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Debt consolidation: What is it and how does it work?

Whether or not debt consolidation is a good idea depends on the nature of your debts and your capacity to secure a low-interest rate, which is based mainly on your credit score. Here's everything you need to know about debt consolidation.

Vivian Tejada
June 12, 2023

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The New York Federal Reserve reports that total consumer debt in the United States reached an alarming $16.9 trillion during the final quarter of 2022. This represents a $394 billion increase from the previous quarter, indicating a 2.4% surge in just three months.

It’s no surprise Americans are actively seeking methods to effectively manage their debt payments. Some individuals prefer to negotiate with their creditors or obtain Home Equity Lines of Credit (HELOCs), while others prefer to consolidate their debts.

Debt consolidation makes sense for borrowers who want to consolidate credit card debt. However, debt consolidation can be used to consolidate a variety of debts. The best debt consolidation loans offer flexible payment terms with low-interest rates and origination fees, although favorable terms are not always guaranteed.

Whether or not debt consolidation is a good idea depends on the nature of your debts and your capacity to secure a low-interest rate, which is based mostly on your credit score. Here's everything you need to know about debt consolidation:

What is debt consolidation?

Debt consolidation allows you to pay off multiple debts — such as credit cards, personal loans, or medical expenses— by rolling them into a single new loan. The purpose of consolidating debt is to simplify the process of repaying debt and potentially reduce interest rates on the debts owed.

Consolidating debt could potentially save you money in the long run, particularly if you can secure a lower interest rate. However, it’s important to note that debt consolidation comes with certain risks and doesn’t necessarily guarantee a low-interest rate.

How does debt consolidation work?

Debt consolidation programs are usually structured with fixed rates, meaning that the interest rate on the consolidated debt remains constant throughout the entire agreement. This allows borrowers to better manage their debt payments, especially when they have multiple lines of credit with varying interest rates.

Borrowers sometimes confuse debt consolidation with debt settlement or bankruptcy. However, the two strategies differ significantly. Debt consolidation is focused on reducing debt by making it more manageable, while debt settlement is focused on eliminating debt that the borrower is no longer able to repay. 

In a debt settlement, a borrower negotiates with their creditors to pay less than what they currently owe. They usually enter into a new agreement with their creditor, where they promise to pay the smaller amount owed in full. Debt settlement is also referred to as debt relief or debt adjustment. 

Bankruptcy, on the other hand, is a legal process by which a borrower asks for some or all of their financial obligations to be forgiven by their creditors. When a borrower declares bankruptcy, they are hoping to get a fresh start on their finances after no longer being able to pay their bills.

Debt settlement and bankruptcy have long-term negative impacts on credit scores, regardless of repayment terms. However, debt consolidations usually don’t. As long as you pay back your new loan responsibly, the negative impacts on your credit score will be temporary.  

Pros and cons of debt consolidation 

Debt consolidation can occur through a loan, a balance transfer credit card, student loan refinancing, a home equity loan, or a HELOC. There are benefits and drawbacks to each method. Here are some things to consider:


  • Simplified debt repayment: Instead of paying multiple credit cards on separate due dates, you’re able to pay a single debt consolidation loan once a month.
  • Higher credit score: Paying down debt consistently could help lower your credit utilization ratio, which could increase your credit score. Making timely payments can also enhance your credit history. 
  • Lower interest rate: Consolidating multiple debts with high, double-digit interest rates into a single loan with an interest rate below 10% can save money in the long run. 


  • Collateral is needed for the most competitive rate products: Home equity loans and HELOCs require using your home as collateral. Failure to pay back a home equity-backed loan could result in the seizure of the property. 
  • Upfront costs: Debt consolidation can come with high fees, which may reduce the overall value of your loan and lower the amount you’d be saving.
  • Higher interest rates: Although a lower interest rate is the goal, it’s not always possible. Lenders may approve a debt consolidation loan with a longer timeline and a similar, or even higher, interest rate. Instead of saving you money over time, you’d end up paying more. 
  • It's easier to take on more debt: By consolidating your debt balances into a new loan, you free up your lines of credit — which, if not managed responsibly, may tempt you to accumulate more debt on your cards.

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Types of debt consolidation

There are multiple kinds of debt consolidation options available to borrowers. Some of the most common are debt consolidation loans, balance transfers, home equity loans and HELOCs, and student refinancing options. 

