How does debt consolidation work?

Consolidating your debt can simplify a chaotic financial situation. Ideally, it can also lower your interest rate and help you pay off debt faster. But debt consolidation isn’t for everyone. Learn how it works and who it's best for to decide if it makes sense for you.

How does a debt consolidation loan work?

A debt consolidation loan rolls your existing debts into a single monthly payment. You can consolidate your debts with a loan — like a home equity loan, 401(k) loan, or personal loan — or a line of credit. Once the loan funds, you can use the money to pay off your various balances. Then, you start making payments on the new loan, usually in monthly installments.

For example, let’s say you have three credit cards that you owe $12,000 on, and the average interest rate across the cards is 20%. You're making a monthly payment of $611 in order to pay them off in two years, which means you'd pay a total of $2,658 in interest.

But say you use a personal loan to consolidate your debts, and you qualify for a 14% interest rate. You maintain the 2-year payoff period. But with the new loan, you only pay $576 per month and a total of $1,828 in interest.

You're most likely to experience the biggest savings using a personal loan for debt consolidation if you have good credit and high-interest debt. If you own a home with equity, you may be able to get a lower rate with a home equity loan or a home equity line of credit (HELOC).

Pros and cons of debt consolidation

Under the right circumstances, debt consolidation can have many advantages for your financial situation, as well as potential drawbacks.

Pros

• Streamlines your finances with a single monthly payment.
• You can lower your overall interest rate, if you qualify for a lower rate.
• You may see a quick boost to your credit score (if you decrease your credit utilization by paying off credit card debt)
• You may be able to lower your monthly payment.
• It can help you pay off your debt in less time, depending on the amount and term.
• You can improve your credit score, if you make payments on time.

Cons

• Debt consolidation may require fees, like balance transfer fees, closing costs, loan origination fees, and annual fees.
• You may end up paying more in the long run in exchange for lower monthly payments.
• You need to apply and qualify for a loan, which takes time and administrative work.
• You may not qualify for an interest rate that’s less than your current average rate.
• Debt consolidation won’t change unhealthy spending habits.

Types of debt consolidation

There’s more than one way to consolidate your debt — in fact, there are several. Below are some of the most common types of debt consolidation.

• Secured personal loans: These have a wide range of uses, including debt consolidation. These loans require collateral — a physical or liquid asset. They’re riskier because you can lose that collateral if you default on the loan, but they’re typically easier to qualify for than unsecured loans. Some collateral examples include: your house, car, or a savings account.
• Unsecured personal loans: These loans don’t require collateral, so they tend to have higher interest rates and are more difficult to qualify for.
• Balance transfer credit cards: This form of debt consolidation usually offers a low or 0% promotional interest rate when you transfer existing balances onto the balance transfer card. This allows you to pay off your balance without incurring interest, at least for a while. Typically, there’s a fee for a balance transfer. Risks include a significantly higher interest rate following the promotional period and the possibility of a rate increase if you miss payments.
• Peer-to-peer loans: These loans allow investors to lend money to borrowers without going through a financial institution. Borrowers can sometimes secure a better interest rate than they’d find at a bank, and lenders earn interest they otherwise wouldn’t. Note that lenders may notify a collection agency if you default on your loan.
• Home equity loans: A type of installment loan you can use to consolidate debt, among other things. It’s secured by the equity you have in your house. The biggest risk is that if you default on your payments, you can lose your house.
• Home equity lines of credit (HELOCs): Similar to home equity loans, they’re secured by the equity you have in your house. But rather than receiving a lump sum payment, HELOCs have a draw period during which you can borrow again and again, up to a set limit. You can also lose your house if you default.
• 401(k) loans: These secured loans allow you to borrow from your workplace retirement account. You may be limited in the amount you can take out and generally have to repay your loan within five years. Plus, you may have to fully repay the loan before getting a new job.

Other methods to consider

If you can’t qualify for a debt consolidation loan — or you’re not sure it’s the right financial move — there are other steps you can take to get a handle on your debt. Consider the following options:

• Create a debt payoff plan: Using either the debt snowball or debt avalanche method, you can start paying off your debts one by one (while making minimum payments on everything else). The debt snowball method focuses on paying off your smallest debt first, and then moving on to the next-smallest debt. The avalanche method focuses on paying off the debt with the highest interest first. Eliminating debts one at a time can give you a lot of momentum in the payoff process.
• Increase your income: If possible, negotiate a raise, start a side hustle, or look for a higher-paying job in order to put more money toward your debt.
• Use a budget: You may be surprised to learn where your money is going every month once you take a closer look. Use a budgeting app or tool to ensure you’re prioritizing paying down your debt each month.
• Negotiate with your lender: Getting a lower interest rate on an outstanding balance may be as simple as picking up the phone. Ask your lender if they can offer you a lower rate. Bring up your good track record and the fact that you’ve been a loyal customer.

