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The Process of Getting Out of Debt

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How to Consolidate Your Debts

How Debt Consolidation Works

Debt consolidation is a debt management strategy in which you get a single new loan, called a consolidation loan, to pay off your existing debts. Most debtors obtain consolidation loans from banks or credit unions (see How to Consolidate Your Debt). Once you receive your loan, you can use it to pay off your existing debts in full. Most consolidation loans have a fixed term—usually 3–5 years. Note that you’ll be fully responsible for paying new debts that you incur after your lender pays off your existing debts: the consolidation loan applies only to existing debt.

Why Consolidate Your Debts?

Debtors use consolidation loans for four main reasons:

To get a lower APR
To get a fixed APR
To pay just one bill
To pay just one rate

Lower APR

Some consolidation loans have APRs that are significantly higher than those of your existing debts. Debt consolidation makes sense only if you can get a consolidation loan with a fixed rate that’s below your current average APR. Never take a consolidation loan with an APR that’s higher than the average APR you’re currently paying.

How Lower Interest Rates Save You Money

Debtors often make the mistake of assuming that a difference of just a few percentage points in their APR won’t add up to much money in the long run. The opposite is true: every percentage point makes a huge difference in the amount of interest you pay over time, as well as the length of time it takes you to pay off your principal. The table below shows the savings in interest payments and the time required to pay off a $5,000 credit card balance by switching from an 18% APR (about the average credit card APR) to a 10% APR (about the average consolidation loan APR).

	Time to Pay Off	Interest Paid
18% APR	94 months	$4,400
10% APR	65 months	$1,500

As you can see, an 18% APR takes about a third longer to pay off and costs about three times more in interest than a 10% APR.

Fixed APR

Many debtors have debts with variable interest rates. The interest rate on these debts can change, which often leads to a sudden rise in monthly payments. Most consolidation loans, on the other hand, have fixed interest rates that never change, which keeps the amount of your monthly payment the same each month. Though a fixed APR won’t necessarily save you money, it will enable you to predict and track exactly how much you’ll pay in interest each month.

Pay One Bill

Once you have a consolidation loan, you’ll need to pay only one monthly bill that covers all the debts you consolidate. Having just one bill will help guarantee that you make your payments on time and in full. It will also enable you to track your progress in paying down your debt. Each month, you’ll see your total remaining balance in one place.

Pay One Rate

Debtors with multiple credit cards and other consumer debts tend to lose track of the APR of each of their debts, especially if they have loans with variable rates. Once you consolidate, all your consumer debt will carry the same fixed APR, so you’ll know exactly how much you’re paying in interest on your consolidated debts each month.

Which Types of Debt Can Be Consolidated?

Almost any type of debt can be consolidated, but the ones that are consolidated most often are credit card balances and personal loans.

Can You Consolidate a Mix of Different Types of Debt?

Debt consolidation makes it possible to combine various types of debt together into one loan. For instance, you can easily consolidate multiple credit card debts with debts from one or more personal loan debts. Due to government regulations, however, student loan debts can be consolidated only with other student loan debts, and government- issued student loans cannot be combined with student loans that were issued by private lenders.

Student Loans and Debt Consolidation

Student loans are loans issued by the government or private lenders to finance higher-education programs such as college or graduate school. Student loans are not bad debt because they tend to have low APRs and tax-deductible interest payments. Student loans are good for debt consolidation, however, because students often have to take out various loans from a combination of government and private lenders. For student loan debtors, debt consolidation is mostly a matter of convenience—paying one bill instead of many—though it’s often possible to consolidate to get a lower overall APR as well.

The Main Types of Consolidation Loans

There are two types of consolidation loans: secured and unsecured.

Secured Consolidation Loans

Like nonconsumer debts, secured consolidation loans use an asset owned by the debtor as collateral. Secured consolidation loans have the following pros and cons:

Pros		Cons
They tend to have the lowest APRs—usually 10% or lower.		You can only get a secured consolidation loan if you own a home, car, or other major asset, such as land or a boat.
They’re the easiest consolidation loans to get.		The amount of your equity in the asset must be substantial enough to cover the total debt that you intend to consolidate.
The interest on home equity loans is tax deductible.		If you default on a secured loan, often the lender can take possession of your collateral.

Unsecured Consolidation Loans

Unsecured consolidation loans have no collateral to back the loan. The absence of collateral makes these loans riskier for lenders, resulting in higher APRs. Even so, if you don’t have equity, getting an unsecured consolidation loan can be a fine way to consolidate—as long as the unsecured loan’s rate is fixed and is less than the average APR of your current debts.

Pros		Cons
Rates are usually lower than the average credit card APR.		Rates are considerably higher than those of secured loans.
Available to people who don’t have a home or equity in a major asset.		Rates may be variable and can rise to levels equal to your current APRs.

Credit Cards as Unsecured Consolidation Loans

Debtors often create a makeshift version of debt consolidation by combining their current credit card balances onto a new credit card that has a lower APR. There are a few reasons why this approach is usually not the best way to consolidate your debt:

Variable rates: Credit card companies often offer a very low introductory APR (sometimes as low as 0–5%), which ends within a few months. At that point, the APR usually shifts to a more typical range of 12–18% or more.
Fees: Even if you find a credit card with a low fixed rate, you will be charged a fee for each balance that you transfer to the new card. Some credit card companies charge a flat fee of $50–75 per transfer, while others charge a percentage of each balance. These fees can quickly undo any savings that you’d get from transferring your balance to a card with a lower APR.
Credit-related consequences: Every time you open a new credit card account, your credit score will most likely go down a few points. Opening several accounts at once and/or maxing out the credit limit on one or more cards can be especially damaging to your credit.
No set term: Credit card companies don’t force you to pay off your balance within a set time frame, which can lead you to remain in debt indefinitely.