What is debt consolidation?

Debt consolidation is the process of paying off multiple debt balances with one new loan or credit account. It's worth considering for a few different reasons, including the potential to pay a lower rate and the simplicity of only managing one payment. To choose the best debt consolidation option, learn about different types of debt consolidation, how the process works, and how much you might be able to save.

How does debt consolidation work?

Debt consolidation is a debt management strategy used to replace multiple debts with a single debt, ideally with a lower interest rate. You can consolidate almost any type of debt, but credit card balances and loans are the most common. The original creditors are paid off with funds from the new loan, and you start making one new payment on the new account.

There are multiple potential benefits to getting a debt consolidation loan:

• Lower monthly payment: If your current monthly payment is unaffordable, or you’re only able to pay the minimum, a debt consolidation loan can lower your monthly payment via a lower interest rate, longer repayment term, or both.
• Lower interest rate: If you have high-interest debt, like some credit card debt, you could qualify for a personal loan with a lower interest rate, and save money on interest.
• One payment: Instead of having to manage multiple payments, with debt consolidation you can simplify your finances with one monthly payment, and potentially avoid late fees.
• Pay debt off faster: If you lower your interest rate, you can pay off your debts faster.
• Improve your credit score: If you consolidate your debt to a lower interest rate and payment you can afford, you can improve your credit score. This can happen in two primary ways. One, you reduce your debt, thereby reducing your credit utilization ratio, which accounts for 30% of your FICO score. Two, you make on-time payments, which benefits your payment history (35% of your FICO score).

Types of debt consolidation loans

There are a few different types of debt consolidation loans. They all accomplish, generally, the same purpose, but do it via slightly different means. The best debt consolidation loan for you depends on factors like your credit score, whether you have home equity, how long you need to pay off your debt, what monthly payment you can afford, and how you feel about putting up collateral.

Personal loans

The best personal loans for debt consolidation offer a lower interest rate than your existing debt and a payment schedule you can afford. Most personal loans are unsecured, meaning you don’t have to pledge collateral like your car or home, and they can be a particularly good option for consolidating credit card debt. This is because the average personal loan interest rate was 11.48% on a 24-month loan in May 2023, while the average credit card interest rate was 20.68%, according to the Federal Reserve.

But personal loan interest rates swing widely, depending on your credit profile. At the time of publication, the best available rates were under 5%, while the highest were near 36%. If you have bad credit, though, you may be able to apply with a cosigner or get a secured personal loan to lower your rate.

If you’re approved for a personal loan, the lender can pay your creditors directly, so you don’t have to handle those transactions. You may even get a “direct pay” discount, which could be 0.25 percentage points off your interest rate.

Balance transfer credit cards

If you have a good credit score, you may qualify for a balance transfer card with a low or 0% introductory rate. These promotional periods typically last from 12 to 21 months, after which the rate adjusts to the credit card’s standard rate (which could be north of 20%).

Balance transfer credit cards can be a good way to consolidate credit card debt you can pay off within the promotional period. However, they come with fees and risks:

• Most cards charge a balance transfer fee, up to 5%, which is added to your balance (thereby increasing your debt).
• If you miss a payment or make one late, you may lose the promotional rate.
• If you can’t pay off your balance within the promotional period, the new interest rate could make payments unaffordable.

Transferring credit card balances to a balance transfer credit card is usually a simple matter of inputting the information online.

Home equity loans and cash-out refinance loans

A home equity loan lets you borrow a lump sum of cash based on the amount of equity you have in your home. You would then use that money to pay off your other creditors and start making payments on the home equity loan. For most people, this results in two loans on their home — a home equity loan and their original mortgage.

A cash-out refinance works similarly, except that instead of two loans, you refinance your mortgage for an amount greater than what you currently owe and take the difference as cash. Like a home equity loan, you must have sufficient equity.

Home equity loan interest rates are usually lower than personal debt consolidation loans because your home is used as collateral. They also may be easier to qualify for if you need a debt consolidation loan for bad credit. But you risk foreclosure if you fall behind on your payments.

