Debt consolidation loans: when they help and when they don’t

What a consolidation loan is

You take out one personal loan and use it to pay off several other debts, usually credit cards. Instead of five balances, five due dates and five rates, you have one fixed payment, one rate and a date when it ends.

Card interest is often 20% to 30%. A personal loan for someone with a fair credit history might be 8% to 15%. On a large balance, that gap is a lot of money every month.

A real example

Here is a real example, with the numbers rounded.

About $50,000 of debt had built up across several credit cards. Between the high rates and fees, the interest alone was more than $1,500 a month. A lot was going out every month, and the balances were hardly moving.

They took out a $40,000 consolidation loan and used it to pay off the most expensive cards. The loan payment is a fixed $780 a month, with a set end date. Then they did the most important part: they cut up the cards, so there was no temptation to use them again.

With far less going on interest, more of every payment went to the debt itself. The rest of the card balances were paid down alongside the loan, and over time the total went from about $50,000 to under $10,000.

That worked because three things were true: the loan rate was much lower than the cards, the payment was affordable every month, and the cards stayed at zero. Take away any one of those and the result can be very different.

When it tends to help

• The new rate is clearly lower than what you pay now, ideally by several percentage points.
• The fees are small. Many loans charge an origination fee of 1% to 8%, often taken from the money you receive.
• The payment fits your budget every month, not just in a good month.
• You can stop using the cards. This is the big one.
• You want simplicity. One payment, one date, and a finish line you can see.

When it does not

• The rate is not much lower. Once fees are added, a small rate cut can save little or nothing.
• The term is stretched out. A lower payment over seven years can cost more in total than a higher one over three. Always look at the total.
• The cards fill up again. This is the most common way consolidation goes wrong. The cards are clear, it feels like breathing room, and a year later there is the loan and new card debt.
• It is secured on your home. Turning card debt into a loan against your home puts the home at risk if things go wrong.
• You are already behind on essentials. A new loan may not be the answer; a credit counsellor or hardship programme may help more.

How to compare

For each option, write down three things:

Then compare with staying as you are and paying the cards with the snowball or avalanche. Sometimes the plain plan, with a bit of extra each month, beats the loan.

Other options

• A 0% balance transfer card. Good for smaller balances you can clear before the 0% period ends. Watch the transfer fee, usually 3% to 5%, and the rate afterwards.
• A debt management plan through a non-profit credit counsellor. They may get lenders to lower rates and roll payments into one, without a new loan.
• Snowball or avalanche on your own. No new loan, no fees, and it works when you can find a little extra each month.

The one rule

Whatever you choose, the cards have to stay at zero. A consolidation loan moves the debt somewhere cheaper. It only pays it off if no new debt takes its place.

Cut the cards up, freeze them, or hand them to someone you trust. Remove them from online shops and phone wallets. Keep the accounts open if closing them would hurt your credit score, but make them hard to use.

How Debt Free helps

• A consolidation checker inside the app. Pick which debts a loan would pay off, enter the rate, years and fee from a real quote, and see your monthly payment, interest this month, debt-free date and total interest, as now and with the loan.
• A clear verdict. It says plainly when a loan would save money, and when it would cost more.
• If you take the loan, Debt Free marks those debts as paid by it and puts the loan on your climb, so your progress stays honest.
• A reminder the day before each payment, so the one payment is never missed.

Debt Free is free. General information, not financial advice.