In this article, we’ll dive into how debt consolidation works, the pros and cons, and real-life examples of when it’s a smart move—and when it’s not.
What is debt consolidation?
Simply put, debt consolidation combines all of the debt you owe into a single payment with a lower monthly interest rate. This typically works by taking out another loan in order to pay off all of your other debt.
Let’s say you have debt across three credit cards, and you owe the following:
- Credit card A: $2,000 at 10% APR
- Credit card B: $1,000 at 20% APR
- Credit card C: $1,000 at 15% APR
Each month, you’re contributing $100 to each card for a total of $300 — however, a portion of each is being eaten by interest:
- Credit card A: $16.67
- Credit card B: $16.67
- Credit card C: $12.50
So, you’re paying $254.16 towards your debt rather than the full $300.
With debt consolidation, you take out a loan of $4,000 and pay off ALL of the above debt — and you get a lower interest rate for the loan at 10%.
Now, when you contribute $300 each month, you’ll pay $266.67 towards your debt rather than just $254.16.
In theory, this means you’ll be able to pay off your debt faster.
The interest rate you’re able to get depends on which type of loan you attain:
- Secured loan: This is a loan where you put up an asset (e.g., car or home) as collateral. If you default on your loan, your creditor will repossess said asset.
- Unsecured loan: This is a loan that just uses credit. As a result, you might end up with higher interest rates than if you had a secured loan.
If you want to get your debt consolidated, you’ll have to go through one of the two routes above — which we’ll get into later.
Before we do that, though, you must know the dangers of consolidating your debt.
The problem with debt consolidation
But before you click on one of those scammy internet ads marketing “DEBT CONSOLIDATION — BE DEBT FREE IN 3 HOURS,” consider the big drawbacks to debt consolidation:
1. It could take longer to pay down your debt
If there’s anything we’ve learned about human psychology over a decade of studying behavior and personal finances, things like that are easier said than done.
For example, if the average person ends up saving $300 in interest payments because of debt consolidation, do you think they’ll use that extra money towards their debt OR do you think they’ll end up spending it?
Most likely, the latter.
Human willpower is limited. It’s the same reason why cutting out lattes or skipping lunch to save money doesn’t work.
A person with 300 “extra dollars” might just blow it on something else.
What happens then is it takes longer to pay down debt. This results in even MORE fees they have to pay.
Aside from diminishing willpower, many debt consolidation loan companies offer up longer loan terms than people realize. So while the interest rate is lower, they end up paying more because they didn’t take into account how long they’d have the loan for.
2. You could lose your home or car
If you decide to put your car or home down as collateral you stand to lose much more than a few thousand dollars off the life of your loan.
A home equity loan is also known as a second mortgage. Taking a second mortgage out on your home means you risk losing your house if you fail to make payments.
Of course, there are some advantages to going this route. You can deduct the interest payments from your home equity loan from your taxes. Plus, you’ll be able to get a lower interest rate than if you went the unsecured route.
Overall, though, it’s just not worth the risk — especially when there are better ways to go about it.
3. Your credit score will suffer
There are a few things that go into making a great credit score. One is your credit history — or how long you’ve had credit for.
It accounts for 15% of your overall score.
That might seem small but consider this: If you get rid of a bunch of different lines of credit at once, your credit score will take a huge drop. That drop gets bigger with more and more lines of credit you close.
How do you know if debt consolidation is right for you?
Debt consolidation can be a great way to plan your route out of debt. But that doesn’t mean it’s the perfect solution for everyone.
The benefits of debt consolidation are hard to argue with. You can simplify your debt, save money on interest, only deal with one creditor, and (hopefully) clear your debt faster. But there are pros and cons you need to know about before you make this decision.
It can be the best move for some but worst for others.
Signs debt consolidation is right for you
Here are a few signs that debt consolidation is right for you:
You have high-interest debts
The number one sign that debt consolidation is a good option for you is if you have several high-interest debts. Why pay interest on several debts when you can pay it on just one?
If you know you can secure a lower-interest loan, it makes sense to consolidate your debts.
According to Experian, the average personal loan interest rate is 9.41% — whereas the average interest rate for credit cards is around 16%. So, if you’ve got a ton of credit card debt, it’s worth considering debt consolidation.
You have good credit
If you’re already in debt, getting another loan might be tricky unless you have good credit. Most creditors will want a credit score of around 670 (FICO Score).
