Debt Consolidation Guide: How It Works [April 2024] (2024)

What Is Debt Consolidation?

Debt consolidation is a prudent financial strategy for consumers struggling with credit card debt. Consolidation merges multiple bills into a single debt that is paid off monthly through adebt management planorconsolidation loan.

Debt consolidation reduces the interest rate on your debt, lowers monthly payments and simplifies bill paying. Instead of keeping up with multiple bills and multiple deadlines from multiple card companies, you make one payment to one source, once a month.

Debt Consolidation Example

Debt consolidation is most successful when you reduce the interest rate you’re paying and the fixed amount you owe each month.

For example, if you owe $15,000 on your card(s) and pay an average interest rate of 27.9%, (the national average in 2024), your monthly payment would be $466 a month for 60 months. The total payout would be $27,968.

That means you’re paying $12,968 just in interest!

If you consolidate the $15,000 in a debt management program, which receives concessions from companies to reduce your interest rate to around 8%, your monthly payment would be $304 for a total pay off of $18,248.

That’s $3,248 in interest, a savings of $9,720!

Debt Consolidation Requirements

Any form of consolidation requires you to make monthly payments, which means that you must have a steady source of income.

If you are looking at a debt consolidation loan, the second requirement is that you be creditworthy. Lenders regard your credit score as the most obvious sign of your creditworthiness. If your score is above 740, you’re definitely creditworthy. If it’s between 670-739, you probably qualify, but may pay a slightly higher interest rate. It’s possible you qualify with a score below 670, but what you likely will get is abad credit consolidation loan, with an interest rate so high, it may not be a worthwhile option.

If you choose debt management as your consolidation program, there is no loan involved and credit score is not a factor. Nonprofit credit counseling agencies that offer debt management plans, work with card companies to arrive at affordable interest rate and monthly payment over five years.

What Are Your Debt Consolidation Options?

There are several avenues open to consolidate debt, including a debt management plan; home equity loan; personal loan; credit card balance transfer; and borrowing from a savings/retirement account.

The route you choose should be based on research and whether the solution offered fits your budget and time frame. Your credit score and debt-to-income ratio are factors if you choose to get any kind of consolidation loan. You many also choose to pursueonline debt consolidation.

Here is a quick look at each option.

Debt Management Plan

The goal fordebt management plansis to reduce the interest rate on credit card debt to 8% (sometimes less), lower monthly payments and eliminate debt in 3-5 years. These plans are offered bynonprofit credit counseling agencies, who receive concessions on interest rates from credit card companies to arrive at an affordable monthly payment.

Personal Loan

This is a form of consolidation loan that could come from a bank, credit union,peer-to-peer lender, family member or friend.Personal loansusually are unsecured, meaning the borrower doesn’t put up any collateral. That could result in a higher interest rate and less money available for the loan. A good credit score will help lower the interest rate.

Credit Card Balance Transfer

Abalance transfer cardallows you to move the balance from your cards to a new card and make payments at 0% interest for an introductory period (usually 12-18 months). There routinely is a fee of 3%-5% of the amount transferred. To qualify, you customarily need a credit score above 670. The balance must be paid before the introductory period ends or interest rates are charged.

Home Equity Loan

If you have equity in your home – meaning you owe less than the house’s market value – consider ahome equity loan for debt consolidation. The interest rate is only slightly higher than mortgage rates because your home serves as collateral. However, you could lose the house toforeclosureif you miss payments on the home equity loan or home equity line of credit (HELOC).

Retirement/Savings Accounts

A 401k retirement plan or bank savings account could be used to pay off credit card debt, though experts would advise against both choices. With a401k loan, you are borrowing your own money so there is no credit check and rates are low, but there is a penalty for taking out money before the age of 59.5.