Debt consolidation loans

Debt consolidation loans are personal loans that merge multiple loans into a single fixed monthly payment. These loans allow for consolidations of up to $50,000 and have terms that range from one to ten years. Once approved, monthly payments are made to a new lender. 

Ideally, borrowers consolidate high-interest debt into lower-interest debt. The length of the debt should also be carefully considered. Although longer payment plans could mean smaller monthly payments, they usually result in more interest being paid over time. Debt consolidation often comes with origination fees of 3%, which would reduce your total loan amount. 

Balance transfers

A balance transfer credit card allows borrowers to pay down debt and reduce interest rates on multiple credit card debts. Similar to a debt consolidation loan, it consolidates high-interest credit card debts onto one card with a lower interest rate for a set amount of time. 

Most balance transfer cards provide an introductory period with a 0 percent APR, lasting 12-21 months. Clearing most or all of the debt during this period can result in significant interest savings. However, if a large balance remains after the introductory period, the higher interest rates of balance transfer credit cards could actually result in more debt. Balance transfer fees are usually between 3%-5% of the total amount transferred. 

Home equity loan and HELOC

Home equity loans and home equity lines of credit allow you to borrow money against your home’s existing equity. Home-equity-backed financing offers lower interest rates when compared to credit cards and personal loans because your property is being used as collateral. However, defaulting on the loan puts your home at risk of foreclosure. 

A home equity loan and a home equity line of credit come with different repayment terms. Once you acquire a home equity loan, repayment starts immediately at a fixed interest rate. You’ll have to make consistent monthly payments throughout the duration of the loan, similar to your mortgage payment. 

On the other hand, a HELOC is repaid only after the draw period of five to ten years is over. Borrowers make monthly payments, often at a variable interest rate. It’s important to note that both home equity loans and HELOCs can come with closing costs. You can expect to pay between 2% to 5% of your total home equity loan amount.


Home Equity Investment

A Home Equity Investment (HEI) allows homeowners with a 500+ credit score to access a lump sum of cash in exchange for a slice of their home’s equity — with no restrictions on how the funds can be used, no monthly payments, and no income requirements. Instead, homeowners repay the investment amount plus a percentage of the home’s future appreciation at any time during a 30-year term. Homeowners pay back the HEI in a lump sum when the house is sold, refinanced, or at some other point in time.

A Home Equity Investment is an attractive financing option for homeowners because it comes with:

  • Lump sum payouts 
  • No monthly payments
  • If the home value goes down, the payback amount may be smaller
  • No restrictions as to how money is used
  • No prepayment penalties ‍

FAQs about debt consolidation

Does debt consolidation hurt your credit score?

Consolidating existing loans into new ones can hurt your credit score in the short term. This is because credit score models tend to favor older debts with longer and more consistent payment histories. However, when used correctly, debt consolidation can benefit your credit score in the long term. As long as you make payments on time, you’ll reduce your credit utilization ratio and enhance your credit history, ultimately improving your credit score. 

Is a debt consolidation loan a good idea?

Debt consolidation is a good idea if you can afford it and have good credit. If the monthly payment on a debt consolidation loan strains your budget, it could lead to delinquency, which ultimately works against what you’re trying to achieve by consolidating your debt. 

However, if you can afford the new monthly payments, which will likely be higher since the new loan combines multiple debts into one, then debt consolidation might be a good idea. Having a good credit score increases your chances of getting approved at a lower interest rate. Debt consolidation only makes sense if you can convert your high-interest debts into one, lower-interest debt. 

When is debt consolidation not worth it? 

Debt consolidation may not be a good idea if: 

  • You can’t afford the monthly payments on your new debt consolidation loan
  • You have a low credit score that may result in poor rates 
  • You don’t want to risk losing your home

If your debt is manageable and can be paid off in months, a consolidation loan may not be necessary. The same is true if the savings from consolidation are insignificant.

Using an HEI to consolidate debt

Not being able to consolidate high-interest credit card debt could be nerve-wracking. As time goes on, interest accumulates, causing your monthly debt payments to grow. However, as you can see from the information shared above, there are plenty of options for tackling debt — and pretty attractive alternative financing options available to homeowners willing to tap into their equity. 

Point provides a unique financing solution to homeowners with low credit scores who want to simplify their debt repayments and take back control of their finances. Visit Point to find out if you qualify for an HEI and start paying back your debt.

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