If you have good credit, you’re more likely to get approved for a loan with decent interest rates. Remember, this part is key because you want a loan with lower interest rates than your current debts. A new loan might not have favorable interest rates if your credit score isn’t the best.
You want a fixed repayment schedule
With some debts like credit cards, it’s easy to make the minimum payments or even miss a payment (please don’t do this). This makes it harder to clear the debt because some of it relies on willpower.
With a personal loan, you have a fixed payment and loan term to abide by. This makes it much easier to stay on track and clear your debts. It also means there are no fluctuations in your monthly debt payments like with a credit card, so it’s easier to budget.
Signs debt consolidation is NOT right for you
Meanwhile, here are the signs that debt consolidation is probably not for you:
You have a poor credit score
Having a poor credit score is one reason many people want to get out of debt as quickly as possible.
However, debt consolidation relies on your ability to take out a new loan and get one without crazy high interest rates.
If the only loans you can take out mean you’ll be paying MORE in interest rates, then it’s not worth it. In this case, the only benefit would be to simplify your loans.
But what you really need is to save on interest so you can clear the debts faster.
You’re on the verge of bankruptcy
If things have taken a downward turn and creditors are threatening to sue, then a debt consolidation loan may not even be accessible to you. Bankruptcy is a scary thought, but if this is your reality, you are unlikely to qualify for a debt consolidation loan.
If this is your current situation, you would be better off looking into debt settlement to try and reduce your debt amount first.
You can’t afford the monthly repayments
Taking on another debt is tricky if you’re already in debt. While you can use this one to clear your other debts, you need to make sure you can cover the monthly repayments.
The monthly repayments will be higher as the debt amount will be higher (to cover all your other debts). Before taking on new debt, make sure you can comfortably fit it into your budget.
After all, missing repayments can set you back even further.
What happens when debt gets in the way
It’s important to make sure your debt consolidation plan actually helps you pay down your debt. When you ignore your debt or choose the wrong strategy, things can spiral out of control.
Look at this real-life example to see what happens when debt payoff goes wrong.
Meet DJ and Adam, a couple in their 30s navigating the complexities of a serious relationship. There’s one big issue between them, and it’s so severe that Adam doesn’t even want to marry DJ because of it.
[00:09:14] DJ: Adam, is it important to you that I’m debt free?
[00:09:18] Adam: You don’t have to be debt free. I’m not debt free. I have a lot of debts. But it’s important that you can manage your debts in a way that won’t drag us both down one day.
[00:09:29] Ramit: What did you just take away from that answer?
[00:09:31] DJ: That he sees me being in debt as a risk?
[00:09:34] Ramit: Mm-hmm. Okay. So what was the question you asked him?
[00:09:37] DJ: If me being debt free is important to him.
[00:09:40] Ramit: Uh-huh. And what do you think that he said just now?
[00:09:43] DJ: He said he doesn’t care if I’m debt free, as long as it doesn’t both drag us both down eventually.
[00:09:48] Ramit: Adam, it’s interesting she asked a pretty direct question, and your answer was quite indirect. Did you notice that?
[00:09:55] Adam: Yeah, a little bit. She knows my answers because I’ve been through this before. I am divorced and finances is one of the major roles that screwed it up the first time.
We were both working jobs that we didn’t like, so spending was our way to just feel better. And I don’t know if that what DJ goes through day in, day out. But for me, I was working a job many people would’ve dreamed about, and I was just so miserable. Spending was what got me by.
[00:10:26] Ramit: Mm-hmm.
[00:10:28] Adam: And then a wall hit where the credit cards were so high. It led to disdain for each other and fighting and eventually splitting up.
[00:10:37] Ramit: think that was directly responsible because of money?
[00:10:40] Adam: Money was absolutely one of the top reasons.
DJ insists that she’s just living in the moment, but I’m not convinced. Something deeper drives her spending habits and needs to be uncovered before she can make any real progress.
[00:35:02] Ramit: Are you good with money?
[00:35:04] DJ: No.
[00:35:05] Ramit: Why?
[00:35:07] DJ: Because I don’t take into account the things I need to save for before I spent.
[00:35:13] Ramit: Okay. Why?
[00:35:14] DJ: Because I live in the right now. And also because I didn’t make very much money for a long time, so it was impossible to even do anything.
[00:35:31] Ramit: That’s not true.
[00:35:32] DJ: So I just threw it all out the window.
[00:35:35] Ramit: I don’t think that’s true, and I think that’s a story you tell yourself.
[00:35:39] DJ: Okay.
