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What Is Debt Consolidation And Is It A Good Fit For Your Finances?

7-Minute Read
Published on May 19, 2022

If you've wished you could simplify your debt, debt consolidation could be your answer.

But what is debt consolidation, exactly? We'll answer that exact question, explore how debt consolidation works, the pros and cons, ways to consolidate debt and more.

By the time you're done reading, you should have a good idea of whether debt consolidation will work for your situation.

What Is Debt Consolidation?

Debt consolidation is a form of debt refinancing that involves taking out one loan to pay off many others. Debt consolidation allows borrowers to roll multiple debts into a single loan with a single monthly payment.

If you have multiple debts and are struggling to pay them on time, debt consolidation can reduce your number of payments, making it easier to avoid late ones.

If you already own a home, you might consider a cash-out refinance to consolidate debt.

How Does Debt Consolidation Work?

Debt consolidation allows you to combine multiple outstanding debts into a single loan with one monthly payment. Depending on your finances, debt consolidation may help you lower your interest rate and save money in the long run.

You'd fill out an application for a lender first. The lender will check your credit and debt-to-income (DTI) ratio (the amount you owe versus the amount of income you bring in each month) as well as identification, your income and more.

Debt consolidation often results in receiving a new loan, usually with new terms and a new interest rate from your lender. A common type of loan for debt consolidation is a personal loan. How do personal loans work for debt consolidation? By allowing you to take out a new lump sum loan with new loan terms to pay off your existing debt. However, there are other ways you can consolidate debt without tapping into a debt consolidation loan, which we'll discuss in more detail below.

The Benefits Of Debt Consolidation

Is debt consolidation a good idea? This is a great question, and debt consolidation does offer unique benefits for borrowers:

  • Simplifies debt: Debt consolidation combines multiple debts into one. This makes keeping track of your obligations easier.
  • Could offer a lower interest rate: Borrowers may be able to lock in a lower interest rate with debt consolidation. For example, if you have a credit card with an 18% interest rate, a student loan with a 6% interest rate and another student loan with a 4% interest rate, you may be able to consolidate them to achieve a lower interest rate altogether.
  • Allows you to pay off debt faster: Consolidating may help you pay off debt more quickly. Consolidating can allow you to shave years off your loan repayment term.

The Downsides Of Debt Consolidation

Though debt consolidation can help many borrowers, there are a few downsides you may need to consider before applying. These include the following:

  • Origination fees: You'll likely have to pay origination fees to consolidate your debt. You pay an origination fee to a lender for the lender to process your loan application.
  • Interest rates could go up: Debt consolidation may increase your interest rate. Other methods beyond a debt consolidation loan could also increase your interest rate. For example, if you choose a credit card balance transfer option, this means you could get hooked by a low interest rate, only to find that the interest rate increases later.
  • Could ding your credit: When getting a consolidation loan, your lender will check your credit, which may temporarily hurt your credit score.
  • You may pay more: Longer repayment terms could mean you pay more over the life of the loan. You may make smaller payments, but that could mean that you've increased your loan term. Between interest and extra payments, you may pay thousands of dollars more than you would have if you’d tackled each debt individually instead.
  • Doesn't mean debt elimination: Ultimately, it's important to note that debt consolidation is not the same thing as getting rid of your debt completely. You'll still have to make your debt payments, even if you've streamlined everything into just one payment.

Debt Consolidation Vs. Debt Settlement

Debt consolidation is different from debt settlement. Consolidation allows you to roll multiple outstanding debts into a single payment.

Debt settlement, on the other hand, means that an independent entity works by lowering what you owe each lender. Debt settlement tends to take a long time and can end up costing you far more than taking out a debt consolidation loan. Debt settlement companies may charge up to 25% to settle your debt for you. It may be less risky to settle your debt on your own. You might even face extra taxes if your debt is forgiven.

Carefully consider whether debt consolidation or debt settlement is the better option for your needs.

The Easiest Debt Consolidation Methods

There are several types of debt consolidation methods you may want to use to reduce your payments, lower interest rates, etc. Take a look at some of the easiest debt consolidation methods available to you below.

Balance Transfer

A balance transfer is a type of credit card transaction that occurs when debt moves from one account to another. This type of debt consolidation is typically only used for credit card debt. It may be beneficial if you know you'll get a lower interest rate that won’t climb later.

Home Equity Line Of Credit (HELOC)

A home equity line of credit (HELOC) is a type of second mortgage that allows you to borrow against the equity in your home. You receive a revolving line of credit, which may get replenished once you reach a preset credit limit, but only as long as you make interest-only or minimum payments throughout what's known as your draw period.

