How Does Debt Consolidation Work?

Are you struggling to keep up with two or more monthly debt payments? If so, then debt consolidation might be the right form of debt relief for you. But before you commit, you probably want to know: “How does debt consolidation work? When does it make sense?”

In the simplest of terms, it can replace multiple expensive monthly payments with a single, more affordable one. It’s a useful option for people who just need that little bit of extra breathing room to get back on their feet. H

ere’s everything you need to know about the process to decide whether it makes sense for you.

What Is Debt Consolidation?

Debt consolidation is a form of debt relief that uses a new credit account to pay off several older ones. It effectively combines a borrower’s existing loans, credit cards, and monthly payments into one.

The new credit account is typically either a:

  • Debt consolidation loan: These are generally low-interest installment loans. The initial lump sum pays off the old credit accounts then the borrower can pay back the new loan over the agreed-upon term.
  • Zero-balance transfer card: Borrowers can move all their outstanding balances to the new credit card, which usually has an introductory period of zero interest accrual. But after that period, interest will resume at a higher rate than with a consolidation loan.

It’s not easy to qualify for debt consolidation loans or balance transfer credit cards. Most lenders want to give these credit accounts to people with at least “fair” credit. If they can, people should always try for consolidation before falling behind on payments and damaging their credit scores.

That said, it’s not impossible to consolidate even with bad credit. Shop around before giving up on the strategy. Online lenders and credit unions are usually the best places to start.

How Does Debt Consolidation Work?

Let’s take a look at an example.

Imagine that John has $16,000 in debt. It’s split equally between his credit card and a personal loan with interest rates of 15% and 10%, respectively.

The personal loan term is six years, so John tries to keep that same pace while paying off the credit card. His monthly payments would be $170 for the credit card and $150 for the personal loan. That’s a total monthly debt expense of $320.

But then John loses one of his jobs and can’t keep up with his debt payments anymore. If he were to do nothing, he would start falling farther and farther behind on his debts, accumulating interest, and damaging his credit scores.

Before the problem gets worse, he shops around for a debt consolidation loan. Luckily, he’s able to find a lender willing to offer him a loan for $16,000 at 9% with a 9-year repayment term. The new monthly payment would be just $216 a month, creating over $100 in savings.

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Some people would argue that this wasn’t a good deal because John will have to pay more in interest under the debt consolidation than he would have with the original loans. But that’s a false dichotomy.

The original loans were no longer viable because John wasn’t able to keep up with his payments. If he hadn’t gotten the consolidation, he would’ve missed his payments, racked up penalties and interest, and damaged his credit significantly in the process.

How Does Debt Consolidation Affect Your Credit?

In the short-term, debt consolidation can lower credit scores. Fortunately, none of the factors it affects are too impactful, so any damage should be recoverable.

Here are the credit score factors that it might negatively affect:

  • New credit activities: Whenever someone applies for new credit, the lender will check their scores and credit reports. That triggers a hard inquiry, and too many can lower a person’s credit scores slightly. 
  • Lower age of credit accounts: Debt consolidation always includes replacing older credit accounts with a newer one. Closing out old accounts will eventually age them off of credit reports, which can lower scores.
  • Reduced diversity of credit accounts: Similarly, debt consolidation reduces the number of credit accounts to one. That naturally reduces the diversity of a credit account portfolio.

These may sound problematic, but debt consolidations should always boost credit scores in the long run. At the very least, they should minimize the damage done to a person’s scores.

People use debt consolidation because they’re struggling to keep up with their monthly payments. If it helps them pay on time when they otherwise wouldn’t have, the benefits will far outweigh any short-term damage.

When Is Debt Consolidation a Good Idea? 

Debt consolidation isn’t the perfect solution for everyone. It’s not the best idea for people who won’t have the income to keep up with payments even after reducing them with the consolidation. It also probably won’t help anyone who is looking to get out of debt faster.

But that doesn’t mean it’s not a useful strategy. It’s just a better tool for other circumstances. Consolidation is for people whose top priority is reducing their monthly payments to get a bit of breathing room.

It makes the most sense when all of the following are true:

  • The borrower in question is struggling to keep up with monthly payments due to their number or size.
  • Their income can cover the monthly payment under the new loan or card.
  • Reducing monthly payments is more important to the borrower than the total interest cost of the loan.
  • They have a budget in place that will keep them from running up more debt after the consolidation.
  • The borrower has a credit score that will allow them to get a decent interest rate on their consolidation loan or a transfer card with a long introductory offer.

That might sound like a lot of limitations, but the truth is that every debt relief strategy is for a specific niche. There are pros and cons to each, and none of them are perfect solutions for every situation.

Debt consolidation is for lowering monthly payments. Even the convenience of reducing their number is secondary. People who can afford their payments could always use autopay.

For people who have other priorities, there are other forms of debt relief.

Consolidation vs. Other Forms of Debt Relief

Debt consolidation might be close to what some people want, but not exactly. Those who are interested but not entirely convinced should take a look at the adjacent options.

Here are the reasons why someone would prefer alternative forms of debt relief to debt consolidation:

  • Refinancing: A refinance is very similar to a consolidation in that it uses a new loan to pay off an existing one. But refinances usually trade loans out one for one, and the purpose is to improve the terms, not necessarily reduce the number of payments. Refinances are almost always about lowering interest rates, but refinances and consolidations in tandem are even better.
  • Credit Counseling: Basic credit counseling is a good idea for people who are struggling with their monthly payments but can’t qualify for (or afford) a consolidation. It includes advice, education, and budgeting tools from a financial expert. It’s usually a free service at non-profit organizations, and they can help people who are having trouble with a wide range of personal finance issues.
  • Debt Management Program (DMP): A DMP is like debt consolidation’s big brother. It rolls up all loan payments into a single monthly payment but doesn’t require the use of a new loan or card. Instead, a third party steps in as a middle man between borrowers and lenders. The borrower pays only the third party, who then pays each lender while attempting to negotiate better terms with them. People can get a DMP from non-profit credit counselors or private specialists.

Remember that there is no perfect debt solution for everyone, and what provides good results for one person can easily backfire for someone else. Make sure to consider all of the options out there and understand their implications before committing to any strategy.

Don’t Hesitate to Consolidate When Necessary

While you should try to meet your payments with less drastic means first (like budgeting or earning some extra cash), don’t hesitate to use a consolidation loan if it’s necessary. They’re much more effective as a timely solution since delaying can make it much harder to qualify for a loan or balance transfer card.

If you have to take one out, don’t worry too much about the extra interest over the life of the loan, as long as it’s reasonable. Consolidations can provide some much-needed breathing room when you know you’re not going to be able to make your payments, and that’s a perfectly valid strategy. Just make sure to take advantage of the opportunity to avoid a backslide.