Ultimate Debt Consolidation Guide

This is Chapter 3 of 5 in our Ultimate Guide to Debt Relief series.

Debt can strain your finances. It can make your day-to-day more difficult. Finding the best way out of debt is the first step to gaining control of your finances. While debt consolidation can sound like an odd idea — why would you take on new debt to get out of current debt? — it can be a good strategy for some.

Here are questions you may have about debt consolidation:

• What is debt consolidation?
• What is credit card consolidation?
• How does debt consolidation affect your credit?
• How do consolidation loans work?
• How do you get a debt consolidation loan?
• How do you get a debt consolidation loan with bad credit?
• What is the best debt consolidation company?

What is debt consolidation?

“Debt consolidation works by transferring several debts to one centralized source, ideally with a lower interest rate than the original accounts and with a fixed repayment period,” says Matt Frankel, CFP and personal finance expert at The Ascent.

In many cases, personal loans are used to consolidate debt. However, depending on your situation, you may be able to use your mortgage or do a credit card balance transfer to consolidate your debt.

Instead of keeping track of multiple payment deadlines, you’ll just have one to remember if you consolidate.

If you’re considering consolidation loan offers, pay attention to the annual percentage rate and loan length.

“Debt consolidation lumps all your debt into a single monthly payment at a lower monthly payment, but usually for a longer period, higher interest, or a combination of both,” says Jacob Dayan, Finance Pal and Community Tax cofounder and CEO.

Ideally, you’ll want a loan that has a lower overall interest rate than your current debts. A loan with a longer term length or higher interest rate may not be the best fit. However, in some cases it can make sense to get a longer term loan for a more affordable monthly payment when you consolidate your debt..

Keep in mind that you’ll need to pay origination fees when you accept a loan offer. You should also pay attention to the APR and interest rate. Note whether or not there are prepayment penalty fees.

What is credit card consolidation?

“Credit card consolidation involves transferring several credit cards into one debt, using the aforementioned options or sometimes even a new 0 percent interest credit card via a balance transfer,” says James Lambridis, DebtMD CEO.

If you have a low amount of credit card debt, around $5,000, a balance transfer can be a great option. However, there are some key differences between a balance transfer and a consolidation loan.

“Using a credit card balance transfer is different than using a personal loan to consolidate credit card debt for a few reasons.

First, it's quite common to find a balance transfer credit card with a 0 percent APR, whereas you'll certainly pay at least some interest on a personal loan.

Second, credit card balance transfers don't have a set repayment period, just an expiration date for the 0 percent APR. If you have the ability (and discipline) to pay off the entire amount you're consolidating within the 0 percent APR window, it's an option worth considering. If you can't, the fixed repayment schedule and interest rate of a personal loan could be the better way to go,” says Frankel.

If you’re considering a balance transfer, compare several different credit cards and check the length of the period. Ask what fees exist for completing a balance transfer.

Before you apply for the credit card, divide your debt over the total length of the interest-free period. Are those payment amounts you can fit into your budget? What happens if you make lower monthly payments? Will you still be able to get ahead of your current debt?

Asking these questions will prevent surprises when you transfer the balance, pick the right card, and help you take advantage of the interest-free period.

Keep in mind that your credit score will affect the rates you qualify for. The better your score, the better the rates. If you don’t quite finish paying off your debt with a balance transfer, don’t plan on using this tactic again. In some cases you may be able to, but ultimately applying for and getting new credit cards regularly has a negative effect on your credit score.

Once you’ve transferred your balance, be disciplined in making regular monthly payments so that your debt is paid off before it starts accruing interest again. For the best results, do not make any new charges on your credit card because it will make it harder to pay off your current debt if you keep adding to it.

How does debt consolidation affect your credit?

Debt consolidation’s effect on your credit varies depending on your approach. However, the overall effects are typically positive if you make the monthly payments.

If you get a consolidation loan

“If you get a debt consolidation loan to pay off your high interest loans and credit cards it will actually help your credit score. Credit utilization ratio is the amount of available credit you're using and the lower your card balances the higher your credit score will be. So when you pay off your card your credit score will likely increase significantly,” Randall Yates, The Lender’s Network CEO.

While this can have a nice positive impact on your credit, it only works for credit cards if you keep your current credit cards open.

“However, there may be negative consequences if you close the accounts that you've paid off. But if you leave them open you may end up with greater debt as a result of continued use of the credit in addition to the consolidation,” Morgan Taylor, finance expert and LetMeBank CMO.

As you look at consolidation loans, you’ll want to be careful about how many you apply for. Lenders do a hard inquiry into your credit every time you apply. If you have too many hard inquiries into your credit within a certain amount of time, your credit usually is negatively affected.

“It can drop your score because it is another hard inquiry being pulled. It also turns short term debts into long term debts.

Still, if you are having financial issues and debt consolidation will help you fix those issues, do it. You shouldn’t be worried about your score at this point,” says RJ Bryan, Credit Reps cofounder.

If you do a balance transfer

“Consolidating your credit card debt to a single credit card may not have as much of an effect,” says Frankel.

Opening a new credit card to do a balance transfer increases your overall available credit. If you do not add any charges to your credit card, your debt-to-credit ratio will be better.

If you close the old credit cards once you transfer the balance, your credit score will typically be negatively affected. Your debt-to-credit ratio also won’t benefit for having the additional unused credit.

