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Debt Consolidation, Explained

After reading this you will be able to work out whether rolling several debts into one loan actually saves money, and how to check the answer with your own numbers.

What consolidation is and one quick example

Debt consolidation means replacing several debts with a single new loan. You borrow enough to clear the old balances, then you make one monthly payment on the new loan instead of many. The pitch is simple: one lower rate, one due date, less hassle. Whether it saves money depends entirely on the arithmetic.

Consider two paths for the same debt. Suppose you owe 5000 on a card at 21% APR and pay 150 a month. Left alone, that card takes about 47 months to clear and costs roughly 1950 in interest. Now suppose you fold it into a loan at 11% over 4 years. The interest on 5000 at 11% over 48 months is about 1200. That is a saving of around 750, before any arrangement fee. The lower rate did the work.

The trap is that the two paths rarely run for the same length of time or at the same payment. Comparing them fairly means comparing the total amount you hand over under each plan, fee included.

When it helps and when it does not

Consolidation helps in one specific situation: the new rate is genuinely lower than the blended rate of your current debts, and you do not re-borrow on the accounts you clear. Both conditions matter.

The blended rate is the average APR across your debts, weighted by balance. If most of your debt sits on a cheap car loan and only a little on an expensive card, your blended rate is already low, and a consolidation loan at 11% could cost you more, not less.

A longer term can make a lower rate lose money. Dropping from 21% to 11% but stretching a 4-year payoff into 7 years often raises total interest, because you are paying that lower rate for far longer. Always compare the total cost, not just the rate.

Consolidation does not help if you keep spending on the freed-up cards. Then you carry the consolidation loan and new card debt, which is the original problem plus a loan.

The math behind the comparison

Two pieces of arithmetic drive the whole tool. The first is the amortised loan payment. For a loan of principal P at a monthly rate i over n months, the level payment is:

M = P \cdot \frac{i(1+i)^n}{(1+i)^n - 1}

Here P is the amount borrowed, i is the annual rate divided by 12 (so 11% becomes i = 0.11/12 \approx 0.009167), and n is the number of monthly payments. The total paid over the loan is M \times n, and the interest is that total minus P.

The second piece is the payoff time for a debt paid at a fixed monthly amount. Starting from a balance B at monthly rate i with payment M, the number of months to reach zero is:

n = \frac{-\ln\left(1 - \frac{iB}{M}\right)}{\ln(1+i)}

The term \ln is the natural logarithm. This formula only returns a real number when M \gt iB, that is, when your payment covers more than the monthly interest. If it does not, the balance never falls. That is the minimum-payment trap in one inequality.

The tool applies the payoff formula to each current debt separately, using its own balance, APR and minimum. It sums the total each debt costs, then compares that against the single consolidation loan.

A worked example using the demo data

Three debts against one loan at 11%

The demo loads three debts and a consolidation loan at 11% over 4 years with a 300 fee.

Current debts, paid at their minimums
DebtBalanceAPRMin payMonthsTotal paid
Card500021%150476975
CarLoan120009%2505714170
Personal300014%100363630
  1. For the card, i = 0.21/12 = 0.0175. Monthly interest at the start is 0.0175 \times 5000 = 87.5, well under the 150 payment, so it will clear. The payoff formula gives about 47 months and roughly 6975 paid in total.
  2. The car loan at 9% clears in about 57 months for roughly 14170.
  3. The personal loan at 14% clears in about 36 months for roughly 3630.
  4. Add them up. Total balance is 5000 + 12000 + 3000 = 20000. Total paid on the current path is about 6975 + 14170 + 3630 = 24775.

Now the consolidation loan. You borrow 20000 at 11% over 48 months. With i = 0.009167 and n = 48:

M = 20000 \cdot \frac{0.009167(1.009167)^{48}}{(1.009167)^{48} - 1} \approx 517

The total paid over 48 months is 517 \times 48 \approx 24816. Add the 300 fee for 25116.

Compare: current path about 24775, consolidation about 25116. Consolidation costs about 340 more here. The reason is the car loan: 12000 of the 20000 was already at 9%, cheaper than the 11% loan. Moving cheap debt to a higher rate wiped out the saving on the card.

Reading and interpreting the result

The tool reports the total cost of each path and the difference. A negative difference (consolidation cheaper) is the case worth acting on. A small positive difference, as in the demo, means consolidation buys you simplicity but not savings, and you should decide whether one payment is worth a few hundred extra.

Watch the blended rate. In the demo it is:

\text{blended} = \frac{5000(21) + 12000(9) + 3000(14)}{20000} = 12.15\%

The consolidation rate of 11% is only just below 12.15%, so the gain is thin, and the fee tips it negative. Compare that to a loan at 8%: the payment drops to about 488, total near 488 \times 48 = 23424 plus fee, comfortably below 24775.

The current path and the 11% loan cost nearly the same; an 8% loan clearly wins.

Using the demo debts (total balance 20000, current-path cost about 24775) over a 4-year term with a 300 fee: at a 8% loan rate you pay about 23724, at 11% about 25116, at 14% about 26520. The break-even rate where consolidation matches the current path is about 10.6%.

Common mistakes

The errors below are the ones that turn a sensible refinance into a costly one.

Ignoring the fee
An arrangement fee of 300 on a 20000 loan adds about 1.5% to the cost. On a marginal deal that alone can flip the answer.
Comparing rate against rate
A 11% loan is not automatically cheaper than a 21% card, because the card may clear in 47 months while the loan runs 48 or longer. Compare total paid.
Consolidating cheap debt
Folding a 9% car loan into an 11% loan raises its cost. Consolidate only debts whose rate is above the new loan's rate.
Re-borrowing on cleared cards
If the freed 5000 card fills up again, you now owe the loan plus a new card balance. The saving becomes a loss.

Related tools

Use these alongside the comparison to check the pieces:

Frequently asked questions

Does consolidation lower my monthly payment?

Often yes, because the term is spread over several years. In the demo the current minimums total 500 a month, while the loan is about 517. If you extended to 6 years the loan payment drops to around 380, but you pay more interest overall. Lower monthly does not mean cheaper.

Why does the tool show the current debts being paid at minimums?

The minimum is the worst realistic case and the one most people default to. It makes the comparison honest: if you would happily pay extra on the cards, you might not need a loan at all.

What break-even rate makes consolidation worthwhile?

For the demo debts and a 4-year term with a 300 fee, the break-even loan rate is about 10.6%. Below that, consolidation saves money; above it, the current path is cheaper. Your own break-even depends on your balances and minimums.

Should I consolidate my car loan too?

Only if the consolidation rate is below the car loan's rate. In the demo the car loan sits at 9%, below the 11% loan, so leaving it out and consolidating only the card and personal loan usually gives a better result.

Is a longer term ever a good idea?

It helps cash flow if a payment is unaffordable today, but it raises total interest. Treat a longer term as buying breathing room, not saving money, and pay extra when you can to shorten it.

Try it yourself in the tool

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