How Does Debt Consolidation Work? (2024)

Debt consolidation can be an effective tool to manage your debt by reducing the amount of time and money it takes you to pay it off. On the other hand, debt consolidation isn’t always the right choice for every financial situation. Let’s take a look at how debt consolidation works and if it’s right for you.

How does a debt consolidation loan work?

Debt consolidation works by rolling various debts you already owe into a single, new loan or line of credit. In an optimal scenario, you will be able to consolidate high-interest debt into a loan with a lower interest rate, saving you money in the long run. A common form of debt consolidation is using a personal loan to pay off credit card debt.

Let’s take a look at a simple example to see how a personal loan could be a highly beneficial financial move. Say you have two credit cards: one with a balance of $2,000, and one with a balance of $2,500. They both charge roughly the average interest rate on credit cards of 20%, per Federal Reserve data from May 2023.

Now let’s say that you have a very good credit score of 750 and qualify for a 3-year loan for $4,500 at an interest rate of 12%. You receive that money and use it to pay off your credit cards.

As a result, you have a $0 balance for both credit cards and no longer have to worry about the compounding interest. Instead, you have a personal loan with a monthly payment of roughly $150 that will be completely paid off in three years.

Check Out: Debt Consolidation Calculator

Benefits of debt consolidation

• Lower interest rates: One of the biggest benefits of debt consolidation loans can be a lower interest rate. If you qualify for a lower interest rate, it can make a huge difference in how much you spend over the life of your debt.
• Shorter repayment timeline: A well-chosen debt consolidation method can also set you up to pay off your debt much faster, saving even more in interest along the way and getting you in the clear months or even years earlier.
• Streamlined payments: Having one bill to pay rather than multiple can be a mental relief and make it easier for you to stay on top of your payments.

Related: How To Consolidate

Risks of debt consolidation

• Not always cheaper: Many debt consolidation loans will charge a fee of a certain percentage of your total loan. These fees are generally automatically deducted from your disbursem*nt, so the amount you receive will not be the total amount of the loan you applied for.
• Not always faster: Debt consolidation comes in many forms and offers many repayment plans. You’ll need to do the math to ensure that the plan you go with is a better decision for you financially than keeping things as they are. Depending on how much you owe and what you can put toward your debt, it may take a while to pay it off.
• May not be doable for everyone: Debt consolidation may save you money over the long term, but if you can’t afford the monthly payments, it may not be the best option.
• May set you up for more debt in the future: If you don’t have your spending under control, you could end up running up credit card debt again. Then you’ll have your personal loan to pay off as well as your new high-interest credit card debt, putting you in a worse position than when you started.

Related: Should You Pay Off Debt or Save?

Types of debt consolidation

There are multiple ways you can consolidate debt. Let’s take a look at some of the most common:

• Secured personal loan: A secured personal loan may be “secured” by a house or a car, meaning that if you don’t make timely payments on your loan, your car may be repossessed or the lender could place a lien or foreclose on your home. While you may lose that asset if you don’t make your payments, secured loans often offer lower rates than unsecured personal loans.
• Unsecured personal loan: These personal loans are not backed or “secured” by your assets. So, you won’t lose your possessions if you don’t make your payments, although your credit score will be impacted and late payment fees will still apply. Because you aren’t offering collateral, having a good credit score is important for getting a low interest rate.
• Balance transfer credit cards: Some credit cards specifically cater to people looking to consolidate their debt. Generally, these cards offer a 0% interest rate for a period of time then charge you a balance transfer fee that’s a percentage of the total amount you transfer over. However, it’s important to pay off your balance before the introductory interest rate expires, or you could be right back where you started, with high-interest credit card debt to pay off.
• Peer-to-peer loan: These loans are from individuals like yourself who will lend you the money you need and then collect the interest on your payments. Often, peer-to-peer loans are offered via websites that cater to borrowers that have had difficulty obtaining a personal loan from traditional lenders.
• Home equity loans: If you own a home and have a good amount of equity in your home, this kind of loan may be a good option for you. This is a secured loan, so you have the possibility of losing your home if you default on your loan. Home equity loans generally have attractive fixed interest rates, according to the Consumer Financial Protection Bureau (CFPB) — though you’ll also want to make sure you understand any additional fees that you might incur.
• Home equity line of credit (HELOC): A HELOC is a form of secured, revolving debt. Revolving debt works like a credit card, where you can borrow repeatedly up to a certain amount. The CFPB notes that since HELOCs usually have variable interest rates (which can fluctuate due to market conditions), and if your home value falls for whatever reason, your creditor could limit your credit.
• 401(k) loan: Some 401(k) plans will allow you to borrow from your own account. You are usually only allowed to borrow up to 50% of your vested balance. Carefully review the terms of the loan to see if the interest rate is attractive and the monthly payments are doable.

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Other methods to consider

You can use other debt repayment tools that don’t require taking on new debt to make strides on your debt. Here are a few effective strategies:

Debt snowball method

The debt snowball method recommends making minimum payments on all your debt, and directing any extra money to your smallest debt. The idea behind this strategy is that you can see results faster with larger payments going to your smallest debt, giving you a win faster and building momentum — and motivation. Once you pay off your smallest debt, move on to the next smallest.

Debt avalanche method

The avalanche method is similar to the snowball method, but instead of directing any extra money to the smallest debt, you direct it to the debt with the highest interest rate.

While you may not see results as quickly, it gives you the biggest bang for your buck by reducing what you owe on your most expensive debt. When you’ve paid off that highest-interest debt, move to the next highest.

