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What is debt consolidation?

CNBC Select defines debt consolidation, how it works and why it can save you money in the long run.

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Before the coronavirus pandemic, financial advisors typically recommended people prioritize debt payoff first and foremost. But now that over 36 million Americans are unemployed, the focus has shifted to savings.

It is very important to have an emergency savings account. And while experts advise you stash anywhere from three to six months' worth of expenses in a high-yield savings account, having at least a $1,000 saved is a good place to start. But it's hard to know what goals to prioritize if you've got a lot of credit card debt and not much savings.

As long as you make your minimum payments on time, your credit score will stay in OK shape, and saving will help you be prepared for financial surprises ahead, such as getting laid off, losing revenue or being furloughed.

However, credit cards have the highest interest rates out of every kind of credit product. If you've recently decided to stop prioritizing paying off your lingering credit card balances so that you can pad your nest egg instead, you may end up paying a staggering amount in interest in the long run.

One solution is to use a personal loan through companies like SoFi, LightStream or Payoff to consolidate your credit card debt into one monthly payment. This usually results in lower interest and can help you interrupt the debt cycle for good.

Below, CNBC Select explains what debt consolidation is, how it works and why it can save you money in the long run.

What is debt consolidation

If you have outstanding debt on more than one credit card, you can apply for a debt-consolidation loan. You use this loan to pay off your credit card debt, then repay the loan in monthly installments, usually with a lower interest rate than you were paying on your credit cards. Typically, personal loans are fixed-rate, meaning the APR is locked in for the lifetime of the loan, and you pay the same monthly amount until it's paid off. This is an advantage over credit cards, which have variable APRs that can go up and down.

You can get a loan through a traditional lender, like a bank, or from an online peer-to-peer lending company like SoFi or Lending Tree. Banks tend to have traditional standards consumers must meet to get approved for a loan, meaning you will need to have a qualifying credit score, significant borrowing history with documented on-time payments and a high enough debt-to-income ratio that proves you have the resources to afford the monthly payment. On the other hand, peer-to-peer lenders have slightly more relaxed or non-traditional requirements. For example, Upstart looks at your level of education and job history in addition to your credit score.

How debt consolidation works

Debt consolidation loans is similar to a balance transfer card with a 0% APR period, but they work a little differently. To begin with, balance transfers typically charge fee between 2% and 5%, unless you opt for a no-fee balance transfer card. The Amex EveryDay® Credit Card, for example, allows you to transfer debt from an existing credit card with no fee, but the Citi® Double Cash Card charges a fee that equal to 3% of your balance. Both cards require excellent credit to qualify, whereas there are a variety of personal loan options for people with fair credit and good credit.

Unlike a balance transfer, where you move debt from one account to another, when you get a consolidation loan, the cash is deposited directly into your bank account that you can use to pay off all of your credit card debt at once. Then, you pay back your lender with monthly payments over a timeline that is determined when you apply for the loan. Once a personal loan is paid off, the credit line is closed and you have no more access to it. 

Like any loan, you'll be charged interest. But unlike credit card interest, which averages about 16.6% according to the Fed's most recent data from February 2020, an APR for a personal loan can be as low as 4% (based on your creditworthiness). Typically, your interest payments are calculated into your monthly payment and divided over the lifetime of the loan. Most loan terms range anywhere from six months to seven years. The longer the term, the lower your monthly payments will be. However, you'll be charged more interest over time so it's best to elect for the shortest term loan you can afford.

In addition, some lenders charge a sign-up, or origination, fee. However, there are several no-fee options with varying interest rates depending on your credit score. You should opt for a no-fee personal loan whenever possible.

Debt-consolidation loans are great if you have multiple credit card balances. Merging those balances into one personal debt consolidation loan is a helpful way to streamline your bill payments, since you'll only have one account to keep up with.

The most important factor in debt consolidation loans

While debt-consolidation loans make budgeting easier, the most important factor to consider when opening one is the interest rate. Americans average $6,194 in credit card debt, and the average APR is about 16.61%. Assuming you were to only make the minimum payment each month (on time, so you avoid paying late fees), it would take you more than 17 years to pay off this balance, and you'd pay an estimated $7,286 in interested fees. (Learn more about how we got these numbers.)

Meanwhile, with the flexibility of peer-to-peer lending platforms, you can score a debt-consolidation loan with APRs as low as 4%, give or take with the prime rate. The current average APR for personal loans according to the Fed is 9.63%.

For example, say you have $10,000 worth of credit card debt with a 16.61% APR. If you paid it off in three years, you would pay a total of $2,656.53 in interest, according to Experian's APR calculator. Meanwhile, if you took out a personal loan with 9.63% APR, you would pay $1,447.90 in interest. This is a potential savings of $1,208.63 — you'd nearly cut your interest payments in half.

Before applying for any kind of personal loan, you should see what APR you prequalify for using the loan company's website. This can usually be done by inputting your social security number, date of birth, annual income, employment status and contact information.

While it's not a guarantee, this will give you an idea of what rates you qualify for. If the lender offers you the same APR, or a higher rate, on the loan as your credit cards, you should not consolidate.

Bottom line

Debt-consolidation loans can help you streamline your budget by letting you pay off debt in one simple monthly payment. Moving your credit card debt over to a personal installment loan will also usually cause a noticeable jump in your credit score, since this effectively brings down your credit utilization rate

However, despite the convenience and simplicity of a consolidation loan, you should pay close attention to interest rates and fees as you inquire about preapproval. Ideally, you can find a loan that can both helps make your monthly payment more manageable while also saving you on interest in the long-run.

And like any credit product, be sure that you have a plan in place once your balance hits $0 to help you keep credit creep at bay.

For rates and fees of the  Amex EveryDay® Credit Card, click here.

Information about the  Amex EveryDay® Credit Card and Citi® Double Cash Card has been collected independently by CNBC and has not been reviewed or provided by the issuer of the card prior to publication. 

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the CNBC Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.