Debt consolidation and debt refinancing are the two major ways that people deal with their debts (past simply repaying them, of course). For many people, the ideal outcomes for consolidation and refinancing are the same: better interest rates, lower payments and more favorable terms for their debt overall. By definition, though, debt consolidation and debt refinancing are very different things.
So what’s right for you? Debt consolidation or debt refinancing? We’ll break it down for you.
What’s the difference between debt consolidation and debt refinancing?
Like we already mentioned, the outcomes of debt consolidation and debt refinancing are often similar. Can there really be that big of a difference between the two?
Yes! If you’re going to decide which is right for you, you’ll need to understand the definition of each so that you’re better informed.
Definition of Debt Consolidation
What sounds better? One source of debt or several?
One, right? That’s the essence of debt consolidation. You consolidate several different debt payments into a single debt payment, which comes with a variety of different potential benefits. You could bring down your monthly payments, reduce your overall interest rates and payments and pay off your loan quicker. In general, it’s also much easier to keep track of a single debt payment than try to keep up with several different ones.
We’ll sketch out a hypothetical example here that could make the concept of debt consolidation easier to understand.
Lucy ran up three different credit cards over the course of a few years due to irresponsible spending. She has a balance of $2,000 at an interest rate of 18.50%; the second has a balance of $2,500 at an interest rate of 19.50%; the third has a balance of $3,000 with the highest interest rate of all, 24.50%.
Each month, Lucy scrambles to keep up with her minimum monthly payments. She owes $100 on the 5th, $115 on the 10th and $150 on the 15th for a total of $365 per month. Much of that payment goes to just paying down interest and she isn’t making much progress on actually getting out of debt. She also has a hard time making sure that she has enough money to make these three separate monthly payments.
If Lucy keeps on just making monthly minimum payments, she won’t get out of debt for ten years or more. Realizing this, she decides to consolidate her credit cards.
There are multiple ways to consolidate debt and Lucy chooses to take out a personal loan. She takes out a loan for $7,500 and pays off all of her credit cards at once. Her monthly payment on the loan is $200 – more than any of her past individual payments but still much less than she was paying before overall. The personal loan also has a much lower interest rate, meaning she’ll pay much less over time. She also only has to worry about one payment each month.
Debt consolidation can take many other forms than a personal loan. It also doesn’t always work out quite this perfectly. But that’s the idea: you turn many debts into one debt and pay less to eliminate it.
Debt refinancing, on the other hand, is a very different beast.
Definition of Debt Refinancing
If debt consolidation is all about taking out new debt to combine your old debts, debt refinancing is more about replacing specific debts for more specific reasons.
When you refinance, that’s exactly what you’re doing – replacing one debt with another debt. Usually, the goal is to secure a better interest rate for your debt, but you can also refinance to change the loan’s type or secure lower monthly payments. You can even use refinancing to consolidate debt – the two aren’t mutually exclusive.
Let’s use Lucy again as an example for debt refinancing. Lucy bought her home with a 30-year mortgage at a fixed interest rate of 4.75 percent. She sees, however, that mortgage rates have gone down and that she could take out a new loan at 4.5 percent interest. Since home loans have such large balances and take such a long time to pay off, she calculates that this slight change in interest rate could save her a lot of money in the long run. So she refinances her home loan by applying for a new loan and using it to pay off the old one.
So what’s the difference between debt consolidation and refinancing?
Debt consolidation aims to turn many debts into a single debt, saving you money and making debt easier to manage. Refinancing aims to optimize an existing debt by replacing it with debt that has more favorable terms (usually lower interest rates).
The two aren’t mutually exclusive, though – some people may refinance and consolidate debt at the same time.
Now that you have a better understanding of debt consolidation and refinancing, here comes the important question: should you consolidate your debt or refinance it?
Should you consolidate or refinance your debt?
Obviously, deciding whether to consolidate your debt or to refinance it depends entirely on your individual situation. Both tactics are totally valid ways to make your debt easier to deal with. Figuring out which one is right for you is basically a matter of figuring out what you’re trying to accomplish and choosing the best way to make it happen.
We’ll sketch out five common scenarios below and indicate what the best path forward might be in each to help you to think through your own situation.
You have too many debts to keep up with.
You have three or four credit cards with high balances to pay off. You have a home loan that you won’t pay off for a long, long time. You have a car loan that you need to keep up with because you can’t afford to lose your vehicle. You have student loans to pay off to multiple different lenders each and every month that aren’t going away anytime soon.
