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Debt Consolidation vs. Refinancing - What's the Difference?

July 17, 2022

If you’re looking for ways to pay off your debt, two options you may have heard of before include debt consolidation and debt refinancing – but how do you know the difference between them and which option might be right for you?

In today’s post we’ll cover what each strategy is, how they impact your debt, and considerations to make when reviewing a lender’s offer.

What is debt refinancing? 💰

Debt refinancing is when you take out a new line of credit or loan under different terms to pay off an existing debt (or multiple debts) usually at a better interest rate or lower monthly payment. For example, let’s say you’re currently paying down loan A with an interest rate of 6% and a remaining balance of $5,000. If you were offered a lower interest rate of 5%, you might take out loan B for $5,000 to payoff loan A using a lower monthly payment and saving money in interest over time.

It's important to note that neither refinancing or debt consolidation eliminates your debt. Ultimately, you'd still be responsible for the debt but hopefully at a lower rate or monthly payment. You can refinance a single debt or multiple debts – individually, or combined (the latter would be considered consolidation).

Curious about refinancing your debt? Find out what you might qualify for through our partner, Rocket Loans.

What is debt consolidation? 💳

Debt consolidation involves taking out a new line of credit to pay off multiple loans, consolidating them into a new, single monthly payment. Similar to debt refinancing, debt consolidation does not eliminate any of your existing debt, but rather, simplifies your payments under new terms.

For example, let’s say you had loan A for $2,000, loan B for $3,000, and loan C for $4,000. You might consolidate them into a single loan of $9,000 to make your payments easier. It’s possible that new loan might use an average weighted interest rate of loan A, B and C –effectively keeping your interest rate the same – or use a new interest rated depending on the terms of the offer.

Ideally, in addition to consolidating your monthly payments, you'd also hope to get a lower interest rate or lower monthly payment. To see what offers you may qualify for, we recommend checking out our partner, Rocket Loans.

Thinking about consolidating your student loans? If you have private student loans and can get a better offer, then student loan consolidation can make a lot of sense. To see what offers you may qualify for, we recommend checking out our partner, Credible. If you have federal student loans however, you'll likely want to consolidate using a Federal Consolidation Loan in order to keep the various benefits that federal student loans provide, like the ability to have an income-based repayment plan or pursue public student loan forgiveness. This is because consolidation your loans through a private lender would rid you of those benefits.

The difference between debt consolidation and refinancing 🤔

The major difference between debt refinancing and consolidation is that debt consolidation must involve more than one debt, while refinancing can be applied to a single or multiple debts.

Both debt consolidation and debt refinancing involve taking out a new loan or line of credit to pay off existing debt. Regardless of which you choose, the new loan will come with new terms that could be beneficial for you. For example:

  • Potential to lower your interest rate, saving you money in the long run
  • Potential to lower your monthly payment, freeing up cash on the monthly basis
  • In the case of consolidation, can simplify your payments, so you only have one debt to pay instead of several

Whether you consolidate or refinance your loans, and what type of offer you might take will depend on your goals: do you want to lower the amount you pay over time, lower the amount you pay monthly, or become debt free sooner? You may also want to simplify your payments.

Did you know?

Credit card refinancing can be done a few different ways, including taking out a personal loan to pay off existing debt, or transferring that debt to a new credit card, known as a balance transfer.

Like student debt consolidation, if you're considering refinancing your student loans, keep in mind that it would involve using a private lender which would take away any benefits of federal student loans. To learn more about the considerations of student loan refinancing, check out this help article.

What to consider when refinancing or consolidating 💸 

Most people refinance because they are looking for either a lower monthly payment, a lower interest rate, or both. The interest rate is what saves you the most money in the long run, and a big reason why people refinance to begin with. But it’s also possible that you may prefer to lower your monthly payment regardless of the interest rate or repayment period – because even if that extends the repayment period for your debt, it can free up cash for other priorities.

So how do you know whether it's the right decision for you? Consider the following four questions: 

  • Will consolidation or refinancing help you manage your payments more easily?
  • Will the new offer lower your interest rate, monthly payment, or both?
  • Will it increase or decrease the total amount of debt you pay overtime, including interest?
  • Will it extend the amount of time you are in debt? This may be particularly important if you're considering another loan or mortgage down the road, as any existing debt will impact your debt-to-income ratio.
  • Is there any prepayment penalty in the event you want to accelerate your debt payoff at a later date?

Refinancing your mortgage 🏡

Depending on your current interest rate, you might also be interested in refinancing the mortgage on your home at some point. Similar to how you'd refinance any loan, the benefits here are that you might save money in interest over time, lower your monthly payment, or borrow from the equity you’ve built up using what's called a cash-out refinance.

In a cash-out refinance, you'll take out a new mortgage, replacing the old one, but you'll borrow more than you owe on the home to take the difference out in cash. For example, if you only owed $150,000 on your home, you could get a new mortgage for $175,000 and use the $25,000 difference in cash. Of course, you'll have to pay this back eventually like any loan, but it could be useful if the interest rate is less than what you might get on a personal loan or credit card.

Want to learn more about refinancing your mortgage? We recommend this article from our partner, Rocket Mortgage.

At the end of the day, whether you decide to consolidate or refinance your debt will always be a personal decision, but we hope this article is helpful in determining what might make sense for you on your financial journey.