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What is Debt Consolidation and How Does it Work?

5 minute read Man wearing headphones at his desk reviewing papers on debt consolidation.

Disclaimer: Upstart is not a financial advisor. The following content is for informational purposes only.

Struggling to manage your debts and juggle multiple monthly payments, but not sure where to even begin? We’re here to help by giving you the answer that may solve your debt woes: debt consolidation.

Debt consolidation is simply the process of combining several of your debts—typically high-interest debt like credit cards—into a single payment.

Debt consolidation can be a good choice if you just want to reorganize multiple bills that have different payments, due dates, and interest rates. The ultimate goal is to pay less interest and/or get out of high-interest debt sooner than if you’d stayed the course with multiple lenders and payments.

Is debt consolidation right for me 

To determine whether debt consolidation is the right move for you, it’s important to consider your financial situation and the options available to you for debt consolidation.

Debt consolidation may be right for you if:

  • You have the means to either pay off your loans over a longer period of time or make larger payments over a shorter loan term
  • Your credit score has gone up since your original loan—making it more likely you’ll qualify for a better interest rate
  • You’re focused on keeping your spending in check and committing to a plan to avoid falling into more debt

It might not be the best option for you right now if:

  • You aren’t able to change your spending habits
  • Your credit isn’t currently strong enough for a good interest rate (Although some lenders and lending platforms, like Upstart, consider factors beyond your creditworthiness to fairly price credit!)
  • Your current debt is small and can be paid off quickly

Debt consolidation options that may be available to you

  1. Home equity loans and home equity lines of credit: A home equity loan (HEL) is essentially a second mortgage or cash-out refinance of a first mortgage that uses the available equity in your home to pay off debt. This type of loan is secured—meaning your house is your collateral—so you can usually get lower interest rates and longer repayment terms.

Lenders may also offer a home equity line of credit (HELOC), which allows you to draw the amount of cash you need when you need it. A HELOC acts similar to a credit card with revolving debt. It’s important to note that a HELOC typically comes with a variable interest rate that may go up or down throughout the life of the loan.

Debt consolidation loans: What is a debt consolidation loan? A debt consolidation loan  combines your different debts under a single account with a single payment. Otherwise known as a personal loan (which may be used for situations other than debt consolidation), they’re offered by places like banks, credit unions, and online lenders. 

Debt consolidation loans are typically unsecured, so they don’t require collateral, only your promise to repay. Secured loans require collateral—such as your home—and are often an option if a borrower has a hard time getting approved for an affordable unsecured loan.

When considering this type of loan, be sure to examine all the terms and fees, as it could end up increasing the amount you pay back.

  1. Balance transfer credit cards: Balance transfer credit cards are often used to consolidate credit card debt. They shift this debt from one or more cards to new single card, usually with a tempting introductory APR. However, once this period is over, the cards typically move to high APRs, which may defeat the purpose of getting yourself out of high-interest debt. Make sure you understand the terms of your new card and when and how it will begin charging you interest. Be wary of balance transfer fees and check to see if any new purchases on the card fall under the promotional interest rate. 

Before following through with a balance transfer card, check the card’s limit. Which debts are you transferring? The credit limit on a potential new card may be lower than your combined debts, which might not make much sense for you if you’re trying to consolidate your debt into one payment.

The benefits and drawbacks of debt consolidation

While weighing whether debt consolidation is the right move for you, you’ll need to consider the benefits and drawbacks of consolidating your debt and how your financial situation factors into your decision.

What are the benefits of debt consolidation?

  1. Saves money. With the right loan terms, you can pay off your debt faster and save money on interest if you qualify for a lower rate.
  2. Makes budgeting easier. When you have multiple credit card bills to manage, it can be easy to miss one—but even just missing one can leave a mark on your credit report. Consolidation lets you roll multiple monthly payments into one, making it easier for you.
  3. Lower monthly payments. While you could pay your debt off faster with consolidation, a longer loan term with lower payments is also an option that will give you more funds in your budget in the short term. Just remember that you’ll pay more in interest over the life of the loan if you choose this option.
  4. Improved credit score. Did you know that your bill payment history isn’t the only factor that affects your credit score? Your credit utilization ratio—how much credit you’re using compared to how much is available to you—can account for up to 30% of your credit score. Consolidating your debt can help you pay your existing debt and open the door for new credit opportunities, thus lowering your credit utilization.

What are the drawbacks of debt consolidation?

  1. Fees. Lenders may charge closing fees, loan origination, and balance transfer fees.
  2. Collateral. If you opt to consolidate your debt into a secured loan, you may need to offer up an item that you own like your home, boat or car as collateral to back up the loan.
  3. No guaranteed lower interest rate. Consolidation doesn’t automatically mean a lower interest rate. This depends on the state of the market and your credit score.
  4. Debt may return. Debt consolidation won’t help you manage your everyday money habits. So, if you don’t address the reasons you got into debt in the first place, your debt may return or even grow.

How to get started with debt consolidation

Think you might be ready to make the jump into debt consolidation? A few items you should check off first before you look into applying for a loan or balance-transfer card:

  1. Check your credit score and credit reports. Review your credit reports at annualcreditreport.com. Look for any inaccuracies that may affect your score and file a dispute with the reporting agencies to get them removed.
  2. Review your budget. The monthly payment you can afford will inform the interest rate and length of a new loan or whether a balance-transfer card is the right move for you once your introductory interest rate is over.
  3. Compare options and consider these variables:
    1. Are there fees?
    2. Are you able to get prequalified?
    3. Is the interest rate fixed or variable?
    4. Are you able to get the amount you need? Some lenders have loan minimums and a balance-transfer card may not have a limit high enough for your debts.

Bottom line

Debt consolidation could be exactly what you need if you’re open to addressing multiple high-interest debts and are open to sticking to a debt management plan. To get started, check out what Upstart has to offer.

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* When you check your rate, we check your credit report. This initial (soft) inquiry will not affect your credit score. If you accept your rate and proceed with your application, we do another (hard) credit inquiry that will impact your credit score. If you take out a loan, repayment information will be reported to the credit bureaus.

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