How does debt consolidation work?
If you're trying to pay off debt, it can feel like you are using a bucket to bail out a boat taking in water. But you don't have to be lost in a sea of debt. There are a variety of strategies to address your debt through consolidation. Consolidating your debts may be an effective financial strategy for anyone juggling multiple bills or facing high interest rates. By rolling multiple debts into one, you may be able to simplify your payments, reduce your interest rates, and manage your finances more easily.
What is debt consolidation?
Debt consolidation allows you to reduce the stress of multiple payments and due dates by getting a lower, fixed interest rate loan. The loan gives you funds to pay off the debts, so that you only make one monthly payment for the term of the loan. When considering how to consolidate debt, the idea 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 gain some peace of mind along the way. But with credit cards, car payments, student loans, mortgages, and medical bills, where should you start consolidating?
4 benefits of a debt consolidation strategy
Debt consolidation offers several potential benefits, including simplified monthly payments, lower interest rates, and an improved credit score.
- Reduced monthly payments: With a debt consolidation loan, you can select terms that work for you. This could mean a longer repayment period, resulting in a lower monthly payment, and/or an interest rate that is lower than what you are currently paying. By setting these terms, you know how long you will be in debt, which lends a sense of control.
- Reduced interest rates and charges: Seek a debt consolidation product with a lower interest rate than you are paying on your current debts. This could result in less interest being paid over the life of the debt if you do not increase your repayment term, which could save you a significant amount of money.
- Improved credit score: Your credit utilization rate, or your ratio of debt to available credit, can impact your credit score. A debt consolidation loan may help you to pay off the debt more quickly, which could improve your credit score.
- Simplified bills: Consolidating your debt simplifies your monthly bill paying cycle. Instead of having a multitude of different payments due on different days, you have just one set payment, thus reducing stress and the potential to miss a payment, which can impact your credit score.
Drawback of debt consolidation
While taking out a new loan to consolidate your debts may look like a good opportunity, there are also some potential downsides to consider about this strategy.
- Temporary credit score decrease: Lenders may run hard credit inquiries when you apply for a new loan. This can cause a temporary dip in your credit score and is something to be aware of. If you successfully make payments on the new loan and eventually eliminate your debt, your credit score will potentially improve above and beyond where it was originally.
- Longer repayment periods: While lower monthly payments are easier to manage, extending your repayment period might cost you more in interest over the long term.
- Temptation to accrue more debt: After you consolidate your existing debts, you might feel a sense of relief and wind up tempted to spend even more. This can potentially worsen your financial situation. It’s important to address the spending that led to the debt in the first place, and make a plan to change your habits and avoid adding new high-interest debt payments to your monthly bills.
Is debt consolidation right for you?
Debt consolidation may be a powerful financial strategy for people struggling with multiple high-interest debts. It offers the advantage of simplicity and potentially reduced interest rates. However, you must carefully assess your financial situation and be disciplined with your spending habits to feel its benefits and avoid falling back into a cycle of debt.
Before consolidating, make sure to do the following:
- Analyze your unique financial situation: Collect information about your total outstanding debts and interest rates and evaluate your ability to make monthly payments. When you look over the numbers, you may decide that a new debt consolidation loan is the right decision for you, or you may find that making a few adjustments in your budget is a better way to go.
- Compare lenders and interest rates: Research and compare terms offered by various lenders to determine what might work best for your finances.
- Improve your spending habits: Debt consolidation isn’t a permanent solution for financial stability. To achieve this, it’s important to reevaluate your spending habits and adjust your lifestyle around what you can afford to pay back when you borrow money.
3 types of debt consolidation loans
- Home equity loans: Homeowners can take out a home equity loan that uses the available equity in their home to pay off debt. Because this type of loan is secured (meaning it is back by collateral—in this case, your house), you can typically get lower interest rates and longer repayment terms than with other debt consolidation loan options. Other lenders may also offer a home equity line of credit (HELOC) which offers the flexibility of drawing the amount of cash you need when you need it. This functions as revolving debt, much like a credit card, but usually comes with a variable interest rate that can go up or down over the course of the loan (please note that Discover® offer home equity loans, but not HELOCs).
- Personal loans: A personal loan does not require you to have collateral (hence it is an “unsecured" borrowing option), so its interest rates tend to be higher and repayment terms tend to be shorter than a home equity loan.
- Balance transfer credit cards: Balance transfer credit cards move debt to a single credit card often offering an enticing introductory annual percentage rate (APR). Once the introductory period is over, these cards usually switch to high APRs, which may not helpful when trying to get out of high interest debt. You’ll want to pay attention to any fees associated with a balance transfer, too.
How to apply for a debt consolidation loan with Discover
Ready to apply for a debt consolidation loan? Specific requirements will vary by depending on which lender you choose, but here is what the next steps look like with Discover.
How to apply for a home equity loan
Most home equity loan applications begin online. For Discover Home Loans, the online application may be completed in a matter of minutes.
The overall loan process generally goes like this:
- Getting the basics (around 1-2 weeks): Apply online or over the phone to review your loan options, then securely upload required documents so we can confirm your initial eligibility.
- Processing your info (around 4 weeks): We gather third-party information about your home and then send your complete application to underwriting for a final decision.
- Closing your loan (around 1-2 weeks): We will contact you to schedule your closing and then arrange for your loan funds to be sent to your accounts.
How to apply for a personal loan
You can fill out an application with Discover® Personal Loans either online or by phone. For an unsecured personal debt consolidation loan, it takes about one to seven days to disperse funds. However, money may be sent as soon as the next business day once you’re approved and accept the loan, provided your application has no typos or errors, the loan is funded on a weekday night, and the funds are arranged to be disbursed electronically to your checking or savings account only.1
Remember that even though you might get the funds from a personal loan quickly, the interest rate will likely be higher than you can get on a home equity loan.
Closing thoughts: Does debt consolidation work?
Debt consolidation works by taking multiple debts and combining them into a single loan, potentially with a lower interest rate. This approach not only simplifies the debt repayment process but also might make it more affordable over the long term. While it may offer substantial benefits like consolidated payments, lower interest rates, and a potential credit score boost, it’s not without drawbacks. A temporary credit score dip, longer repayment periods, and the temptation to take on more debt are all possible pitfalls.
Before applying for a debt consolidation loan, pull together all the information you have about your monthly bill payments and your budget. Once you evaluate these details about your current financial situation, research lenders, compare interest rates, and think about your spending habits. Is there anywhere you can cut back on purchases, or could you reduce an existing bill payment? If so, you may free up money that can go toward paying off other high-interest debt.