How to consolidate debt

Expect five primary steps as you kick off the debt consolidation process:

1. Evaluate your debts: Make sure you understand all of your outstanding balances, including the total amount owed, the interest rate, and each debt’s status (such as up to date or in default). You should prioritize the most expensive loans and those in default or collections because they're costing you more money and lowering your credit score. If you're not sure how to analyze your debts, talk to a credit counselor or debt consolidation attorney to help make a plan.
2. Compare APRs: Compare personal loans with other debt consolidation methods by getting prequalified. Most personal loan lenders let you prequalify without affecting your credit score. No matter what, this is a great move since it lets you compare estimates of annual percentage rates (APRs) — which factor in both your interest rate and any fees — and monthly payments based on your credit profile and debt consolidation needs. Note that prequalified loan estimates are not offers of credit, and a hard credit inquiry will be conducted when you apply for a loan, which could temporarily ding your credit.
3. Choose the right consolidation method: Once you’ve prequalified, choose the best loan type for your needs. The choice may be obvious. Perhaps you have bad credit and a home equity loan gives you the lowest rate. Or, perhaps you don’t have home equity or aren’t eligible for a balance transfer offer. You’ll have the most options if you have excellent credit and home equity. In that case, you might choose a personal loan to avoid putting your home at risk, a home equity loan for a low APR, or a balance transfer offer if you can pay your debt off within the promotional period.
4. Apply: Prepare for the application process by gathering a few documents and pieces of information, including employment and income information (W-2s, pay stubs, bank statements, or tax returns), monthly rent or mortgage payment information, driver's license, and lender payoff information. You may require more or less information and documentation depending on the type of loan and lender.
5. If approved, consolidate and start repaying the new loan: Once your loan is finalized, mark your calendar for the new monthly due date. Consider enrolling in autopay to avoid missing payments. Some lenders even offer an autopay discount.

Is debt consolidation a good idea?

Weigh the pros and cons before jumping into debt consolidation. The advantages are simplifying monthly payments, potentially lowering them, and possibly reducing your interest rate.

However, many debt consolidation options involve fees that increase your debt balance (such as closing costs, origination fees, and balance transfer fees), which could make your situation worse if you can’t keep up with the payments. Plus, there are specific drawbacks to certain types of debt consolidation.

Credit card balance transfers can backfire if you don’t pay the amount off within the promotional period. Personal loans and home-equity-based loans, on the other hand, offer longer repayment periods at fixed rates — up to seven years or longer with some personal loans, and up to 30 years with home equity loans. However, home equity loans and cash-out refinances put your home at risk if you can’t make payments, while personal loans and credit card balance transfers do not.

Finally, a personal loan could have the highest APR, costing you more than either a credit card balance transfer or home-equity-based loan in the long run.

But the most important factor in choosing the right debt consolidation method is to make sure you can afford to make payments. Otherwise, you could make your debt situation worse.

Debt consolidation loans for bad credit

Getting approved for a debt consolidation loan with bad credit can be challenging. If you’re approved, you may be looking at a high APR and an origination fee. But you can increase your odds of approval and potentially lower your rate and fees with the following strategies:

• Look for secured loans: In addition to home equity loans, some personal loan lenders accept collateral, such as a car, or savings and retirement accounts. The downside is that those assets can be seized if you default on payments.
• Get a cosigner: A cosigner shares equal responsibility in repaying the loan (but doesn’t have access to loan funds). A friend or family member with good credit who’s willing to cosign your application could be enough to get your application approved and lower your rate. Just be mindful of the consequences to their credit if you fail to make payments.

FAQ

Does debt consolidation affect your credit?

Yes, debt consolidation can have short-term negative effects on your credit, since applying for a loan results in a hard credit inquiry, which can lower your score. However, the inquiry will drop off your report after two years, and timely repayment can increase your score, along with the impact of reducing your credit utilization.

What types of debt can be consolidated?

Most unsecured debt qualifies for consolidation. This includes credit card balances, installment loans, payday loans, and medical expenses. It often doesn't make sense to consolidate secured loans like mortgages and auto loans.

How do I get a debt consolidation loan?

Many lenders have an online application you can fill out. You'll need to input personal and financial information, as well as employment details. Also be prepared to upload copies of recent pay stubs and other financial documents.