Increasing your income

This is one of the best ways to get ahead financially, but of course it’s easier said than done. Look for higher-paying jobs or consider taking on gig or freelance work and putting any extra money you make toward your debts.

Gig and freelance work often have associated taxes and costs — such as the cost of gas and car maintenance if you drive for a ride-hailing app — so make sure you’re planning for those costs as well.

Negotiating with your lender

Often, lenders will understand when you’re struggling and unable to make your payments. Reach out to your lender and see if they’ll work with you to make your debt more manageable.

You can ask that they lower your monthly payment, reduce your interest rate, waive fees, or change your payment’s due date, according to the CFPB.

Learn More: How To Negotiate Credit Card Debt

How to qualify for a debt consolidation loan

• Boost your credit score: If you have a great credit score, you will usually qualify for a better loan because lenders see you as trustworthy. Most lenders prefer a FICO score of 670 or higher to be considered for a lower interest rate.
• Have a healthy debt-to-income ratio (DTI): Your debt-to-income ratio shows what percentage of your income goes to paying off debt. Most lenders prefer a DTI of less than 35%.
• Have a solid employment history: Having a steady job is a good indicator to a lender that you’re more likely to repay your loans.
• Consider offering collateral: Offering collateral to secure the loan isn’t without its risks, but it can lower the risk for the lender and make them more interested in lending to you.
• Consider asking someone to cosign the loan: Having a cosigner who has a good income and a great credit score can secure you better terms. But make sure you can handle the payments, because if you can’t make them, your cosigner is on the hook for them, which can hurt your relationship.

Related: How To Build Credit

How to apply for a debt consolidation loan

1. Determine how much you can afford to pay each month: Sit down and create a budget with all of your monthly income and monthly expenses. Afterward, you should have a clear idea of the maximum payment you can make to a debt consolidation loan.
2. Check your credit score: This is one of the most important elements in your application, so if there are mistakes on your credit report or other easy fixes that can boost your score, wait to apply until you can do so.
3. Shop for loans: Compare the terms, including interest rates, fees, and how long you’ll be repaying it. Remember to compare these loans not only against each other, but against the terms of your current debt — you want to ensure that your financial situation and debt repayment plan are improved by this loan, not the same or worse.
4. Apply to your top choice: Lenders will often ask you to provide government ID, proof of income, proof of residence, and bank statements. If you have a cosigner, they will want the same information from them.
5. Wait for approval: Once you’re approved, the lender will give you a time frame in which you can expect the funds to be available to you. Take that money and pay off your old debts, and begin payments on your new loan. Set up automatic payments if possible to ensure you don’t fall behind or forget a payment.

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Alternatives to debt consolidation

If you find that debt consolidation isn’t available to you and you’re falling behind on your debt payments, there are steps you can take to get back in control financially.

• Debt management plans: You can work with a credit counselor to implement a debt management plan. The CFPB recommends reaching out to the Financial Counseling Association of America or the National Foundation for Credit Counseling to see if they can connect you with a credit counselor. These experts may be able to help you find ways to save money and pay off debt that you weren’t aware of, and can help you make a plan and stick to it.
• Debt settlement: While debt settlement companies can help you negotiate with your lenders, it’s important to realize that debt settlement companies can be expensive and risky, possibly even legally. Make sure you research any debt settlement company thoroughly and that the math checks out — i.e., doesn’t leave you worse off than when you started.
• Bankruptcy: If you feel like there’s no way you could ever catch up on your debts, bankruptcy may be an option for you — specifically, Chapter 13 bankruptcy. However, this option should be a last resort. This type of bankruptcy is intended to allow you to work with your lenders to create a 3- to 5-year repayment plan.

FAQ

Will debt consolidation hurt my credit score?

It depends on your unique financial situation, but in many situations, debt consolidation can boost your credit score.

A debt consolidation loan can lower your credit utilization and improve the mix of accounts you hold if it’s a different form of debt, both considered positives for credit scores.

On the other hand, a new account may lower the average age of your accounts, and a hard credit inquiry may slightly drop your score for a while.

Can I consolidate all types of debt?

Many types of debt can be consolidated, including credit card debt, personal loan debt, and student debt. Mortgages and car loans can also be refinanced, though the process is often more complex.

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

Yes, you can still use your credit cards after paying them off via a debt consolidation loan, so long as you’re still in good standing with your credit card company.

Make sure you spend only as much as you can pay off in full every month to avoid paying the same high-interest rate you just took out a loan to avoid.

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

How long it will take to pay off your debt after consolidating will depend on the method you choose to consolidate and the terms of that payment. P

ersonal loans often offer terms between two and seven years, while a balance transfer credit card won’t have a set term, but you’ll want to pay it off before the introductory APR ends.

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

If you’re going to miss a payment on your consolidation loan, first call your lender and explain the situation to them.

Often, especially if the missed payment is due to a job loss and you otherwise have a good payment record, they may be able to work with you to slightly delay the payment or otherwise find a way to avoid triggering late fees or a report to the credit bureaus.

Keep Reading:

• Best Low-Interest Personal Loans
• How To Pay Off Debt Fast
• How To Use a Personal Loan to Pay Off Debt
• Debt Consolidation Pros and Cons
• What Happens When You Default on a Loan?
• What Are Collateral Loans?
• Secured vs. Unsecured Personal Loans
• Co-applicant vs. Cosigner
• 401(k) Loan vs. Personal Loan