How Debt Consolidation Works

Debt consolidation is a potential option for those who are struggling to reduce their debt. It is important to understand what debt consolidation is, how it works, and why it might not work for you.

What is debt consolidation?

According to Investopedia, Debt consolidation means taking out a new loan to pay off a number of liabilities and consumer debts, generally unsecured ones.

In general, this means combining the debt that is on several credit cards by taking out a new loan. Ideally, the new loan will have a lower interest rate and lower monthly payments than the amount the person was previously paying across all of their credit cards. Debt consolidation can also be used to deal with student loan debt, medical debt, and other types of debt.

How does debt consolidation work?

Ideally, debt consolidation includes debt counseling. The company offering the debt consolidation service sits down with the person who wants a loan and works out a plan to eliminate their debt in three to five years.

Debt consolidation starts when a person takes out a debt consolidation loan. The person's debt (from credit cards, medical bills, and other unsecured debt.) get rolled into that loan.

The person makes a single payment - on that new loan - every month instead of multiple payments, on different loans, on different days, with different interest rates, every month. The loan provider takes that one monthly payment and distributes it to the person's various creditors.

Debt consolidation is a service that helps a person manage their debt. It does not erase their debt. The person must continue paying down their debt.

Why debt consolidation might not work for you

Debt consolidation is for unsecured debt. It is not for secured debt (such as mortgages and car loans). There are different debt relief options available for secured debt.

Debt consolidation comes with fees. There can be a setup fee, and there will be monthly fees. People should consider whether or not they can afford to pay that monthly fee on top of the amount they must give to the debt consolidation company each month.

The debt consolidation interest rate might not result in a lower interest rate. This means a person could get stuck paying more than they would have if they did not consolidate their debt. There is no guarantee that a loan that started with a low interest rate will stay that way for ever. It could go up.