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What is Debt Consolidation and How Does it Work?

April 14, 2021 · 7 minute read

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What is Debt Consolidation and How Does it Work?

If you’re repaying a variety of different debts to different lenders, keeping track of them and making payments on-time each month can be a hassle. It isn’t just tough to keep track of these various debts, it’s also difficult to know which debts to prioritize in order to fast track your debt repayment. After all, each of your cards or loans have different interest rates, minimum payments, payment due dates, and loan terms.

Rather than trying to master all those numbers in your head or creating an epic spreadsheet, you might just want to consolidate your various lines of credit. Debt consolidation is when you combine existing debts into a new, single loan. If you’re able to secure a lower interest rate it can help reduce the cost of debt over the life of the loan, can simplify your monthly payments, or potentially help you get out of debt more quickly.

What Is Debt Consolidation?

Debt consolidation is actually pretty easy to understand. It’s when you take out one loan or line of credit and use it to pay off your various debts—whether that’s student loans, car loans, or credit card debt.

Recommended: How Much Credit Card Debt is Too Much?

It consolidates all of those existing loans into one loan, which means you go from having several monthly payments and various interest rates to just one. This is not the same as debt or credit relief, where a credit counselor helps you reduce interest rates or eliminate debt altogether. Credit relief programs can help you consolidate your debt, but they aren’t getting you a new loan—it’s only consolidation.

While you are able to consolidate many different types of loans, the process for consolidating student loans is different. Keep reading to understand how they are different.

Applying For a Debt Consolidation Loan

When choosing a debt consolidation loan, look for one that has an interest rate and terms that fit into your overall financial picture. The overall goal when consolidating debt is to save you money, either on interest in the long term, or on monthly payments in the short term (which may end up making it more costly over the life of the loan).

Once you apply and are approved for a debt consolidation loan, it may take anywhere from a few days to a week to get your money. Sometimes the lenders will pay your debts off directly, other times they will send you the loan money, and you’ll pay the debts off yourself.

The Benefits Of Debt Consolidation

The most significant benefit of consolidating debt is that it is possible to qualify for a more competitive interest rate, which could help save money over the life of the loan. Debt consolidation loans tend to come with lower interest rates than credit cards.

A debt consolidation loan may be an option to consider if your monthly payments are feeling way too high. When you take out a new loan, you can extend the term length to reduce how much you pay every month.

It’s important to note that the longer the term length of your loan, the more you’re likely to pay in interest over the life of your loan. Still, if you’re struggling with your monthly payments, it might be worth it to consolidate your debt and extend your repayment timeline. This way, you won’t be struggling to stay afloat every month, and you’re less likely to miss payments.

Alternately, you could shorten your term length if you’re trying to aggressively pay off your debt and get rid of it more quickly. This could help reduce the cost of interest over the life of the loan.

Consolidating could potentially help improve your credit score. That’s because if you carry debt on credit cards or lines of credit, your score might suffer if you’re using more than 20% to 30% of your available credit. By taking out a consolidation loan and depending on how much you qualify for, you could be creating more available credit, instead of racking up a credit card tab.

Finally, if some of your current debts are secured loans, debt consolidation might be worth considering because they are typically unsecured loans. With secured loans, you use an asset like a home or car to guarantee the loan. If something happens and you cannot repay the loan, then the bank can seize the asset that is acting as collateral. An unsecured debt consolidation loan can help you avoid putting other assets on the line.

Recommended: Secured vs. Unsecured Loans 101

Consolidating Credit Card Debt

Tired of dealing with mounting credit card debt? Consolidating credit card debt is the most obvious form of debt consolidation. This is because people can save a considerable amount by consolidating their high interest credit card debt with a new lower-interest loan.

The first step is generally applying for a credit card consolidation loan. There are many banks, credit unions, and online lenders who offer loans for consolidating debt. In some cases, the application process can be completed online.

Generally, people seeking debt consolidation loans have multiple sources of debt and want to accomplish two things: First, lower their interest rate—and thereby pay less each month—and reduce the amount they have to pay over the life of their loan. Second, they are trying to merge multiple loans into one, making it easier to keep track of monthly payments.

With a lower rate of interest, it’s possible to lower the monthly payment, shoring up money for other expenses or financial goals. Another option is to opt for a shorter repayment term, which shortens the payback period and to help get the borrower out of debt faster.

Recommended: See how much you will pay in interest alone with our Credit Card Interest Calculator.

For example, say a borrower has $10,000 on a credit card, paying 20% in interest, and the minimum payment is 4%. If they pay the minimum statement balance each month, it would take 171 months, or 14 years and three months, to pay it back. It would cost a total of $6,989.36 in interest.

But if you consolidate that debt with a new loan that has an 8% interest rate and a 10-year term, you will pay $4,559.31 in interest. Not only would you save money in interest by consolidating your credit card debt, but you could potentially improve your credit score by paying back your consolidated loan on time.

Who is Eligible for a Personal Loan for Debt Consolidation?

