When you’re unable to pay your debts, it may be for different reasons. It could be because a high interest rate is making the payments unbearable, or perhaps it carries a variable interest rate, making the payments unpredictable. You may want to consider a debt consolidation loan to get better terms and reduce your debts to just one monthly payment. Here’s how debt consolidation works and what types of debt will be eligible.

What is debt consolidation?

Debt consolidation is essentially a loan used to pay off your existing debts. Borrowers will use the funds from a debt consolidation loan to pay off the balance of each outstanding debt they wish to eliminate.

This could be a very effective way to get yourself out of high-interest debt. Consolidation loans may have lower fixed interest rates and more favorable terms, depending on what the borrower can be approved for. This can help make the monthly payments more predictable and manageable.

Does all debt need to be consolidated?

Not necessarily. Debt consolidation loans are typically only used for debts causing the borrower financial burden (such as those with high interest). If, on the other hand, the borrower has other loans with reasonable interest rates and terms they are comfortable paying, then these debts do not have to be considered as part of a debt consolidation loan.

Why can’t all debts be consolidated?

In some instances, the borrower may have certain loans which are not eligible for debt consolidation. The main distinction will be whether it’s secured or unsecured.

• Secured debts are debts that include collateral as part of the terms. Collateral is something of value that the lender can take possession of and sell to reduce the balance if the debt is not repaid. For example, with an auto loan, the vehicle purchased with the funds may serve as collateral.
• Unsecured debts are debts where there is no collateral. An example of this would be a credit card. Funds are issued in good faith of the creditor and the applicant’s creditworthiness.

In most instances, only unsecured debt is eligible for debt consolidation. Examples include:

• Unsecured personal loans
• Credit cards
• Store cards
• Medical debt
• Payday loans

If a borrower has student loans, they may also qualify for debt consolidation. However, this will depend on whether it’s a federal or private student loan. If it’s a private student loan, then it should be eligible.

Federal student loans can always be refinanced with a private lender and later consolidated with other unsecured debt. However, borrowers should be cautious with this approach. Refinancing federal loans with private loans forces the borrower to give up any rights and privileges that the federal government gives to federal student loan borrowers. For example, the federal government could forgive or cancel student loans that meet certain criteria.

The bottom line

Debt consolidation can be an effective way to make your payments more manageable and avoid the effects of compound interest working against you. However, not all debts can be or should be considered. Generally, only unsecured loans such as credit cards, medical debt, and private student loans will be eligible for conventional debt consolidation.

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