What is Debt Consolidation?

Managing multiple debts can be challenging. Debt consolidation may make the task easier—if it makes sense for your situation.

Having a lot of debt isn't uncommon. In August, the Federal Reserve Bank of New York reported that U.S. households, combined, had more than $17 trillion in debt. Housing debt made up about $12 trillion of the total. The other $5 trillion was comprised primarily of auto loans, retail cards, student loans, and credit card balances, which rose to about $1 trillion of the total.

What is debt consolidation?

Debt consolidation refers to the process of obtaining a new loan and using the proceeds to pay off the balances of two or more existing loans. For example, the new loan might be a personal loan or personal line of credit, a home equity loan or home equity line of credit (HELOC), or a new credit card with a balance transfer feature. The goal is not to reduce the total amount of debt, but to restructure the debt with fewer monthly payments.

To see how this works, suppose you have three credit cards with a combined balance of $20,000 and a combined annual percentage rate (APR) of 27.99%. If you made monthly payments of $1,098 toward those balances for two years and you didn't make any new purchases with those cards, you'd pay a total of $5,641 in interest expense.

Now, suppose you consolidated those three card balances into a $20,000 personal loan with a two-year term and a rate of 11%. Your monthly payment would be $932, and you'd pay $2,372 in interest expense. After a loan origination fee of 1%, your total savings would be $1,269. (You'd typically need excellent credit to obtain a personal loan with an origination fee that low.)

With a longer term and lower monthly payment, your interest expense would be higher and result in less savings. For example, a $20,000 personal loan with a rate of 11% and a five-year term would lower your monthly payment to $435, but you'd pay $6,091 in interest expense.

Another strategy is to use a balance transfer card with a 0% introductory APR. Moving an existing balance from another card to this type of card could lower your monthly interest expense on the part of your card debt for a set number of months, giving you time to pay off the debt at a lower cost until the introductory APR ends and the rate rises.

Does debt consolidation make sense?

Debt consolidation can be a good idea if it helps you achieve your goals. Maybe you want a lower combined APR, a single monthly payment or fixed repayment term. Or you'd like to pay off debt sooner. Thinking about what you want to accomplish—and why—should help you decide whether it makes sense for you.

Pros and cons of debt consolidation

Debt consolidation comes with pros and cons. Here are some to consider before you decide to consolidate debt:

Pros:

• Fewer monthly payments to manage. Rather than making multiple debt payments every month, you may have just a few or even only one monthly payment.
• Lower monthly interest expense. Paying less interest every month with a lower combined APR should give you more room in your budget to pay off debt faster, accumulate savings, or meet other financial needs or wants.

Cons:

• You may not save money. A combined lower APR should mean you'll pay less interest each month, but saving over the long term isn't guaranteed. To figure out how much you might save, you'll need to consider how much debt you have, how long you'll need to pay it off, what your current and new APRs will be, and how much you'd pay in fees if you decided to consolidate.
• Fees could exceed your savings. Debt consolidation typically involves upfront costs to obtain a new loan or transfer a credit card balance from one card to another. Credit cards may also have annual fees. In some cases, these fees may add up to more than your anticipated interest savings.
• You’ll put your house in jeopardy. If you use a home equity loan or HELOC to consolidate other types of debt and then you're unable to repay that loan or HELOC, you could lose your home.

When you evaluate a debt consolidation offer, you should consider both the financial aspects—the dollars and cents—and the emotional aspects—how you feel about your ability to manage your debt in its current form or after you consolidate.

Read the offer carefully. Make sure you understand the interest rate, repayment term, and upfront fees. Will you be able to make your new payment and lower your interest expense or pay off your debt sooner? After you consolidate your existing debt, will you be able to avoid taking on additional new debt, such as new credit cards, store cards, or buy now, pay later loans? It’s always a good idea to ask a financial planner to help you evaluate your options.