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What is Debt Consolidation and How Does it Work?

September 07, 2018 · 7 minute read

We’re here to help! First and foremost, SoFi Learn strives to be a beneficial resource to you as you navigate your financial journey. Read more We develop content that covers a variety of financial topics. Sometimes, that content may include information about products, features, or services that SoFi does not provide. We aim to break down complicated concepts, loop you in on the latest trends, and keep you up-to-date on the stuff you can use to help get your money right. Read less

What is Debt Consolidation and How Does it Work?

Do you have so many debt payments that it feels like it takes you hours just to pay them every month? Maybe there’s a few thousand dollars on that department store credit card from when the fridge suddenly stopped working. A few thousand more on a rewards credit card that you took out to get the introductory bonus points. And a few student loans you’ve been steadily paying off since graduation.

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 can save you thousands of dollars, simplify your monthly payments, or 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.

It consolidates all of those 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.

How To Apply For a Debt Consolidation Loan?

Your first step is to apply for a credit card consolidation loan. There are many banks, credit unions, and online lenders who offer loans for consolidating debt. In some cases, you’ll just need to fill out a quick online application.

When choosing your debt consolidation loan, you want to find one with an interest rate and terms that fit into your overall financial picture. The goal is to save you money, either on interest in the long term, or on monthly payments in the short term, or both.

Once you sign on for a debt consolidation loan, it can 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 you can get a better interest rate on your existing debt, which can save you money. Debt consolidation loans tend to come with lower interest rates than credit cards. Also, your credit situation might have improved since you first took out your car or student loans, which could qualify you for a better rate.

A debt consolidation loan may be a good idea 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. Alternately, you could shorten your term length if you’re trying to aggressively pay off your debt and get rid of it more quickly.

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.

Consolidating your debt might also 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 your home or your car to guarantee your loan. If something happens and you cannot repay the loan, then the bank can seize the asset you put forward as collateral. Since debt consolidation loans are often unsecured, you can ensure that your assets are better protected.

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 low-interest loan.

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

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, you are able to lower your monthly payment, shoring up money for other expenses or financial goals. You can also opt for a shorter repayment term, which shortens your payback period and gets you out of debt faster.

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

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?

If you have one or more sources of debt where the interest rate is higher than 10%, it’s 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. 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 poor 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, which most of them do.

Also know that your credit score isn’t the only data point that’ll be considered in determining whether you qualify 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 exactly what you need.

When To Consolidate Your Debt

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 to consolidate your debt with a new loan.

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.

Most people considering a personal loan feel overwhelmed by having multiple debt payments every month. A personal loan can lighten this load for two reasons. For one, you can lower the interest you pay on your debt, which means you could potentially save money on paying interest over time.

Secondly, it can also make it possible to opt for a shorter term, which could mean paying off your 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

You can consolidate your student loans just like you can consolidate any other form of debt. Consolidating your student loans with a private lender is often referred to as “refinancing.”

If you have only federal student loans, you can consolidate them through federal student loan consolidation. However, if you have private and federal loans, some private lenders allow you to roll them all into one refinanced loan. Student loan refinancing can potentially get you a lower interest rate than the federal loan consolidation program.

The 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.

Nonetheless, student loan refinancing can consolidate your student loan debt, and depending on the terms you choose get you more manageable monthly payments or save you quite a bit over the life of your loans.

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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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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