How Does Debt Consolidation Work? We Explain 3 Options
In a nutshell, debt consolidation involves replacing multiple types of debts with a single debt. Depending on how you consolidate, you could realize multiple benefits from having a single account.
When you have loans with multiple companies, it can be a challenge to keep track of your payments. They all have different due dates, terms, and late fees. Make a mistake with any one of them, and you can damage your credit.
Consolidation solves all that. Ideally, your terms are better and your interest rate is lower at the end of this process.
There are three things people normally think about when it comes to debt consolidation. They are:
- Personal loans
- Credit card balance transfers, and
- Debt settlement, which people often confuse with debt consolidation, but it’s actually quite different.
Let’s take a look at each option.
How do personal loans work?
This approach to debt consolidation is pretty straight-forward. You take out a personal loan from a bank and use it to pay off your credit cards. Then you pay off the personal loan via fixed monthly payments.
This move can have a net positive effect on your credit for several reasons. First, credit card debt is more harmful to your credit score than personal loans. Why? Because credit cards are revolving debt. You can increase your balance at any time. Personal loans are installment debt. You borrow a fixed amount and pay it off in a defined amount of time.
Replacing even some credit card debt with this type of loan may give your score a boost.
Second, replacing your credit card debt with a personal loan can reduce your credit utilization ratio — the amount of debt you have vs. the amount available on your cards. The lower this number, the better for your credit score.
Third, you can’t over spend using a personal loan. Replacing a credit card with a personal loan removes the temptation to spend more, and can help you curtail bad spending habits.
See our current picks for the best deals on debt consolidation loans.
How do balance transfers work?
Moving all of your credit card debt onto a single credit card is called a balance transfer. Most people do this by transferring their debt onto a single 0% APR credit card, which comes with zero interest. Credit card companies often offer this deal as a way to entice people to open new cards.
However, this can be a risky move. After your trial period, the interest rate generally shoots up, often to rates as high as 20%. So if you haven't paid off the card in full, you'll be on the hook for high interest charges every month.
This approach is really only safe if you’re certain you can pay your balance back within a year. You may also have to pay fees that make that “free” card more expensive than you’d expect.
There's one more serious drawback to consider: Carrying a high balance on a single card can throw off your credit-utilization ratio and put a significant dent in your credit score.
How does debt settlement work?
The biggest thing you need to know about debt settlement? It's extremely risky.
With debt settlement, you generally make an agreement with a third-party lender that agrees to accept less than you owe as a final payment. Does that sound confusing? It should, because it's a convoluted process.
Debt settlement companies serve as middlemen — they negotiate a lower payment with your lenders on your behalf. Meanwhile, you make reduced monthly payments to the debt settlement company, which they distribute to your lenders.
It may sound good at first, but there are serious drawbacks.
First, it can wreck your credit by sending your accounts into default. That’s because debt settlement companies often don’t pay off your debts to your original lenders right away. Rather, they withhold payment until you’ve paid the full, reduced amount you agreed to pay.
Then, they use that money as leverage to get your original lenders to accept less money than you owe. The idea is that your credit card company would rather accept a smaller total amount than get stiffed altogether.
Other drawbacks include the fees these companies charge. These are usually taken out of your payment, and they can be significant. In addition, you may find you owe taxes on the amount your debt has been reduced by.
Perhaps the worst part of this, however, is that despite their claims, debt settlement companies aren’t always successful in negotiating lower payments from their customers’ lenders. Some debt settlement companies make claims of being able to reduce customer debt by 50% or more. But that’s hardly guaranteed, and some lenders refuse outright to negotiate with these companies.
Debt settlement companies are a huge risk — and you don’t need to take that risk to get out of debt.
What's right for you?
Personal loans can actively increase your credit score, and a balance transfer can work if you have a smaller balance and you carefully evaluate the terms and conditions first.
The bottom line? Do your research and don’t rush into a plan you aren’t sure of. If it sounds too good to be true, it probably is.
One way to help ensure that you're getting a good deal is to work with a well-established lender. We like debt consolidation loans from Citizens Bank for their low rates and fast approvals.