, you make the minimum required payment on all accounts, but now you apply any extra funds to the debt with the lowest balance. Once that account is paid in full, you move on to the account with the next lowest balance. Follow this approach until all the accounts are paid off.

The debt avalanche and debt snowball methods both have their fans, who can argue why one is better than the other. What’s more important is choosing the one that you are most likely to stick with to the end.

What Is the Fastest Way to Consolidate Debt?

The fastest way for you to consolidate debt will depend on which methods you qualify for. For example, if you are approved for a debt consolidation loan large enough to cover all of your debts, that could accomplish it in one step.

Is It a Good Idea to Consolidate Debt?

Debt consolidation could be a good idea if you have good credit, have high-interest debt, and are overwhelmed by the amount of your outstanding debt or the number of payments you have to make each month. 

Does Debt Consolidation Hurt Your Credit?

Debt consolidation might temporarily ding your credit score, but it won’t do serious damage unless you fail to make the required payments on your new account or accounts.

What Credit Score Do You Need for a Debt Consolidation Loan?

Credit score requirements vary widely by lender, so it’s important to shop around to find one that will work with you based on your credit score.

The Bottom Line

Debt consolidation can be an effective way to reduce your debt, but every method has pros and cons. Before you attempt to consolidate, look into the options and interest rates that are available to you to determine if it will be worth the effort and potential costs.  

Read the original article on Investopedia.