How to apply for a debt consolidation loan

Applying for a debt consolidation loan may vary slightly based on the lender you work with. But generally, you’ll take the following steps:

1. Determine your goals: Your debt consolidation goals will help you choose a loan and create a plan. Consider whether you want to pay off your debt faster, pay less in interest, or lower your monthly payment.
2. Check your credit score: Most lenders use your credit score as a basis for determining your eligibility for a loan. Ask lenders what scores they accept when shopping for a loan.
3. Choose a lender: Based on your goals and credit score, compare types of loans and different lenders to narrow down your best options. Look for low interest rates and eligibility requirements you can meet.
4. Gather the necessary information and documentation: Typically, you’ll need forms of identification and proof of employment, income, and address. If you’re applying with a cosigner, they’ll need to provide this information, too. Check with your lender to make sure you have all the necessary documentation ready when you apply.
5. Wait for approval: Approval could happen immediately or take several days. Make sure you stay tuned to provide any other information or documentation the lender needs to complete the process.

Is a debt consolidation loan right for you?

There are certain situations where debt consolidation makes the most sense. But there are other times when it doesn’t.

A debt consolidation loan may be right for you if:

• Your credit score has improved since you last took out a loan, and you can now qualify for a lower interest rate
• You’re able to handle your debt payments every month but want the simplicity of a single payment.
• It’ll take more than a year to pay off all your debt at your current payoff rate.

On the other hand, debt consolidation may not be for you if:

• You already have low interest rates on your existing debt.
• You’re on track to pay off your debt within a year.
• You’re completely overwhelmed by your debt and need additional help.
• You have unresolved spending issues that won’t change with debt consolidation.

In some cases, consolidating your debt may not be worth the fees or extra hassle. Other times — like with out-of-control spending habits or a very high debt-to-income ratio — you may be better off with debt relief strategies.

Alternatives to debt consolidation

Sometimes — whether you can’t qualify for a better loan or your debt is simply too much of a burden — debt relief is the best solution. When it comes to debt relief, there are several options:

• Debt management plans: Debt management plans enlist the help of a nonprofit credit counseling agency. The agency helps create a payoff plan, contacts lenders on your behalf, and may negotiate interest rates. This typically has less of a negative impact on your credit score than settlement or bankruptcy.
• Debt settlement: Either on your own or with the help of a third-party company, debt settlement is negotiating your debts down, then agreeing to pay the new amounts in full. Settlement can negatively impact your credit score and incur additional fees. Additionally, debt settlement companies usually require you to stop making payments, which can impact your score and potentially lead to legal trouble with your creditors.
• Bankruptcy: Bankruptcy is a legal proceeding usually initiated by a person or business who can’t pay back their debts. It’ll dramatically impact your credit score for years, so it should only be considered as a last resort, but it can also provide a necessary fresh start.

FAQ

Will debt consolidation hurt my credit score?

Applying for a debt consolidation loan — or any loan — may temporarily lower your credit score. But if you make consistent on-time payments to pay off your new loan, your credit score will start to rise. On the other hand, falling behind on your payments or closing out old credit cards after consolidating can lower your score.

Can I consolidate all types of debt?

Generally, you can consolidate any type of debt, but it’s most common to consolidate higher-interest debt, like personal loans and credit cards. There may also be limitations on how you consolidate various types of debt — or the type of debt consolidation loan you can use. For example, many lenders prohibit you from using personal loans to pay off student loans.

Can I still use my credit cards after consolidating my debt?

Usually, yes. But some lenders may require you to close credit cards before funding your loan. Additionally, if you enroll in a debt management plan, you usually can’t use credit cards or open new accounts while on the plan.

How long does it take to pay off debt through consolidation?

It depends on the amount you have, your interest rate, your loan’s term, and how aggressively you pay it off. Consolidating your debt doesn’t necessarily mean you’ll pay it off sooner. But if you can qualify for a low interest rate or pay extra on your monthly payments, debt consolidation can speed up the repayment process.

What happens if I miss a payment on my consolidation loan?

First, you may have to make a late payment fee. Second, late or missed payments will negatively impact your credit score, making it even more difficult to borrow in the future. And third, you’ll push your debt payoff date further into the future.