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What Is Debt Consolidation?

When you’re stuck in the deep end of credit card debt, student loan payments, car loans and medical bills, it’s hard to stay above water. You’re probably looking for a life preserver, and maybe you’ve heard about different methods out there that offer help—like consolidating, balancing, transferring, refinancing or settling your debts.

Hey, we understand your fears and frustrations, but you need to know the truth about debt consolidation. Because most of these schemes are run by companies who claim to offer hope but really just want a profit. But listen carefully: There is real hope for you. Let’s look through your options so you can get out of the dangerous waters of debt for good.

Questions answered in this article:

What Is Debt Consolidation?
How Does Debt Consolidation Work?
What Are the Types of Debt Consolidation?
When Is Debt Consolidation a Good Idea?
Should I Consolidate My Debt?
Does Debt Consolidation Hurt Your Credit Score?
What’s the Difference Between Debt Consolidation and Debt Settlement?
What Are Alternatives to Debt Consolidation?
What’s the Fastest Way to Get Out of Debt?

What Is Debt Consolidation?

Debt consolidation is the process of combining several debts into one monthly bill on a streamlined payoff plan.

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But before you decide to consolidate your debt, here are a few things you need to know:

  • Debt consolidation offers a lower monthly payment because you’ll have an extended repayment term. Aka—you’ll be in debt longer.
  • A lower interest rate isn’t always a guarantee when you consolidate. (Yup, you could get a higher one. No. Thanks.)
  • Debt consolidation loans often come with fees for loan set up, balance transfer, closing costs, and even annual fees.
  • Debt consolidation does not mean debt elimination.
  • Debt consolidation is different from debt settlement. (P.S. Both can scam you out of thousands of dollars.)

How Does Debt Consolidation Work?

When a person consolidates their debt, they get one big loan to cover all their smaller loans. Sounds easier, right? You only have to make one payment instead of several. But that one loan comes with added fees, longer payment periods, and often a higher interest rate!

The process can vary based on what kind of loan you get, but it usually goes something like this:

  1. You fill out an application.
  2. The lender checks your credit and debt-to-income ratio.
  3. You provide a heck of a lot of documentation about your debt, finances, identity, mortgage, insurances and more.
  4. The lender evaluates you.
  5. You do or don’t get the loan. In some cases, the lender pays off your debts and now you’re in debt to that lender. Other times, you get the money or a line of credit to go pay them off yourself.

What Are the Types of Debt Consolidation?

There are a few types of debt consolidation: Some work as secured loans and others are unsecured loans. Both are varying degrees of terrifying. Here’s why:

If you take out a secured loan to consolidate your debt, you have to put up one of your assets (like your car or your house) as collateral. This is basically like leveling up your debt in one of the worst ways possible. Now you’ve got this consolidated loan from a company that can come after your car or your home if you miss payments. No, no, no, no.

If you take out an unsecured loan, you aren’t offering up your stuff as collateral. Great, right? No, because the loan company knows this is riskier, so they charge a higher interest rate to cover their backs.

Now, let’s take a look at the different types of debt consolidation:

Debt Consolidation Loan

Debt consolidation loans can be secured or unsecured, depending on the terms. They come from a bank or a peer-to-peer lender (aka social lending or crowd lending from an individual or group).

Peer-to-peer lending is growing in popularity, but that doesn’t mean it’s a trend to jump on. Those “peers” aren’t doing this out of the goodness of their hearts. They’re running a small business that profits from your financial struggles.

Credit Card Balance Transfer

Credit card balance transfers are another way people consolidate their debt. This is where you move the debts from all your credit cards to one new one.

First of all, this method usually comes with transfer fees and other various and painful conditions, like a huge spike in the interest rate of the new card if you make a late payment.

Secondly, if you’re thinking of this option so you can work the system and rack up credit card rewards, think again. Those risks we just mentioned are not worth a few airline miles or a couple gift cards to your favorite burger joint.

Finally, if you’re struggling with credit card debt, having another credit card isn’t going to solve the problem. It’s going to create a new one.

Home Equity Line of Credit (HELOC)

Some people use a home equity line of credit (better known as a HELOC) as a type of debt consolidation. This secured loan allows you to borrow cash against the current value of your home, using the equity you’ve built up in your home as collateral.

Equity is the difference between what you owe on the house and its market value. So, with a HELOC, you’re basically giving up the portion of your home you actually own and trading it in for more debt so you can pay off your other debts. That’s not how you get ahead. That’s how you stay behind. Longer.

Student Loan Consolidation

Finally, there are student loan consolidations. This option works for federal student loans only, rolling all those loans into one lump payment. (If you’ve got private student loans, you could look into refinancing, as long as you follow our recommendations on doing that wisely.)

Type of Debt Consolidation

What It Is

Should You Do It?

Debt Consolidation Loan

A personal loan that combines multiple debts into one monthly payment

No. These come with an extended payoff date, fees and often higher interest rates. Sometimes you have to put your car or home up as collateral. Gag.

Credit Card Balance Transfer

A new credit card that combines all your other credit card debt into one monthly payment

No. This method comes with fees and a huge spike in interest with any late payments—and it gives you one more credit card to worry about.

Home Equity Line of Credit (HELOC)

A secured loan where you borrow against the equity in your house to pay off your debts

No. You’ll be giving up the portion of your home you actually own and trading it for more debt. Plus, your home becomes collateral and can be taken away. Again—gag.

Student Loan Consolidation

A loan that rolls your federal student loans into one lump payment

Yes—if there is no charge to consolidate, you get a lower, fixed interest rate, your repayment period is shorter, and your motivation to pay off debt doesn’t drop.

Consolidating your federal student loans is the only consolidation method we’re okay with—in the right circumstances. Let’s break that down even more.

When Is Debt Consolidation a Good Idea?

Student loans are the only kind of consolidation we can get behind—and only in particular cases. Here’s what we mean.

You should consolidate your student loans if (and only if):

  • There’s no cost to consolidate.
  • You’ll get a fixed interest rate (not a variable rate).
  • You’ll get a new interest rate that’s lower than the one you have now.
  • Your repayment period will not be longer than the one you have now. 
  • Your motivation to pay off your debt doesn’t drop because you’ve got just one student loan payment. 

Pro tip: Check out our Student Loan Payoff Calculator to see the difference you can make on those loans if you pay extra on them now or even after consolidation!

Should I Consolidate My Debt?

Unless it’s student loans and you’re following the checklist we just ran through, the answer is no. Here are five reasons why you should skip debt consolidation:

1. When you consolidate your loans, there’s no guarantee your interest rate will be lower.

The lender or creditor will set your new interest rate depending on your past payment behavior and credit score. And even if you qualify for a loan with low interest, there’s no guarantee your rate will stay low.

2. Lower interest rates don’t always stay low.

That low interest rate you get at the beginning is usually just a promotion and only applies for a certain period of time. Spoiler alert: That means this rate will eventually go up.

Be on guard for “special” low-interest deals before or after the holidays. Some companies know that holiday shoppers who don’t stick to a budget tend to overspend and then panic when the bills start coming in.

Though this offer is often used to tempt you into a credit card balance transfer, other loan companies will also hook you with a low interest rate, then inflate the interest rate over time, leaving you with even more debt!

3. Consolidating your bills means you’ll be in debt longer.

In almost every case of debt consolidation, those lower payments mean that the term of your loan gets dragged out longer than the seasons of Grey’s Anatomy. Extended terms mean extended payments. Not interested, thank you. The goal isn’t to extend the length of time you’re making payments—your goal is to get out of debt . . . ASAP!

4. Debt consolidation doesn’t mean debt elimination.

If debt consolidation meant debt elimination, we wouldn’t warn you to stay away. We’d tell you to jump on board! But sadly, debt consolidation really means that you’re just moving your debt around, not crushing it.

5. Your behavior with money doesn’t change.

Most of the time, after someone consolidates their debt, the debt grows back. Why? Because they don’t have a game plan to stick to a budget and spend less than they make. In other words, they haven’t established good money habits for staying out of debt and building wealth. Their behavior hasn’t changed, so why should they expect their debt status to change too?

Debt consolidation doesn’t fix any problems. It just shuffles them around.

Does Debt Consolidation Hurt Your Credit Score?

Does debt consolidation hurt your credit score? Yup. And we aren’t fans of credit scores, but you should know exactly what happens if you consolidate your debt.

The way credit scores are set up, they really value you having a debt for a long time (part of why we don’t like them) and paying consistently on it over time. When you roll over old debts into a new debt, you hurt that consistency in the eyes of FICO. So, yes, your credit score will suffer if you choose debt consolidation.

What’s the Difference Between Debt Consolidation and Debt Settlement?

There’s a huge difference between debt consolidation and debt settlement.

We’ve already covered consolidation loans: a type of loan that rolls several unsecured debts into one single bill. But debt settlement is when you hire a company to negotiate a lump-sum payment with your creditors for less than what you owe.

Sounds good, right? Someone does the dirty work and you get to keep more of your paycheck? Not so fast. These debt settlement companies also charge a fee for their “services,” usually anywhere from 20–25% of your debt! Ouch. Think about it this way: If you owe $50,000, your settlement fees would range from $10,000–12,500.

And if that’s not bad enough, dishonest debt settlement companies often tell customers to pay them directly and stop making payments on their debts. Once you fork over the fee, they promise to negotiate with your creditors and settle those debts on your behalf.

If it sounds too good to be true . . . it is.

Most of the time, these companies will just take your money and run—leaving you on the hook for late fees and additional interest payments on debt they promised to help you pay!

Debt settlement is a scam, and any debt relief company that charges you before they actually settle or reduce your debt is in violation of the Federal Trade Commission.1 When it comes to debt settlement—stay away. Period.

What Are Alternatives to Debt Consolidation?

Well, here’s the very best one possible: the debt snowball method. With this alternative to debt consolidation, you aren’t focused on moving around or combining your debts—you’re working on paying them off. Every. Last. One.

Here’s how it works. List your debts smallest to largest (no matter the interest rate). Pay minimum payments on everything but the smallest—you’re going to throw everything you can at this one to pay it off as quickly as possible. (How? Cut back your spending, get on a budget, make extra money, etc.)

Once that debt is gone, take all the money you were paying toward it and apply it to the second-smallest debt. Keep making minimum payments on the rest.

It’s like a snowball plowing down a hill at top speed—nothing can stop the momentum and nothing can stop you! Keep going until every single debt is gone.

Yup—gone. Not “settled” or “balanced” (which are two super misleading words when it comes to these debt companies). Not somewhere else with a different interest rate. Gone.

What’s the Fastest Way to Get Out of Debt?

The fastest way to get out of debt is to first decide it’s time for a life-change—and then make it happen! It’s not easy, but it’s way easier with a membership to Ramsey+.

Ramsey+ gives you access to our best money courses. Financial Peace University shows you how to attack your debt and save real money. Know Yourself, Know Your Money helps you see how your past and your personality affect how you deal with money today. Plus, you’ll get the premium version of EveryDollar so you can budget your way to freedom from debt.

It’s time to break up with your debt, not move it around. Sign up for your free trial of Ramsey+ and learn the best way to say “It’s not me, it’s you . . . You suck, debt.” Then you can start building the life you really want with your money.

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners. Learn More.

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