What Is Debt Consolidation and How Does It Work?

The average American has $5,551 in credit card debt, according to a Motley Fool report. That signals too many of us carry debt with high interest rates.

The best option would be to pay off all your debt at once. But that’s not always possible. Thankfully, other solutions may exist that can save you money and, most importantly, give you time to pay off what you owe. It’s vital to consider such options.

Enter debt consolidation—a way to turn multiple monthly debt payments into one monthly payment. If you’re drowning in multiple monthly credit card and loan payments, debt consolidation could be right for you.

In this article, we’ll discuss the benefits and disadvantages of a debt consolidation loan, as well as cover the best way to use debt consolidation.

How does debt consolidation work?

Simply put, debt consolidation rolls multiple monthly payments into one. But how is that accomplished?

With debt consolidation, you take a debt consolidation loan. That loan pays off all your other debts, leaving you with one loan to pay off.

To get a better picture of the process, let’s go over an example of how you consolidate debt. Let’s say you have $10,000 in credit card debt across five cards. That’s six payments per month, all with different due dates and different amounts. It can be stressful to manage.

To simplify your finances and save money, you decide to consolidate your debt. Considering you have equity in the home you own, you apply for a home equity loan to pay off your credit card debt. Considering the average interest rate of a home equity loan is 5.76% (ValuePenguin data), you stand to save a lot of money on interest over time. After all, credit cards have notoriously high interest rates, with current averages ranging from 16.68% to 23.7%.

As you can see, a debt consolidation loan can come in multiple forms. It’s simply a loan to pay off all your other debts. You want debt consolidation loans with low interest rates (that’s how you save money!). That could be a personal loan or home equity loan. Some banks specifically offer debt consolidation loans, though these may have higher interest rates than personal loans.

Which loans can be used to consolidate debt?

Though there are many types of loans to consolidate debt, you’re either taking a secured or unsecured loan. It’s vital you know the difference between the two.

A secured loan pledges certain property to secure loan repayment. For instance, a home equity loan or line of credit pledges your house as collateral. With a 401(k) loan, your retirement fund serves as collateral. A mortgage loan refinance can also put cash in your pocket to pay off your other debts.

An unsecured loan isn’t backed by collateral. They’re merely backed by your creditworthiness and promise you’ll repay. Examples of unsecured loans include credit cards, personal loans, and student loans. A common way for consumers to consolidate debt is through credit card balance transfers with promo 0% APR offers.

The type of debt consolidation loan you take depends on your financial situation. Always opt for the solution that will save you money overall. Crunch the numbers with any debt consolidation loan you consider.

Advantages and disadvantages of debt consolidation

So for consolidating debt, what are the benefits of secured loans and unsecured loans?

The benefits of a secured debt consolidation loan include:

  • Lower interest rates: Since you have collateral that the lender can seize if you become delinquent, they have more assurance you’ll pay. At the very least, the lender can recover lost money through your asset if you don’t repay. Therefore, interest rates are often much lower than unsecured loans. This can ease your financial burden significantly with one lower monthly payment. The amount you pay each month should be lower than your combined current monthly payments on all your accounts.
  • Easier approval: Secured loans carry less risk for lenders. They’re asset-backed. This means approval is often more probable and faster. If you’re facing bankruptcy, or just want to take control of your finances now, secured loans offer a good solution.
  • Payment simplification: If you want to pay off your debt, debt consolidation through a secured loan offers you a way to simplify your payments. With one monthly bill with one deadline, it could be easier to manage.

For unsecured loans, advantages include:

  • Lower interest rates: If you have good credit, you can get a lower interest rate than what you’re currently paying on high-interest credit card, auto, and student loan debt. That means lower monthly payments overall.
  • Payment simplification: Like with secured loans, you combine everything into one easy-to-manage monthly payment.
  • No property at risk: For instance, with an unsecured personal loan, you don’t have to put your home, retirement funds, life insurance, or other assets at risk.

Of course, you do have to consider the downsides of debt consolidation loans. Both secured and unsecured debt consolidation loans come with disadvantages.

For secured loans and credit lines, you must remember:

  • You're putting an asset of yours at risk. If you can’t make repayments, your home, retirement funds, car, or another asset could be seized by your lender.
  • If you pledge an asset like retirement funds or life insurance, you may not be able to use that money while your loan is in repayment.
  • The loan term may be longer than your previous debts. This can lead to you paying more in interest fees over time, even if you get a lower rate.

For unsecured loans and credit lines, you must remember:

  • Getting favorable rates and terms with unsecured loans or credit may be difficult. You need good credit to make debt consolidation worthwhile.
  • There are often fees involved that can increase the total cost of debt consolidation. For instance, credit cards with a 0% intro APR period for balance transfers may still implement fees of 3-4% per transfer.
  • Promo offers get tricky and aren’t that long. High interest rates could set in before you pay off a credit card balance.

Finally, for any type of debt consolidation solution, realize that it doesn’t mean debt elimination. You still have to pay off your debt. When you consolidate your debt, you risk thinking your financial situation has improved. This can cause you to continue accumulating debt if you’re not careful and diligent.

Using debt consolidation wisely

Debt consolidation makes sense if:

  • Your debt is still manageable and you just want to reorganize your bills. But what is manageable? Experts say your total debt, excluding your mortgage, shouldn’t exceed 40% of your gross income.
  • You have good credit and can therefore get a lower interest rate. If you can qualify for a credit card with a 0% intro APR for balance transfers, it may make sense to consolidate your debt (especially if you can pay off that balance before the period ends).
  • You have high-interest debt and can save money with a debt consolidation loan. Get out a calculator and see how much you’ll save overall.

The last point is key. As an article in CNBC notes, when you consolidate debt, you must take steps to ensure you don’t enter another debt trap. That begins with building up emergency savings as you make monthly payments on your new loan or line of credit.

A good starting point is to try to save at least $1,000 to begin, and slowly accumulate enough to cover 3–6 months of living expenses. This way, if the unexpected happens, you won’t have to borrow to maintain your quality of life.

If you consolidate debt wisely, and have the discipline to not add any more debt, you can enjoy simple monthly payments and save money as you pay off your debt. Debt consolidation—done right—can bring you peace of mind and ultimately greater financial security.

So is a debt consolidation loan right for you? If you think it might be, try requesting a debt consolidation loan with Finzmo to see what rate you can get.