Education Center

How Debt Consolidation Works

Does debt consolidation really work? And if so, does it work in just any situation?

cartoon of man looking into telescope in search of debt free land
Debt consolidation is a relief option you can use when debt payments take over your budget and cause financial hardship. It truth, however, consolidation doesn’t just refer to a single solution. There are a number of ways to consolidate different types of debt. Which way you use depends on the types of debt you hold, your credit and your financial situation.

How debt consolidation works, in general

  1. You use consolidation when you have multiple debt payments of a certain type that are causing problems for your budget.
  2. You find a means to combine those debts into a single monthly payment.
  3. In most cases (not all) you also reduce or eliminate interest charges applied to the debt.
  4. This allows you to get out of debt faster with lower total interest charges.

Does debt consolidation work for any type of debt?

For the most part, debt consolidation only applies to unsecured types of debt. Secured debt refers to any debt that has collateral. So, you typically don’t consolidate things like mortgages or auto loans.

Consolidation does work for these types of debt:

  1. Credit cards
  2. Student loans
  3. Tax debt

There are ways to consolidate each of these types of debt. It most cases, however, you must keep them separate. If you have all those types of debt to repay, you may need more than one consolidation plan.

Type of DebtOptions for Consolidation
Credit card debt 1.      Balance transfer

2.      Consolidation loan

3.      Assisted consolidation program

Student loan debt 1.      Federal Direct Consolidation Loan + federal repayment plan

2.      Private consolidation loan

Tax debt 1.      Installment agreement

How credit card debt consolidation works

With credit card debt, the goal of consolidation is always to reduce or eliminate interest charges applied to your debt. Credit cards have relatively high interest rates, which makes it difficult to pay off the balances quickly. Consolidation allows you to roll all your balances into a single repayment plan at the lowest interest rate possible.

There are three ways to consolidate credit cards:

  1. Credit card balance transfers
  2. Debt consolidation loans
  3. Debt consolidation programs

How consolidation works with a balance transfer

This only works if you have a finite amount of debt to repay and a good credit score.

  1. You open a balance transfer credit card that offers 0% APR for an introductory period.
  2. Then you transfer all your existing balances; there’s typically a fee for each transfer that ranges from $3 to 3% of the balance transferred.
  3. This zeros out your other balances, leaving only the consolidated balance to repay
  4. You pay the debt off in the biggest chunks possible. Your goal is to reach zero before the 0% APR introductory period ends; once that happens a standard high rate will apply.

Learn more about balance transfers »

How do debt consolidation loans work?

This is another DIY option that only works if you have a good credit score.

  1. You take out an unsecured personal loan, at an interest rate based on your credit score; ideally you want the rate to be around 5%, but it should at least be less than 10%.
  2. You choose a term that offers monthly payments that fit your budget; a longer term means lower payments, but you should try to keep the term to 5 years or less.
  3. Once approved, you use the funds you receive to pay off your credit cards
  4. This leaves only the loan to repay.
  5. The monthly payments are often lower, so you can get out of debt faster even though you pay less money each month.

Learn more about consolidation loans »

How debt consolidation programs work if you have bad credit

The only way to consolidate credit card debt with bad credit is with professional help. You enroll in a debt consolidation program through a consumer credit counseling agency. This is also referred to as a debt management plan or debt management program.

  1. You contact a credit counseling agency to see if you qualify; typically, as long as you have income to make a reduced monthly payment, you should be eligible.
  2. You work with the credit counselor to find a monthly payment you can afford.
  3. Then, the counseling team negotiates with your creditors to:
    1. Accept the adjusted repayment schedule
    2. Negotiate reduced or eliminated interest charges
  4. Once all your creditors sign off, you make one payment to the credit counseling agency each month. They distribute the funds amongst your creditors as agreed.

It’s important to note that a consolidation program doesn’t transfer your debt to the consolidation company. You still owe your original creditors. This just creates a repayment plan that makes it easier to get out of debt with monthly payments you can afford.

Learn more about debt management plans »

How student loan debt consolidation works

For this type of debt consolidation, interest rate reduction is not always the primary goal. That’s because student loan interest rates work differently from other types of debt. For federal student loans, loan servicer set rates based on the 10-year Treasury Note Index. Even for private student loans, you can usually qualify for lower rates even with bad credit or no credit.

However, as a result, consolidation rarely lowers the interest rates applied to your debt. Instead, you consolidate to simplify your repayment schedule. People also typically use this to lower their monthly payments, so it’s easier to afford.

How federal loan consolidation works

This only applies to federal student loans; you can’t use this to consolidate private student loan debt.

  1. First you must apply for a Federal Direct Consolidation Loan.
  2. To be eligible, you must have at least one loan from the Federal Direct lending program.
  3. As long as you do, you can consolidate most types of federal loans, minus PLUS loans to parents
  4. The interest rate on the consolidation loan takes a weighted average of your existing rates; the term is always 10 years.
  5. The monthly payment is based on the total debt consolidated.
  6. If the payment is too high, you can then apply for a hardship-based federal repayment plan.
  7. This extends the term of your loan to 20-30 years, so it lowers the monthly payments.
  8. The monthly payment amount is based on your Adjusted Gross Income and family size.
  9. You must recertify your income and family size each year to maintain enrollment

Start by exploring Federal Direct Loans »

How private student loan consolidation works

This can apply to both federal and private student loan debt. However, think carefully before you consolidate federal loans through private consolidation. This converts the debt to private, meaning you’re no longer eligible for federal relief options like the one described above.

  1. You take out a private student consolidation loan.
  2. The rate may be at least partially based on your credit score.
  3. Once approved, you use the money you receive to pay off your student loans
  4. This leaves only the consolidation loan to repay.

Learn more about private consolidation »

How tax debt consolidation works

The final type of debt you can consolidate is unpaid tax debt. In this case, there is really only one way to consolidate multiple years of back taxes.

  1. You apply for an Installment Agreement (IA)
  2. The IRS works with your to set up a repayment plan that works for your budget.
  3. Large-dollar IAs usually involve a review of your income and expenses to see what you can afford.
  4. You can also try to use penalty abatement in combination with this to reduce penalty interest charges and other fees.
  5. Once the plan is set, you make one monthly payment until all your tax debt is paid off.

Learn more about Installment Agreements »


Article last modified on November 24, 2017. Published by, LLC . Mobile users may also access the AMP Version: How Debt Consolidation Works - AMP.