Keep in mind that many credit cards are considered revolving debt, which is not the best kind of debt. Revolving debt means that the card issuer has approved you indefinitely for a set loan limit that you can use at your discretion. Since the approval remains whether or not you use it consistently, it’s considered revolving.

“If the new loan is a revolving account and if by consolidating your debt you maximize the revolving debt limit, this, too, will hurt your credit and your credit score,” says Bryan.

Keep in mind that credit card issuers also do hard inquiries when you apply, so do your research beforehand and limit your credit card applications to protect your credit score.

“While there is no way to know for sure how debt consolidation will affect your credit, it's likely to be a positive catalyst, especially if you consolidate your credit card debt and don't run it back up,” Frankel concludes.

Bryan agrees. “Overall, it all depends on your situation. It could affect your score hugely or just knock off five points for the hard inquiry.”

How do consolidation loans work?

Consolidation loans are typically unsecured loans or personal loans that make it easier for you to pay off current debt.

An unsecured loan has no collateral that can be seized if you fail to pay. A car loan is a kind of secured loan because the bank can take the car if you fail to pay. Unsecured loans usually have higher interest rates than secured loans because there is no collateral.

You can also find secured consolidation loans. While lower interest rates are a plus, you’ll need to put up collateral for the loan.

“Keep in mind that some debt consolidation loans are secured by collateral. Which means the loans are secured (another term for insured) by things such as your home, property, business, etc. So, if you default on your loan, the lender will be able to recoup their loss when you sell the home, property, business, or whatever you may have put up for collateral,” Dayan says.

Consolidation loans can offer easier payment terms with lower monthly payments, though the term length of the loan may be longer. Longer payment terms can mean paying more in interest overall. Determine how much you’d pay to get out of debt, including interest, by making your current payments.

As you consider loan offers, calculate how much you’d pay to get out of debt with each offer. Include any origination fees and interest in your calculations.

Compare the two totals and consider the payment terms. Are the payment terms of the consolidation loan better for your monthly budget? How large is the total difference between making current payments and getting a consolidation loan?

If you have a better shot of successfully paying off your debt through a consolidation loan, it may be worth paying more overall to have monthly payments that you can afford. If you get a bonus or have extra cash, some loans allow you to make additional payments on your loan sooner to help lower the interest that can accrue. Some loans have prepayment penalties, so before taking a consolidation loan, check to see if those exist and what they are.

If neither option is feasible given your budget or how quickly you’d like to get out of debt, you may need to consider other debt relief options like bankruptcy or debt settlement.

How do you get a debt consolidation loan?

As with most loans, you need to apply, be approved, and accept the loan. Before you apply, compare consolidation loan offers from multiple companies. Luckily, you can find plenty of options with a bit of research.

“Over the past few years, the personal lending market has exploded. There are dozens of reputable financial institutions now offering personal loans, so the best course of action is to compare several of the best personal lenders to see which best meets your needs,” says Frankel.

You’ll want to find a lender that offers favorable terms to borrowers in similar situations. To do this, you’ll want to have all the details about your financial situation so that you can better identify potential lenders.

“In the United States, a federal student loan consolidation does not have a credit requirement. Other consolidation loan credit requirement varies. Get your credit score, list your loans and payments, and start shopping around,” says Bryan.

In many cases, you can do much of your loan shopping online.

“There are many ways to obtain a debt consolidation loan. Most people use online lenders such as Lending Club, Prosper, or Upstart. This is the quickest and most convenient way to secure a loan,” suggests Lambridis.

“Another way is to go into your local bank or credit union. You may be better off going this route because smaller institutions like these typically offer lower interest rates,” Lambridis continues.

Do some research online then compare with your bank or credit union to see what they can offer to find the best rates.

Pay attention to interest rates, length of repayment, origination fees, and what penalties exist for late payments or prepayment. Looking at these factors will help you compare loans and choose the best fit for your debt management needs.

Approval for a loan and the rates you qualify for are based on your credit score. The better your score, the easier it is to be approved and get the lowest rates.

How do you get a debt consolidation loan with bad credit?

It’s hard to find a consolidation loan if you have bad credit.

“Typically lenders want borrowers to have at least a 640 credit score to qualify. Borrowers with credit issues may have to look at a secured loan to consolidate debt, such as a home equity loan or cash out refinance,” says Yates.

Some lenders may look at other factors, like your job history and income, in addition to your credit score to select the loan terms it can offer you. However, it can still be difficult to find a loan with favorable terms to consolidate your debt.

If you find some consolidation loan offers, pay attention to the interest rates and compare it to your debts’ current interest rates. If the interest rates are higher with the loan than your current interest rates, it’s probably not worth it.

If the terms are significantly worse than your current debts, that’s a good indicator that a consolidation loan does not fit your situation. It may be better to pursue another option, like debt settlement.

What is the best debt consolidation company?

As with all financial institutions, you’ll want to consolidate debt with a stable and transparent company that serves its clients well.

Research companies to understand their experience and track record. Company websites will tell you all of the positive aspects. Looking at third-party review websites can help you get more objective information.

Reading customer reviews can also give you a strong sense of how well a lender operates and treats its customers. Notice when people are leaving reviews — are they speaking mostly to the application and approval process or are they addressing experiences after applying for a loan?

Check out Best Company’s top-rated personal loan companies and debt relief companies to read customer reviews.

Learn more about how Best Company ranks companies. (Spoiler: Companies can’t buy rankings. Our ranking algorithm weights customer reviews.)