How Does Debt Consolidation Work?

Debt consolidation combines several loans into one. The overall debt total typically isn't affected, but you may save money on interest by shifting balances to a low-rate loan.

Debt Consolidation Purposes

A primary motive for debt consolidation is a lower interest rate, according to Lending Tree. Combining balances from high-rate credit cards in a lower-rate personal loan or equity loan can cut your average interest rate by several percentage points. Over time, you save a lot of money in interest. Closely related, people may consolidate to get into a fixed-rate loan for more consistency in payments.

Reducing total monthly debt payments and creditors are additional consolidation goals. When you lower interest rates, your minimum monthly payments typically go down. Spreading out debts over an extended repayment period can reduce monthly cash requirements further. Cutting down the number of bills you receive each month is a psychological advantage.

Loan Types

Banks sometimes offer loans dubbed "debt consolidation loans," typically personal loans packaged for the purpose of consolidation. Knowing that you intend to consolidate is useful, because the bank otherwise may have concerns about your existing debt load.

Another common approach to debt consolidation is a home equity loan. Secured loans normally offer lower interest rates than personal loans, though banks often have options with no upfront closing costs for each type. Another major benefit of an equity loan is that the interest payments are typically tax-deductible.

Risks of Consolidation

Despite the significant financial benefits of debt consolidation, this financial maneuver isn't without risks. A major risk of using home equity to consolidate is that you the lender places another lien on your property. If you fail to repay the debt, you could lose the home.

Also, people sometimes consolidate debt without adjusting spending habits. After consolidation, you end up with a number of existing credit cards with no balances. Continuing to borrow and spend causes you to add the new debt that you take on to your consolidated debt balances, which exacerbates your financial troubles.