When you reach the end of your draw period, you'll shift to repayment mode and must make full interest and principal payments. A lender usually allows you to borrow around 80% of the equity in your home.

However, it's worth noting that HELOCs use your house as collateral for the loan. This means that you must have equity in a home in order to get one, you could also lose your home if you stop repaying on the amount you've borrowed.

This type of loan may be beneficial for homeowners who know they are in a solid financial position to make their payments, who will also receive a lower interest rate and pay less overall.

Please note that Rocket Mortgage® does not offer HELOCs at this time.

Home Equity Loan

A home equity loan is also a second mortgage and debt consolidation strategy that allows you to tap into your home equity. Lenders typically allow you to borrow around 80% of equity in your home with a home equity loan. You'll receive a lump sum, which you pay off with a fixed interest rate based on a schedule of fixed payments. Just like with a HELOC, you'll put your home up as collateral for a home equity loan.

Similar to a HELOC, it's a good idea to have confidence that you can make your payments throughout your loan term, and that you're OK with the debt consolidation for mortgage strategy. In addition, you'll want to make sure you'll pay less over time with this option than you would have if you’d kept all your loans separate.

Rocket Mortgage® is now offering The Home Equity Loan, which is available for primary and secondary homes.

Cash-Out Refinance Loan

A cash-out refinance is an option that replaces an old mortgage with a new one with a larger amount than the original amount owed. It’s a method of debt consolidation for mortgage holders only. You'll tap into the equity in your home when you opt for a cash-out refinance.

If you want to transfer to one convenient payment and are comfortable with borrowing from the equity in your home, a cash-out refinance could be a good move.

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When Is Debt Consolidation A Good Idea?

Debt consolidation isn’t always the right fit for some people. There are a few easy ways to tell if it’s the right fit for your situation. Let's take a look below.

Your Debts Have Higher Interest Rates

You may want to consider debt consolidation if your debts have higher interest rates. Having higher interest rates means that you'll pay more on every dollar you borrow. If your interest rates are higher than what you could get through a cash-out refinance mortgage, home equity line of credit or home equity loan, consolidating may be the right move.

You’re Planning On Applying For A Mortgage

When you apply for a mortgage, a lender will consider your complete financial situation and weigh your debt-to-income ratio (DTI) to decide if they’re willing to issue you a mortgage. By consolidating debt, you may be able to pay it off faster, which will make your mortgage application stronger.

You may have another question: Can I consolidate my debt before applying for a mortgage?

It's a great question, and it's worth noting that because consolidating debt involves taking out a new loan, it may make it more difficult for you to take out a new personal loan or mortgage immediately after consolidating your debt. Therefore, it's best to consolidate long before you start applying for mortgages.

You Have A Firm Plan To Stay Out Of Debt

One of the reasons that debt consolidation isn’t a solution for everyone is that it doesn’t curb spending habits or keep borrowers from accumulating more debt. It's a very good idea to have a firm plan to stay out of debt once you pay off what you owe instead of falling into the high-debt trap yet again.

When Should You Avoid Consolidating Your Debts?

Debt consolidation is only a viable option if you can comfortably make the minimum payments on it. If you're feeling overwhelmed by your debt or are struggling to make payments each month, you may want to consider looking into debt relief or debt settlement options. Also, if the amount of debt you're carrying is small enough for you to pay it off on your own, you may be able to tackle it yourself, without involving another entity.

The Bottom Line: Debt Consolidation Can Help You Save Big

Debt consolidation is a form of debt refinancing that involves taking out one loan to pay off many others. Debt consolidation allows borrowers to roll multiple debts into a single loan with a single monthly payment.

Debt consolidation can simplify debt, offer a lower interest rate and allow you to pay off debt faster. However, there are a few downsides – you might have to pay origination fees to consolidate your debt and it could increase your interest rate and it may temporarily hurt your credit score. You may also pay more over the life of the loan.

You may want to consider debt consolidation if your current obligations have higher interest rates or if you're planning to apply for a mortgage sometime in the future. However, it might be tricky to get a mortgage loan immediately after consolidating your debt.

It's a good idea to have a firm plan to stay out of debt. If you can pay off your debt as is, you may not need to consolidate it at all – you might just want to handle it yourself.

Examine your financial situation before deciding if debt consolidation is best for your needs. Consider applying for a cash-out refinance if you're interested in consolidating your debt.

Melissa Brock.

Melissa Brock

Melissa Brock is a freelance writer and editor who writes about higher education, trading, investing, personal finance, cryptocurrency, mortgages and insurance. Melissa also writes SEO-driven blog copy for independent educational consultants and runs her website, College Money Tips, to help families navigate the college journey. She spent 12 years in the admission office at her alma mater.