[00:35:41] Ramit: I think it’s really important to really dig into that. Were there other teachers around you making similar incomes?
[00:35:49] DJ: Yeah. And one just paid off all her debt.
[00:35:52] Ramit: Wow, that’s shocking.
[00:35:53] DJ: By getting a new job.
[00:35:55] Ramit: Mm-hmm. Like you.
DJ’s logic behind her credit card use was baffling. I discovered she really did have a different way of viewing her credit card debt, and having this view makes it hard even to approach something like consolidation.
[00:55:24] Ramit: All right, let’s look at the debt payoff. What’s your interest rate?
[00:55:29] DJ: Adam, did we write this down the other night?
[00:55:31] Adam: I didn’t save it.
[00:55:36] Ramit: We’ll just say 26%, because I bet it is. And how much currently pay every month?
[00:55:42] DJ: It varies. It really does vary. I pay–
[00:55:48] Ramit: Why?
[00:55:49] DJ: I try to put as much as I can when I can.
[00:55:52] Ramit: Okay. How much?
[00:55:54] DJ: I usually put at least 2,000 a month towards it, but then I charge it back up. That’s the problem. I will pay and then I’ll use my credit card so that I get points.
[00:56:07] Ramit: What the fuck? Why? What the fuck? What are you talking about? Why are you using it for points?
[00:56:14] DJ: I don’t use– because I don’t want to use my checking account. Because you don’t get any rewards to use your checking account when you pay.
[00:56:18] Ramit: Are you kidding me right now?
[00:56:20] DJ: What? You’re supposed to do that, right?
[00:56:23] Ramit: Who told you that? Who told you? Who told you that you’re supposed to go into more debt to earn one cent in rewards?
[00:56:34] DJ: Well, you just don’t get any rewards when you spend money out of your checking account.
[00:56:38] Ramit: Who cares? You are in debt. You know why you actually care? Do you know why I’m getting so mad and you’re not? Do you have any idea why this is happening right now?
[00:56:48] DJ: Because the math doesn’t equal out.
[00:56:51] Ramit: No. I’m getting mad because you don’t even see the consequences of what you’re doing. Because you have no consequences. You are staying in debt, not just because of the interest, which is already crazy high, but because you keep spending on it.
And when I ask you why, you go, so I can get points. It makes no sense. These points are worthless for somebody like you in credit card debt. The last thing you should be thinking about is points.
[00:57:27] DJ: I needed to hear that.
[00:57:31] Ramit: Has anyone ever told you that?
[00:57:34] DJ: No. I thought that if you were good with money, that you used credit cards to your advantage to earn points so that your money was making you money.
[00:57:51] Ramit: Your money is not making you money. All that money you’re putting in your credit card on the backend is just costing you more than those points. You’re basically spending a dollar to pay a 1.50 and then you get one cent back. It makes no sense.
[00:58:14] DJ: Yeah. When you put it like that, it doesn’t make sense at all.
[00:58:17] Ramit: Okay, so we got to stop that. This is why people who are in credit card debt, they use their debit card. It’s a huge behavioral peculiarity. But it actually makes sense because those people go, shit, I do not want to put more on this credit. I’m paying it off. I don’t want to add more to it, so I’m going to pay for my dinner with a debit card.
Finally, the numbers reveal a shocking truth about how quickly DJ could turn her financial life around—if she sticks to the plan. In this situation, consolidation might be a good idea if it makes payments easier and eliminates the temptation to use a credit card after making a payment.
[00:59:00] Ramit: All right. So currently, if you’re paying off $2,000 a month, that’s why now the math actually adds up. If you’re paying 2,000, I’m like, this thing’s going to be paid off right away. What’s the problem? Then I find out you’re spending all this money for miles. I go, oh my God. All right, so how much, by the way, were you spending on that credit card?
[00:59:23] DJ: I just use it for everything.
[00:59:26] Ramit: Like?
[00:59:26] DJ: One with my lowest interest, I just use for everything. Gas, groceries, everything.
[00:59:31] Ramit: Okay. Don’t do that anymore.
[00:59:33] DJ: Okay.
[00:59:34] Ramit: So you can only buy how much you have in your checking account.
[00:59:38] DJ: Okay.
[00:59:39] Ramit: All right, so if you pay, can you continue paying $2,000 a month towards your credit card?
[00:59:46] DJ: Yes.
[00:59:47] Ramit: How long will it take you to pay off?
[00:59:51] DJ: A year probably.