In short, you have so many debts to keep up with that it can feel impossible and overwhelming just to keep it straight. Maybe you’re even starting to miss payments, either because you’re low on funds or because, with everything else going on in your life, the bills slipped your mind.
In this situation, debt consolidation is probably the right move for you. While refinancing some of your debts to get better interest rates or terms would be helpful, consolidating some of those debts into a single payment is probably going to a better move for you in the long run. Consolidating your debt might also lead to lower interest rates and less money paid to your creditors in the short term and the long term as well, which could make a huge difference in your financial life.
You have higher-than-average interest rates.
You bought a home recently, within the last five years or so (congratulations!). It was the perfect house for you – it had everything you wanted, it was within your budget and you couldn’t see yourself living anywhere else. You needed to move and lock this house down before anyone else got to it.
There was just one problem – it wasn’t necessarily the best time for you to get a home loan. Maybe the housing market wasn’t quite right and interest rates for all mortgage types were higher than they usually are. Maybe your own financial life wasn’t quite in order yet and you had to accept a loan with terms that weren’t exactly favorable. Whatever the reason, you accepted a home loan that was far from perfect.
Zoom ahead five years and everything has changed. Interest rates for home loans are at historic lows and your financial picture has flip-flopped from “questionable” to “unimpeachable.” You realize that, if you were to go and get a mortgage today, you’d be much better off.
In this situation, you’d want to refinance, not consolidate your debts. Refinancing would allow you to replace your old unfavorable home loan with a new home loan with much more favorable terms.
A few things to note here. First, you can actually consolidate debt while refinancing a home loan if you need to do both. Basically, you use the equity you’ve built in your home to borrow more money that your home is actually worth, then use that extra cash to pay off other debts, effectively consolidating them into your home loan. It’s called a “cash out refinance” and can be helpful for a wide variety of things, not just debt consolidation.
Second, note that we’re talking about a home that you’ve bought in the last five years or so above. Refinancing your loans essentially restarts the clock on repayment, since you’re taking out a brand new loan. Because of that, it often doesn’t make a lot of long-term financial sense if you’ve already sunk a lot of cash into paying off your current loan, since you’ll be paying off the new loan for a much longer time (and paying a lot more interest as a result). That’s not to say that it’s never a good idea to refinance if you’ve owned your home for a while, just that you should really think about what you’re doing before you make a decision.
You want to change your debt type.
Changing the type of debt you hold can be beneficial for a variety of reasons.
Mortgages and loans, for example, can be either fixed rate or variable rate. Fixed debts have an interest rate that’s set in stone so you’ll always know exactly how much you’ll be paying. With variable debts, the interest rate can change, introducing a level of unpredictability into your loan.
Credit cards, on the other hand, are almost always variable rate, and they often have the highest interest rates out there (on average around 15 percent). That’s much higher than most personal loans.
Changing your debt type, then, can have a variety of benefits.
If you have a home loan or a student loan and you’d like to get a better interest rate on it or change the term, then you’re likely looking at a refinance. Your bank may be able to help you with that, as well as a variety of companies and institutions that specialize in these sorts of things.
If you’re looking at high-interest variable-rate credit card debt, though, then debt consolidation might be the right move for you. If you have multiple high balance cards, you can take out a personal loan to consolidate them. That loan will likely have a much lower interest rate, meaning you’ll likely pay less each month and less over time in interest to get out of debt sooner.
You just want to get out of debt faster.
Economists theorize debt as a generally positive thing that transfers wealth from institutions that have too much to use (i.e. lenders) to people who need those resources to achieve things they couldn’t otherwise (e.g. go to college, buy a car and a home, etc.).
Debt certainly does those things, but let’s be real – the actual lived experience of debt is profoundly negative. It’s a financial and emotional burden that can control our lives, limit our choices and, if we can’t pay it off on time, have long-lasting negative consequences.
So of course you want to get out of debt faster! We all do. What works better: debt consolidation or refinancing?
Again, it depends on your circumstances. Do you owe multiple smaller debts, like credit card debts, to a variety of different lenders? Do you owe several different forms of the same debt, like student loans? Then you might be a good candidate for debt consolidation, which can turn those many debts into a single, more affordable and more manageable debt that you can focus on paying off.
If you simply want to make a single debt more manageable, like a home or auto loan, then you’re probably better off refinancing. If you can find a better rate and better terms out there somewhere and it’s going to save you money in the long run, it makes sense to at least pursue refinancing and do the math.