Debt consolidation loans explained: when one loan beats many

Debt consolidation means replacing several debts with one. The appeal is simple: one payment instead of many, often at a lower rate and with a smaller monthly outlay. Whether it actually costs less depends on three numbers, the rate, the term and the fees, and a lower monthly payment can hide a higher total. This guide explains the main ways people consolidate, works through one set of debts under different loan terms using DebtWren’s engine, and sets out what to check before the figures mean anything.

What consolidation is

Consolidation takes a group of balances, typically credit cards, store cards, overdrafts or small loans, and pays them all off with one new source of credit. The old accounts go to zero and the new account takes their place. The amount owed does not fall on the day you consolidate; it simply moves. What changes is the interest rate charged on it, the length of time you have to repay it, and any fee charged for setting the new arrangement up.

Because the total owed stays the same, consolidation is not a way of reducing debt. It is a way of changing the terms on which the debt is repaid. The US Consumer Financial Protection Bureau makes the same point: consolidating can simplify payments and may lower the rate, but it does not erase the debt, and if it stretches repayment out it can increase what is paid over time.

Four common routes

Consolidation is a goal rather than a product, and several kinds of product can serve it. Each has a different shape.

• Unsecured personal loan. A fixed amount borrowed for a fixed term at a fixed (or occasionally variable) rate, repaid in equal monthly instalments. The loan is paid out, the old balances are cleared with it, and the only remaining debt is the loan. This is the structure the worked examples below use.
• Balance transfer card. An existing card balance is moved to a new card, often with a low or 0% promotional rate for a set number of months. A transfer fee, usually a percentage of the amount moved, is charged up front. There is no fixed term; the balance is revolving, with a minimum payment, and the card’s standard rate applies to anything still owed when the promotion ends.
• Secured or home-equity borrowing. A loan secured against property, which the CFPB describes as borrowing against the equity in a home and repaying in fixed instalments. Rates are often lower than unsecured credit because the lender has security, but the consequence of not paying is different in kind: the property itself is at risk.
• Debt management plan. Not a loan at all. An arrangement, usually through a debt advice organisation, in which one monthly payment is distributed to existing creditors, who may agree to freeze or reduce interest. MoneyHelper in the UK describes it as an informal agreement that can be used for non-priority debts such as cards and unsecured loans. The debts remain in place; what changes is how they are serviced.

DebtWren does not recommend any of these. The arithmetic of the two fixed-term routes, the personal loan and secured borrowing, can be checked in the same way, because each replaces a set of balances with a single rate, a term and a fee. A balance transfer can be approximated by entering the promotional period as the term and the transfer fee as the fee, with whatever is left at the standard rate after the promotion worked out separately.

The three numbers that decide it

Strip away the product names and every consolidation comes down to three inputs:

• APR. The annual rate charged on the new balance. In DebtWren’s engine the monthly interest is the balance multiplied by the APR divided by 12, rounded to the smallest unit of the currency. A lower APR means less interest per month on the same balance.
• Term. The number of months over which the new balance is repaid. A longer term lowers the monthly instalment but keeps a balance outstanding for longer, and interest is charged on a balance for as long as it exists.
• Fees. An arrangement, origination or transfer fee is either added to the amount borrowed or deducted from what is paid out. The calculator models it as added to the principal, so it is repaid with interest over the whole term and costs more than its face value.

The monthly instalment on a fixed-rate loan comes from the standard level-payment formula, payment = P × i ÷ (1 − (1 + i)−n), where P is the principal, i the monthly rate and n the number of months. The term appears in the exponent, which is why stretching it has such a large effect on the instalment and, in the opposite direction, on the interest.

Worked example: a 24-month loan

Take the same two debts used in the avalanche vs snowball guide, with a budget of 500 a month currently going towards them:

• Debt A: balance 6,000 at 24% APR, minimum payment 150.
• Debt B: balance 1,500 at 6% APR, minimum payment 50.

Kept as they are and paid in avalanche order at 500 a month, the two debts are cleared in 18 months with 1,146.87 of interest, a total of 8,646.87 paid. Now compare a single loan of 7,500 (the two balances added together, no fee) at 10% APR over 24 months.

This is the case the calculator labels as winning on both counts: the loan is cheaper every month and cheaper in total. The price of that is time. The loan runs for 24 months, six months longer than the existing debts would have taken, because 346.09 a month is a smaller payment than 500. Anyone who kept paying 500 a month towards the loan instead would clear it sooner and pay less interest still, but that is an overpayment rather than the loan’s own terms.