[00:59:54] Ramit: Let’s get the exact number because I want you to see it.
[00:59:58] DJ: Okay.
[00:59:58] Ramit: Oh, you’re not going to be able to do this on a calculator of your own.
[01:00:01] DJ: Why not?
[01:00:03] Ramit: Unless you can do the calculations with the interest rate.
[01:00:07] DJ: Oh.
[01:00:08] Ramit: I’ll just tell you. It’s nine months.
[01:00:11] DJ: That’s it?
[01:00:14] Ramit: Yeah.
[01:00:15] DJ: Okay.
[01:00:17] Ramit: What do you think about that?
[01:00:19] DJ: That’s awesome.
[01:00:21] Ramit: It’s easy. Is that surprising to you?
[01:00:27] DJ: Yeah, that’s shocking.
[01:00:29] Ramit: What’d you think it would be?
[01:00:31] DJ: At least two years.
As you can see from DJ and Adam’s story, ignoring financial issues or delaying crucial decisions can lead to difficult situations and strain your relationships. If you’re considering debt consolidation, it’s best to start sooner rather than later.
How to consolidate debt — and get rid of it completely
If you’re STILL keen on consolidating your debt, here’s how you can get started in three simple steps:
Step 1: Find a non-profit debt consolidation firm
Non-profit debt consolidation firms are 501(c)(3) organizations that help provide consolidation services and credit counseling and will even negotiate with your creditors for you.
The best part: They do so with little to no costs to you since they’re funded by third-party sources such as donations and grants.
Unfortunately, even scammers and bad consolidation services have non-profit status. So, you’ll have to do your research to find a reputable one.
Two good signs a non-profit debt consolidation firm is the real deal:
- Fees: A reputable non-profit will likely have monthly maintenance fees. Luckily, they’re relatively low cost — and if you’re in really dire straits, some non-profits will waive the fees entirely for you.
- Non-profit status: This might seem like a no-brainer, but it still needs to be said: Ask them to verify their non-profit status. Too many scam companies pretend they’re non-profits to lure people in. Don’t be one of those people.
Make a list of 5 to 10 non-profit debt consolidation firms. Spend the next week calling each of them and getting a consultation on your situation and what they can do for you.
A good non-profit will spend about an hour on your consultation. Beware of any organization wanting to take your money and put you into a plan immediately. They are NOT looking out for your best interests.
…but you don’t have to take the same path as everyone else. How would it look if you designed a Rich Life on your own terms? Take our quiz and find out:
Step 2: Eliminate temptation
Luckily, a non-profit debt consolidation firm will take care of a lot of legwork for you. That means they’ll call your creditors, negotiate down your debt and interest rate, and work with them to consolidate your debt into one manageable monthly payment.
Unluckily, that’s the easy part. The hard part means paying down your debt — and that’s up to you.
To do that, you need first to get rid of the temptation of using your credit cards until you’re debt-free. If you ever expect to pay down your debt, you can’t add more.
Here’s my favorite tip: Plunge your cards into a bowl of water and shove it all into your freezer.
Seriously. Remember what we said about human willpower? It’s very weak — so weak that a solution like freezing your cards is necessary sometimes to delete temptation.
When you freeze your credit, you’ll have to chip away at a massive block of ice to get it back, giving you time to think about whether or not you want to make the purchase you were going to make.
You can also give them away to a loved one to keep until you’re out of debt.
Step 3: Confront your debt
It’s good to finally confront your debt. That’s the first step to getting out of it.
While it may be tough to climb out of debt, the sooner you plan to do so, the better. You’ll be able to repair your credit score, work on boosting your savings, save on interest, and finally get some sleep at night. Debt can weigh heavily on the mind, after all.
The good thing is, you don’t have to do this all alone. There’s help at hand. You can contact a non-profit debt consolidation firm for help. Take advantage of their credit counseling services to help steer you through unmanageable debt. Do your research and find a non-profit so you can avoid the scammers out there.
It’s easy to feel bad for yourself and avoid confronting your debt. It’s harder to actually take action.
Since you’re here, that means that you’re willing to work to dig yourself out of your financial hole, which is amazing!
What is the difference between debt consolidation and debt settlement?
Another term you’ll likely come across in your quest to clear your debt is debt settlement. But what is it?
Both debt settlement and debt consolidation are used to handle personal debt, but they work in very different ways.
Debt settlement is used to reduce the total amount of debt owed. On the other hand, debt consolidation is about reducing the number of creditors you owe.
