Debt consolidation is the process of taking out a single loan to pay off two or more loans.

Some common loans used for debt consolidation are credit cards, personal loans, and home equity loans.

Common Debt Consolidation Loans

Credit Cards

Card companies sometimes offer a period, usually of around several months to a year, of 0% APR shortly after transferring a balance to the new card. This interest-free period can give borrowers an opportunity to quickly repay debt.

Personal Loans

Personal loans usually offer lower interest rates than credit cards. They have a fixed term, and must be paid back within a defined amount of time.

Home Equity Loans

Homeowners can consider taking out a Home equity loans or Home equity line of credit (HELOC) on their mortgage. This type of loan usually has the lowest interest rates, as it uses property as collateral.

Some for-profit companies offer debt consolidation services, but at a significant cost. Most borrowers can achieve the same outcome as debt consolidators without outside help.

Calculations

If the single interest rate of the consolidated loan is lower than the weighted average of previous interest rates, debt consolidation can make repayment cheaper. Even if the interest rate of the consolidated loan is higher, consolidated loans can provide a longer or more flexible repayment schedule, yielding advantages to the borrower.

Suppose a borrower had two credit cards. One has a balance of approximately $10,000 and interest rate of 20%, while the other has a balance of $5,000 and interest rate of 25%. The borrower decides to consolidate their loans with a new $15,000 personal loan, which has an interest rate of 10% and term of 1 year.

Compounded monthly, the borrower accrues $3,597.57 in interest from the two credit cards. The personal loan, with an interest rate of 10%, accrues only $1,570.70 in interest over the course of a year, lowering the borrower’s total payments.

	Credit Cards	Personal Loan
Principal	$15,000	$15,000
Term	1 year	1 year
Total Interest	$3,597.57	$1,570.70
Effective Interest Rate	21.7%	10%

Pros & Cons

Pros

Lower payments: If implemented correctly, debt consolidation can reduce a borrower’s debt.
Lack of long-term damage to credit scores: Contrary to debt settlement, the act of debt consolidation itself has a negligible effect on credit scores.

Cons

Credit Requirements - To qualify for a debt consolidation loans, borrowers must usually pass a credit check.
Less Repayment Flexibility - Oftentimes, consolidated loans offer better interest rates, but with more stringent repayment terms. For instance, borrower can continue to accumulate a balance on a credit card indefinitely, while personal loans have a fixed term.