The same loan over 48 months

Lenders often quote a range of terms for the same loan, and the longer ones carry the smallest monthly payment. Run the identical 7,500 at 10% APR over 48 months instead of 24 and the picture changes:

At 48 months the monthly payment falls to 190.22, less than two-fifths of the current 500. The interest bill, however, rises to 1,630.50, which is 483.63 more than keeping the existing debts, even though the loan’s 10% rate is far below the 24% on debt A. The reason is duration: 7,500 at 10% charges 62.50 in month 1 and keeps charging on a slowly falling balance for four years, while the current path, expensive as it is per month, is finished in a year and a half. At 36 months the loan is already slightly more expensive than the current path, by 65.30.

What an arrangement fee does

Many loans and balance transfers carry an up-front fee expressed as a percentage of the amount borrowed. Suppose the 24-month loan above charged a 3% arrangement fee. On 7,500 that is 7,500 × 3% = 225, added to the principal, so the loan starts at 7,725 rather than 7,500.

Two things are worth noticing. First, the fee itself attracts interest, because it is part of the balance for the whole term: 830.28 minus 806.08 is 24.20 of interest charged on the fee alone. Second, the fee’s effect on the monthly instalment is largest on a short loan (10.38 a month at 24 months, 5.71 at 48), because it is spread over fewer payments; its effect on total cost is largest on a long loan, because it sits in the balance for longer. The same 3% fee on the 48-month version lifts the interest to 1,679.38 (48.88 of it on the fee itself) and the total paid to 9,404.38, which is 532.51 more interest than the current path.

The re-borrowing risk

The figures above assume that once the cards are cleared they stay at zero. That assumption is the weak point of most consolidations. Paying off a card with a loan leaves the card open with its full limit available, and any new spending on it is additional debt on top of the loan instalment. The CFPB cautions that consolidating credit card debt can lead to more debt if the cards are used again, and that is purely a matter of behaviour, not of rates.

The arithmetic is unforgiving. If debt A were cleared by the 24-month loan and 2,000 were then spent on the same card at 24% APR, the first month’s interest on that new balance alone would be 2,000 × 24% ÷ 12 = 40.00, on top of the 346.09 loan payment. The consolidation would have changed the shape of the debt without reducing it, and the total owed would be higher than at the start.

What lenders check

A consolidation loan is a new credit application, and the rate offered, or whether one is offered at all, depends on what the lender sees. Two things dominate:

• Debt-to-income ratio. The CFPB defines it as total monthly debt payments divided by gross monthly income. Lenders differ on whether they assess the ratio with the new instalment replacing the old payments or on top of them, which can depend on whether the loan is paid straight to the old creditors. How the ratio is worked out, and what lenders commonly treat as high, is covered in the debt-to-income ratio guide.
• Credit record. Payment history, how much of the available credit is in use, and recent applications all feed into the rate a lender quotes. The advertised rate on a loan is often a representative or “from” rate rather than a guarantee, so the figure to put into any comparison is the one actually offered.

Secured borrowing changes the lender’s view because there is an asset behind the loan, which is why rates can be lower. It changes the borrower’s position for the same reason.

How the calculator compares the two paths

The debt consolidation calculator takes the existing debts (balance, APR and minimum for each), the total currently paid each month, and the proposed loan’s APR, term and fee. It then runs two separate calculations and sets them side by side:

• The current path. The existing debts are paid in avalanche order at the stated monthly total until every balance is zero, using the same month-by-month rules as the debt payoff calculator: interest at APR ÷ 12 rounded to the smallest unit of the currency, minimums first, the rest to the highest-rate debt, freed minimums rolling over. This produces a number of months and a total interest figure.
• The loan path. The balances are added together, the fee is added to that sum, and the result is amortised over the chosen term at the loan’s rate to give a level monthly payment and the total interest.

The three differences shown are the ones that matter: the change in monthly payment, the interest saved (or added), and the months saved (or added). The interest-saved figure includes the interest charged on any fee but not the fee’s face value, so for the “full cost” comparison used in this guide subtract the fee from the interest saved, or compare the total paid on each path. A loan is flagged as winning on both counts only when the monthly payment is no higher and the interest is no greater; a longer loan with a lower payment and more interest, like the 48-month case, is not. The comparison assumes the loan has one fixed rate for its whole term, that it clears every balance on day one, and that there are no early-settlement charges on the old debts and no new borrowing afterwards. The monthly rules are set out on the methodology page so every figure in this guide can be reproduced.

This guide explains how things work in general terms. It isn’t financial, tax or legal advice. Spotted something out of date? Email errors@debtwren.com and we’ll check it against the source.