With debt consolidation, you combine multiple debts into one. Debt settlement is when you ask one or more creditors to accept less than you owe.
If the creditor agrees, you reach a settlement agreement in a lump sum or installments.
Which option is better for you?
This depends on your circumstances and what the creditor will agree to. If you want to make your monthly repayments more manageable and reduce the interest you pay, then debt consolidation is the way to go.
If you’re already behind on payments and struggling to meet them, debt settlement might be a better option.
In this case, if you’re already behind on payments, you might struggle to get a debt consolidation loan because of the impact on your credit score. So, debt settlement is definitely something to try to reduce the burden.
Debt settlement is the next logical step if you’re out of options, have poor credit, and want to avoid declaring bankruptcy if possible.
It may mean taking a hit on your credit score, but you might have to just accept that. Once the debts are clear, you can get to work on repairing that damage.
How does debt settlement work?
Debt settlement is tricky and requires you to whip out your negotiation skills. There’s no guarantee the creditor will agree, but there’s no harm in asking.
The process is pretty simple. You can ask your creditor if they would negotiate a settlement. Do this over the phone or in writing to keep a record of the conversation.
A creditor can do one of three things:
- Accept it
- Reject it
- Make a counteroffer
With the counteroffer, you will need to consider if the amount they want is affordable in your budget. Make sure you’re agreeing to something realistic and fair.
Once you agree on a settlement amount, all that’s left is to arrange the payments. This can be a lump sum or through installment payments, whichever you agree to.
After you’ve made the payments, the remaining balance hanging over your head will be a nice round zero.
If negotiating debt settlement on your sounds like a nightmare, don’t worry. There is help at hand. You can hire a debt settlement company to negotiate on your behalf. However, this does involve paying them a fee, and again, you have to do your research to avoid hiring a scammer.
Pros and cons of debt settlement
In this section, I’ll outline the pros and cons of debt settlement
Pros
Some of the benefits of debt settlement include:
You reduce your debt amount
The biggest pro to debt settlement is that it reduces your debt amount. Many people don’t know that they can ask their creditors for this, so they continue struggling.
But if you’re struggling, it can’t hurt to ask. If a creditor agrees, you could cut hundreds of dollars from your debt and all the interest on top of that.
You can clear your debt faster
With a smaller debt amount to pay off, you can pay it off faster. Whether you agree on a payment plan or a lump sum, you can say goodbye to your debts much sooner.
This means your money will be freed up faster to put into savings accounts or whatever else you want to spend it on. Once the debt is clearer, you can also get to work repairing any damage to your credit score. The sooner, the better.
It could help you avoid bankruptcy
If bankruptcy is on the horizon, debt settlement should absolutely be a consideration. The last thing you want is a bankruptcy on your record. You can say goodbye to being able to take out credit for a LONG time if you reach this point.
Cons
While the cons for debt settlement are:
Your credit score will take a hit
Naturally, debt settlement does not reflect well on your ability to repay debts. If you have debt settlement in your credit history, it signals to future creditors that you are riskier to lend to. This could result in sky-high interest rates or outright credit rejection.
However, if your credit score is already low and your debts are just making it worse, you have nothing to lose. Yes, you’ll take a hit, but you’ll also get out of debt sooner if your creditors agree to debt settlement.
You might struggle to get credit again… especially with those creditors
A lower-than-ideal credit score does affect your ability to take out credit in the future. However, if you’ve been in a tricky situation with credit, it’s probably worth avoiding new loans and finance for a little while anyway.
The creditors who agree to debt settlement will likely avoid lending to you again because they will be worried about losing money. This could limit your options in the future. But if it’s your only option, you might just have to just bite the bullet.
There is no guarantee creditors will agree
Unfortunately, you might be out of luck if you’re relying on creditors to throw you a lifeline here. In an ideal scenario, they’ll be forgiving and offer you a way to climb out of debt to benefit everyone.
But there’s no guarantee they’ll do this. They could outright reject your request or be inflexible with their counteroffer.
There’s little you can do if this is the case. You can try another of your creditors if you have several debts to see if any of them will agree.
Avoiding debt in the future
After you’ve decided on a method to reduce your debt – don’t stop. Ridding yourself of debt is just one key part of building strong personal finances. The other part of the puzzle is to manage your spending so you don’t end up in the same position as before.
The last thing you want to do is put all your hard work into clearing the debt, only to succumb to temptation or poor money management, which will put you right back where you started.
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