Debt Consolidation

Debt consolidation is the replacement of several debts with one. A new obligation is created, the proceeds pay off the existing balances, and the borrower is left with a single payment to a single creditor. Nothing about the amount owed changes in the act itself, which is the first thing to be clear about: consolidation is a change to the terms, the schedule and the identity of the creditor, not a reduction in the debt.

It is not a single product, and treating it as one is the source of most confusion about it. The same act can be carried out by moving card balances to another card, by taking an unsecured installment loan, by borrowing against home equity, or, without new credit at all, by entering a repayment arrangement administered by a credit counseling agency. Those routes differ in cost, in speed, in what happens if you cannot pay, and in whether anything of yours is pledged. So the useful question is never whether to consolidate but which instrument, and on what terms.

Two adjacent words are worth separating. Refinancing replaces one debt with a new one on different terms, so consolidation is refinancing applied to several debts at once. Debt settlement is a different act entirely, in which a creditor agrees to accept less than the full balance. Consolidation restructures what you owe; settlement reduces it, at a cost to your credit record and often with tax consequences.

The information a consolidation offer is designed not to give you is the total. A consolidation is sold on the monthly payment, because that is the number that falls immediately and visibly. The payment can fall for two completely different reasons: because the rate dropped, or because the term got longer. Only the first of those saves money, and the second can cost a great deal while feeling identical. The Consumer Financial Protection Bureau's warnings on consolidation offers are worth taking literally, and there are three: a lower monthly payment may simply mean you are paying over a longer time, so you can pay considerably more overall once fees are counted; many advertised low rates are temporary and expire; and consolidating unsecured balances into home equity borrowing introduces the risk of losing the house. The test that follows from all three is to compare total cost against total cost, and never payment against payment.

The ranking question the category actually poses, and it is not about the rate. Debts differ in what happens when they are not paid, and consolidation can change that answer. An unsecured balance is enforced by collection and, if the creditor sues and wins, by a judgment; it is dischargeable in bankruptcy in the ordinary way. The same balance moved onto a home equity loan or line is enforced against the house. That is a genuine improvement in price and a genuine reduction in your options, purchased together, and the price is cheaper precisely because the lender's remedy is better. So before comparing two offers on cost, sort them by what they put at risk. Rate differences of a few points are recoverable; a foreclosure is not.

The routes, and the question to ask of each. A balance transfer moves card balances onto another card, usually at a promotional rate for a stated window and for an upfront fee, so its question is whether the balance will actually be gone before the window closes. A personal loan is unsecured closed-end credit on a fixed amortizing schedule, so its question is the term, because a longer one lowers the payment and raises the total. A home equity loan or home equity line of credit is secured by the residence, so its question is the one above about consequences. A debt management plan arranged through a nonprofit credit counseling agency is not new credit at all; the agency negotiates concessions with existing creditors and administers one monthly payment, so its question is what the agency charges and what the creditors have actually agreed to. And federal student loan consolidation is a different legal instrument that happens to share the word, discussed below.

Consolidating does not close anything, and the accounts that stay open are a live question in both directions. Paying a card to zero leaves the account open with its full limit available, which is how a household ends up with a consolidation loan and, a year later, a fresh set of card balances beside it. But closing the cards is not automatically the right response either, because removing their limits raises the share of your available revolving credit that your remaining balances represent, and the published material on credit utilization covers what that does. The honest answer is that consolidation works when it is the last step of a plan that already deals with why the balances appeared, and that the decision about the old accounts belongs to that plan rather than to the consolidation.

One right that travels with a consolidation and is easy to leave on the table. Where a loan being paid off is a precomputed consumer credit transaction, 15 USC 1615(a)(1) requires the creditor to refund promptly any unearned portion of the interest charge, and (a)(3) states expressly that the right applies "without regard to the manner or the reason for the prepayment," naming a prepayment made in connection with a refinancing, consolidation or restructuring. So the old loan's unearned interest is yours, and it should appear in the payoff figure rather than being quietly absorbed.

A naming point, because one federal instrument uses the same word for something else. A Direct Consolidation Loan is a specific statutory federal student loan that combines existing federal loans into one new federal loan. It is not consumer debt consolidation, and it has consequences that have no analogue here, including resetting progress toward loan forgiveness and, in some cases, changing which repayment plans are available. Consolidating federal student loans through a private lender is a third thing again, and it permanently gives up the federal protections. The published material on federal student loans and student loan refinancing covers those; this page is about consumer debt.

You apply for the new credit, the lender or issuer pays the old balances directly or advances you the money to pay them, and the old accounts go to zero. From then on you owe the new creditor on the new schedule. Fees are charged at the front, either as an origination fee deducted from the advance or as a percentage of each balance moved, and they belong in the total you compare.

A hypothetical example of why two offers with lower payments can land on opposite sides of doing nothing. Omar owes $18,000 across cards at a blended 22% and is paying $600 a month. On a monthly-interest illustration, that clears the balances in roughly 44 months for approximately $8,400 of interest.

Offer one: 60 months at 13%. The payment is $409.56, so the scheduled total is $24,573.60 ($409.56 × 60) and the interest is $6,573.60. That is about $1,800 less than changing nothing, and the payment falls by about $190 a month.

The same offer, used differently. If Omar keeps sending $600 a month against that loan rather than the required $409.56, the balance clears in roughly 37 months for approximately $3,900 of interest. The offer was the same; the difference between capturing $1,800 and capturing $4,500 was entirely what he chose to pay.

Offer two: 84 months at 18%. The payment is $378.32, lower than either figure above, which is what makes it attractive. The scheduled total is $31,778.88 ($378.32 × 84), so the interest is $13,778.88. Against approximately $8,400 for changing nothing, this offer costs about $5,400 more while feeling like relief every month for seven years.

Both offers reduced the payment. One saved money and one lost a substantial sum, and the monthly figure gave no indication which was which. Multiplying the payment by the number of payments takes a few seconds and separates them completely.

Pros

• One payment on one date to one creditor removes several chances to miss a payment, which is a real operational gain independent of any saving.
• Where the new rate is genuinely lower and the term is not longer, it reduces total interest with no change in behavior required.
• Replacing revolving balances with an installment schedule imposes an end date, and a schedule that ends is doing work a revolving balance never does.
• A fixed payment is easier to plan around than card minimums, which move with the balance.
• It can convert a set of unpredictable obligations into one budget line, which makes the rest of a plan possible to build.

Cons

• It does not reduce what you owe by a cent, and an offer presented as debt relief is presenting the wrong thing.
• A longer term lowers the payment and can raise total cost substantially, and the monthly figure conceals the difference.
• Fees come off the top. An origination fee or a transfer fee has to be recovered before any saving begins.
• Moving unsecured debt onto a home-secured instrument buys a lower rate by putting the residence behind the balance.
• Advertised promotional rates end, and the rate that follows is the one you will be paying if the balance is still there.
• The old accounts stay open unless you close them, so consolidation without a change in what filled them tends to produce a loan and a fresh set of balances.