Borrowers who have one or more sources of debt where the interest rate is higher than 10%, it may be worth exploring a personal loan. While there’s no guarantee that you’ll find a lower interest rate, you can’t know unless you get quotes from a few lenders. (And these days, it’s a pretty painless process because lenders often offer quotes online. If it proves difficult, find yourself a different lender.)

Those with the best credit scores will typically qualify for the best rates on their new personal loans, but don’t let an average or even low score keep you from requesting quotes. This is especially true if you have more than $10,000 in credit card debt and those cards charge exorbitant interest rates.

Also know that credit score isn’t the only data point that’ll be considered in determining whether someone qualifies for a loan and at what rate. Potential lenders typically also consider employment history and salary, and other financial information they deem important in determining loan-worthiness.

A personal loan isn’t for everyone. If you’re doing it only for convenience and there isn’t a legitimate financial motive, it’s probably not worth it. Instead, focus that energy on paying back the money you owe as efficiently as possible.

While personal loans can be a great tool to reduce interest payments, it doesn’t reduce the actual debt you owe. If you’re looking to get out of debt so you can focus on other financial goals, but the interest rates on your debt are making it nearly impossible, a personal loan could be helpful.

When Consolidating Debt Makes Sense

Which types of debt make the most sense to consolidate? Any debt that has high interest rates or unappealing terms. If the loan term is longer than you want it to be, if the interest rate is variable and you’d prefer fixed, if your loan is secured and you’d rather it not be attached to collateral—these are all reasons that might merit debt consolidation.

There are many loans to consolidate debt, but some may have their drawbacks. Make sure you shop around when looking for consolidation lenders, and only choose a reputable lender that you know you can trust.

Some people considering a personal loan feel overwhelmed by having multiple debt payments every month. A personal loan could lighten this load for two reasons. For one, it may be possible to lower the interest paid on the debt, which means it’s potentially possible to save money in interest over time.

Secondly, it can also make it possible to opt for a shorter term, which could mean paying off credit card debt years ahead of schedule. If it’s possible to get lower interest than you have on your current debt, or a shorter term on your debt to pay it off faster, a personal loan could be worth looking into.

On the other hand, you’ll also want to be careful about fees that might come with your new loan, separate from the interest rate you’ll pay. For example, some online lenders charge a fee just to take out a personal loan, and some don’t, so you’ll want to do your research.

Debt Consolidation for Student Loans

It’s possible to consolidate student loans like other forms of debt. Consolidating student loans with a private lender is often referred to as “refinancing.”

If you have only federal student loans, you can consolidate them with a Direct Consolidation Loan. This program allows borrowers to combine all their federal loan into a single, consolidated loan. The new interest rate is the weighted average of the existing loans, so it won’t result in a decreased interest rate. Direct Consolidation loans still qualify for many federal loan protections and programs.

Borrowers with both private and federal loans are able to roll them all into one refinanced loan with a private lender. Student loan refinancing could potentially allow you to qualify for a lower interest rate than the federal loan consolidation program.

The major drawback is that refinancing your federal loans with a private lender means you give up your federal student loan protections, including access to the income-driven repayment programs, deferment, and forbearance.

The Takeaway

Debt consolidation allows borrowers to combine a variety of debts, like credit cards, into a new loan. Ideally, this new loan has a lower interest rate or more preferable terms to help streamline the repayment process.

In the long term, debt consolidation could potentially help people spend less money over the life of the loan, if they are able to secure a lower interest rate on the consolidation loan.

One type of debt consolidation is student loan refinancing. This could help borrowers streamline their student loan repayment by consolidating debt into one loan. Depending on the terms and interest rates, borrowers could also spend less money in interest long-term.

Thinking about consolidating your debt or refinancing your student loans? SoFi loans can help you get there—and may save you money along the way.



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IF YOU ARE LOOKING TO REFINANCE FEDERAL STUDENT LOANS PLEASE BE AWARE OF RECENT LEGISLATIVE CHANGES THAT HAVE SUSPENDED ALL FEDERAL STUDENT LOAN PAYMENTS AND WAIVED INTEREST CHARGES ON FEDERALLY HELD LOANS UNTIL THE END OF JANUARY 2022 DUE TO COVID-19. PLEASE CAREFULLY CONSIDER THESE CHANGES BEFORE REFINANCING FEDERALLY HELD LOANS WITH SOFI, SINCE IN DOING SO YOU WILL NO LONGER QUALIFY FOR THE FEDERAL LOAN PAYMENT SUSPENSION, INTEREST WAIVER, OR ANY OTHER CURRENT OR FUTURE BENEFITS APPLICABLE TO FEDERAL LOANS. CLICK HERE FOR MORE INFORMATION.
Disclaimer: Many factors affect your credit scores and the interest rates you may receive. SoFi is not a Credit Repair Organization as defined under federal or state law, including the Credit Repair Organizations Act. SoFi does not provide “credit repair” services or advice or assistance regarding “rebuilding” or “improving” your credit record, credit history, or credit rating. For details, see the FTC’s website on credit.
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