How Does Debt Consolidation Work?

LanternUpdated May 20, 2021

Share this article:

Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.

Owning a business can be a costly proposition, which is why many business owners take on debt to do so--a mortgage here, a line of credit there, a loan to stock up on inventory… But the costs of borrowing money can add up. That’s why some business owners may wonder if debt consolidation could be a worthwhile strategy to reduce how much they’re paying for their different loans. According to the 2021 Small Business Credit Survey, an annual report by the 12 Federal Reserve Banks, 79 percent of employer firms have outstanding debt. That’s an eight percent increase from 2019. And nearly half of those businesses owe more than $100,000.When you consider all the expenses associated with opening and running a business, it’s no surprise that many owners have to take on some debt to support their companies. But it’s not only the amount of money borrowed that dictates how expensive debt can be. The cost of borrowing also plays a significant role in how much money a business ultimately has to pay back to lenders, whether they’re credit card companies, banks, or other entities. Paying interest can take a hefty toll on your business’s finances. At the same time, lengthy loan terms may reduce your flexibility in paying back your loans, resulting in prolonged interest costs. Additionally, for a busy small business owner, riding herd on multiple loans with different due dates can be challenging. As well as the inconvenience, if you miss a payment, you may be charged even more in late fees. Debt consolidation is one option that small business owners may choose to try to address these challenges.

What Is Debt Consolidation?

Simply put, debt consolidation is a strategy in which you take out a new loan in order to pay off other debts so that you’ll have only one set of payments to make. For example, if your business owes money for a mortgage, a line of credit, and several short-term loans, you may be juggling different interest rates and payment schedules. The idea behind debt consolidation is that you could take out one loan to pay off all of those smaller loans. Then you would have just one monthly payment to deal with. There can be fees associated with debt consolidation, but, ideally, you might be able to reduce your overall interest rate and, ultimately, costs, as well.

How Does Debt Consolidation Work?

Because debt consolidation involves shifting multiple debts to a single loan, the first important step in deciding whether it’s a good option for you is to gain a clear picture of your business’s current debt status. This means making a list of all the debt you want to consolidate and determining the amounts due and interest rates for each.With this information in hand, you can figure out the weighted interest rate you’re currently paying on your debt. That gives you a figure to compare with the interest rate and new terms offered by different lenders in order to decide if debt consolidation is worth it for you. Ideally, the interest rate on the consolidated debt loan should be lower than what you pay on your multiple loans.It’s not hard to figure out the weighted interest rate on your total debt load . First, add up all your outstanding debt (the total balance you owe). Next, add up the interest you pay each year on those loans. Divide the first number by the second and multiply the result by 100 to arrive at the overall interest rate you’re paying on these loans. That interest rate can give you some guidance as you look at the rates on debt consolidation loans. If you think you can get a better rate by consolidating your debt and you want the convenience of having only one set of payments to track, it might be worth considering debt consolidation.

How to Consolidate Debt

Once you’ve determined what your current debt interest rate is and decided that you want to apply for a debt consolidation loan, the process is similar to the procedure you’d use to apply for any loan.1. Find a loan to apply for. Once you’ve decided to look into consolidation, you can start by applying for loans to see whether you can get a better interest rate than the one you calculated that you’re already paying. Some common kinds of loan you might consider are:

Bank loans
Small Business Administration (SBA) loans
Alternative loans

Bank loans and SBA loans will likely offer the best terms and rates, but will probably be difficult for a business to get if it hasn't been in operation for at least two years or doesn't have a good credit rating. Alternative loans (which are generally offered by online lenders) may be easier to qualify for but may not offer terms that are as favorable. As with many types of loans, all of these will likely involve a credit check and review of your business’s history. 2. Delve into the details. Once you’ve found a loan that you like, read the fine print so you understand all the nuances. In addition to the interest rate, don’t forget to check the following:

Does your existing debt have prepayment penalties? If so, you’ll have to subtract those costs from any potential savings debt consolidation might create.
Are there fees associated with your potential new loan? These costs also need to be factored in.
What would your new monthly payment be and how does that compare with what you currently pay per month? Having a great interest rate won’t help you much if you can’t cover the monthly payment.
What is the term of the loan? It’s important to make sure that you’re comfortable with how far into the future you can expect to be making payments. A loan with a lengthy term may have a smaller monthly payment but cost you more in interest in the long run.
Finally, will the loan save you money and/or make your debt payments easier? If the answer is yes, you may want to consider taking the loan

3. Make your decision. If you opt to take out a debt consolidation loan, most likely your lender will pay off your other debts directly. If not, you may want to do so right away so you can get started on your new streamlined payment schedule.

Is Debt Consolidation Worth It? Weighing the Pros and Cons

Debt consolidation can be a helpful financial strategy, but ultimately the question of whether debt consolidation is worth it depends on your business’s individual situation.

Potential Advantages of Debt Consolidation

At a high level, here are some of the top benefits of consolidating debt.

Lower Interest Rate

One of the most straightforward ways debt consolidation can be advantageous for a small business is the cost savings from reducing the overall total interest it has to pay. Consolidating debt into a single loan with a lower interest rate than the average interest on several loans can result in cost savings as well as improved monthly cash flow.

Streamlined Bookkeeping:

Having multiple debts means having to stay on top of multiple payments and due dates each month. Consolidating debt can streamline bookkeeping because there are simply fewer payments to make each month.

Drawbacks of Debt Consolidation

In some cases, consolidating debt can also have potential drawbacks.

Prepayment Penalties:

In deciding whether to consolidate debt, it’s important to consider not only the interest rates on existing loans but also the payment terms. Some loans charge you additional fees for early payment—which may negate the potential savings of loan consolidation.

Lengthy New Loan Terms:

When considering a consolidated loan, it’s also wise to look at the terms of the loan you’re thinking about. A loan at a lower rate may sound attractive—but if the new loan term is considerably longer than the terms of the existing debts, the interest may still add up to more over time.

The Takeaway

In business, you often have to spend money to make money—investing in staff, equipment, and other expenditures necessary to maintain or grow operations. But it’s a good idea to review business debt from time to time in order to determine if there are opportunities to reduce costs.Whether via debt consolidation or a small business refinancing loan, reorganizing debt can be a helpful tool in some cases. If you think it might be helpful for your small business, learn more about Lantern’s financing options for small businesses.

SOLC21030

About the Author

Lantern

Lantern is a product comparison site that makes it easy for individuals to shop for products and compare offers with top lenders. Lantern is owned and operated by SoFi Lending Corp., the digital personal finance company that has helped over one million people get their money right.

Share this article: