Debt consolidation

Consolidation changes the shape of a debt, not its size. The new loan pays off the old balances, so on the day it closes the household owes exactly what it owed the day before, to one lender instead of several, at one rate and on one schedule. Whether that is cheaper turns on two comparisons: the new rate against the old ones, and the new term against how long the old payoff would have taken. The saving comes entirely from the rate, and a longer term can give all of it back, which is why the same $8,500 of card balances costs $1,649 of interest as a three-year loan and $2,819 as a five-year one.

In a sentence

• "Debt consolidation turned three card payments into one $281.92 loan payment, and cut the interest from about $4,550 to about $1,650."
• "A debt consolidation loan does not shrink the debt; it changes the rate, the term and the number of payments."
• "Their debt consolidation worked because the cards stayed at zero afterward; the cards that fill back up are how people end up with the loan and the balances."

How it works

1. List the debts to be combined, each with its balance, rate and minimum payment, and add up the balances. That total is the amount to borrow.
2. Find a loan at a lower rate than the balances carry. The usual vehicles are a personal loan, a balance transfer card, a home equity loan or line of credit, and, for federal student loans, a consolidation loan of their own.
3. Compare the total cost, not the payment: the new loan's interest plus any fee, against what the old debts would cost at the same monthly payment. A lower payment on a longer term can cost more in total.
4. The lender pays the old balances, or sends the money for you to pay them, and the old accounts read zero.
5. Pay the new loan on its schedule and leave the old accounts at zero. The loan replaced the balances; it did not replace the spending that built them.

An example

Three card balances, $8,500 in all, and a household that can send $282 a month to them. The loan's rate and fee are the example's assumptions.

The three-year loan costs $2,902 less in interest than the cards at the same payment and ends eleven months sooner, and a 3% origination fee, $255, still leaves the saving at $2,647. The five-year loan has the lowest payment and still beats the cards, but it costs $1,170 more than the three-year loan and runs two years longer, and if the cards are used again in those five years the household is paying both.

Why it matters

Consolidation is the one payoff method that changes the interest rate rather than the order or the amount, and on card balances the rate is the whole cost. It is the strongest move a household with several high-rate balances and the credit to get a lower rate can make, and the most misread. The payment falls, the number of bills falls, and the debt has not moved; the mistake it invites is to read the lower payment as progress and let the term, or the cards, refill what was cleared. The decision turns on three things: whether the new rate is lower once the fee is counted, whether the term keeps the total cost down, and whether the spending that built the balances has stopped. Two out of three is how people end up owing the loan and the cards together.

Debt consolidation versus a balance transfer

A balance transfer moves card balances onto another card, usually at a promotional 0% rate for a set number of months and for a fee of typically 3% to 5% of the amount moved; consolidation replaces them with a loan at a fixed rate and a fixed term. The transfer is cheaper if the balance can be cleared before the promotional rate ends, and more expensive if it cannot, because the card's regular rate then applies to whatever remains and nothing forces the payoff. The loan costs interest from the first month but ends on a date. One is a sprint with a deadline; the other is a schedule. See Balance transfer.

Common questions

Is debt consolidation the same as refinancing? Refinancing replaces one loan with a new one on better terms; consolidation replaces several with one. A single card balance moved to a personal loan is closer to a refinance, and both are judged the same way, by the total cost over the new term with the fees counted. See Refinancing.

What is a good rate for a consolidation loan? One low enough that, after the fee, the total interest over the new term is less than the old debts would cost at the same monthly payment. There is no fixed number: 11.9% is a large saving against cards at 22% to 28% and no saving at all against a car loan at 6.9%. Run the totals before signing.

Should a mortgage or a car loan go into the consolidation? Usually not. Those already carry the lowest rates a household has, and folding them into an unsecured loan raises their cost. Consolidation is for the high-rate, unsecured balances, which on most lists means the cards.

What if I can't qualify for a lower rate? Then consolidation has nothing to offer, and the same $282 a month sent to the cards highest rate first is the next best plan: it costs more than the loan would have, but it needs no approval. See Debt snowball versus debt avalanche.

Go deeper

• The Debt payoff calculator takes your cards and loans and what you can pay each month and compares the avalanche and snowball methods; enter a consolidation loan as its own debt at the rate you will really pay, fee included, to compare the totals.
• The Loan calculator turns the consolidation loan's amount, rate and term into the monthly payment and the total interest, and shows how much sooner it ends if you pay a little extra each month.
• Debt snowball versus debt avalanche, with a worked example runs the alternative that keeps the cards, month by month on the same kind of debts.