HOW DEBT CONSOLIDATION WORKS: WHAT TO KNOW BEFORE YOU APPLY

How does debt consolidation work? In plain terms, you take out one new loan and use it to pay off several debts you already have, usually credit cards. Instead of juggling several balances, rates and due dates, you make one payment each month to one lender.

This is the work we do at Key 2 Debt Free, so I want to explain it plainly. Consolidation can help some people a great deal. It can also cost more if the terms are wrong. Here is how to tell the difference.

DOES CONSOLIDATION SAVE MONEY? A SIMPLE EXAMPLE

Say you owe $8,000 across a few credit cards, with interest rates that average 24 percent, and you pay $265.71 a month toward them.

1. 1

   Keep paying the cards. At that payment, it takes about 47 months to pay them off, and you pay about $4,368 in interest.

2. 2

   Consolidate over three years. Now say you qualify for an $8,000 loan at 12 percent for 36 months. The payment is the same $265.71, the debt is gone in 36 months, and the interest is about $1,566.

3. 3

   Consolidate over five years. The same loan stretched to 60 months drops the payment to about $178, but the interest rises to about $2,677.

In this example the three year loan costs far less than staying on the cards. The five year loan still costs less than the cards here, but you pay over $1,100 more than the three year option for the lower payment. I wrote more about that trade in Does a Lower Monthly Payment Actually Save You Money?

These numbers only hold if the rate you are offered is lower than what you pay now. The rate depends on the lender and on your own credit and income, and a licensed lender makes every approval decision.

WHAT SHOULD YOU CHECK BEFORE YOU APPLY?

1. 1

   The interest rate. Compare it to the rates on the debts you want to pay off.

2. 2

   Fees. Some loans charge an origination fee, often taken out of the loan amount. A 5 percent fee on $8,000 is $400.

3. 3

   The term. Ask for the total cost over the life of the loan, not only the monthly payment.

4. 4

   Prepayment penalties. Make sure you can pay the loan off early without a charge.

5. 5

   Your monthly budget. The payment needs to fit every month, including the expensive ones.

WHAT IS THE MOST COMMON MISTAKE?

The most common way consolidation goes wrong has nothing to do with the loan. Once the cards are paid off, the balances are back to zero, and it is easy to start using them again. Then you have the loan payment and new card balances on top of it.

Before you consolidate, decide what happens to those cards. Some people put them away somewhere hard to reach. Others keep one for emergencies only. Choose what fits you, and make the decision before the cards are paid off, not after.

WHEN DOES CONSOLIDATION NOT MAKE SENSE?

Consolidation tends to make the most sense when you have several high rate balances, steady income and a plan to stop adding new debt. It may not help if the rate offered is close to what you pay now, if the fees are high, or if the only way to lower the payment is to stretch the loan for many years.

I shared the plain money steps I followed in The Key, and the story of where I started in Welfare to Wealthy.

HOW WE CAN HELP

At Key 2 Debt Free, we lay every debt you have side by side and look at whether combining some of them lowers what you pay in the end. Sometimes it does. Sometimes the answer is that it does not, and you deserve to hear that too. Key 2 Debt Free is not a lender, and a licensed lender makes every approval decision. If you would like a second set of eyes on your numbers, you can book a session with me, or you can connect with me here.

Rachael J Katz is a financial educator, author and speaker. This article is general education, not personal financial advice. The figures above are a simplified example with fixed rates and payments, and your own terms will differ.