What is debt consolidation and how does it work
Consolidating your debt could reduce your interest rate, lower your minimum monthly payment, and simplify your finances. There are several debt consolidation options, and understanding each of them can help you choose the most efficient path to pay off your debt.
Here’s what to know about debt consolidation and how it works.
What is debt consolidation?
Put simply, debt consolidation merges multiple debts — such as loans and credit card balances — into a single loan. This new loan can potentially have a lower interest rate and monthly payment compared to what you’re currently paying, depending on your credit and other factors.
For example, let’s say you have high-interest credit card debt with a 22% variable annual percentage rate (APR). If you have decent credit (usually 650+), you could take out a personal loan to consolidate your debt and qualify for a lower, fixed interest rate of 15%. As a result, you would pay less interest, avoid future rate hikes, and have a predictable monthly payment to easily track your payoff progress.
Find out: How does credit card interest work?
How debt consolidation works
Debt consolidation conveniently restructures your existing debts into a single loan with a new interest rate, monthly payment, and repayment schedule. Here’s a brief overview of how the process works:
- Compare debt consolidation lenders. The primary goal of debt consolidation should be to get a better rate and more favorable terms to help you get out of debt faster. Shop around and compare your options with as many debt consolidation lenders as possible to find a loan that will help you meet this goal. For example, you might look into lenders that offer a personal loan or credit card for debt consolidation.
- Pick a lender and apply for a debt consolidation loan. After you’ve done your research, choose a lender and fill out an application. Keep in mind that the lender will perform a hard credit check when you apply to determine your creditworthiness as well as your rate and loan amount.
- Get the funds and pay off your debts. If you’re approved, you can use the money from the loan to pay off your accounts, such as loans and credit cards. Some lenders might even send these funds directly to your creditors to simplify the process.
- Start your new repayment schedule. After your loan has been processed and your former creditors have been paid, you’ll begin your new repayment schedule. This will involve making just one monthly payment to your new lender with a clear payoff timeline. Having a lower monthly payment might also help you get ahead financially — you could use these extra funds to make additional loan payments or save them for a rainy day.
Types of debt consolidation
Here are some of the most common ways to consolidate debt:
- Personal loans: With a personal loan, you can get a fixed rate and monthly payment, simplifying your . Loan amounts can range from a few hundred dollars up to $100,000 and repayment periods are typically one to seven years, depending on the lender. This option usually doesn’t require collateral, and rates can be competitive if you have good to excellent credit.
- Balance transfer credit cards: This option allows you to consolidate credit card balances on a single card. You’ll generally pay a balance transfer fee for each balance that you move to the new card. Many of these cards provide an introductory APR as low as 0% — typically for 12 to 21 months, depending on the card. After this period ends, you’ll pay the standard APR on any remaining balance.
- Use your home’s equity: Using a home equity loan or home equity line of credit (HELOC) let you tap into your equity while using your home as collateral. Because this is less risky for the lender, you could qualify for larger loan amounts and more favorable rates than with unsecured loans or credit cards. You’ll typically need at least 15% to 20% equity to be eligible.
- Debt management plans: If you struggle to qualify for loan products, you might consider working with a non-profit credit counselor certified by the National Foundation for Credit Counseling (NFCC). While your personalized debt management plan won’t be a loan, you’ll have a structured payoff program. Your counselor might also be able to reduce or waive interest rates and finance charges while you work to pay your accounts in full.
Which type is right for you?
The best consolidation option depends on your creditworthiness, debt portfolio, and ability to repay. But to make it easier, we’ve put together a comparison so you don’t have to do all the legwork.
| Personal loan | Balance transfer credit card | Home equity loan | HELOC | Debt management plans | |
|---|---|---|---|---|---|
| Average loan limit | $300 to $100,000 (depending on the lender) | $1,000 to $15,000 | Up to 90% of your home’s value (minus what you still owe on your mortgage) | Up to 90% of your home’s value (minus what you still owe on your mortgage) | Not a loan (existing balance) |
| Interest rate type | Fixed | Variable | Fixed variable | Variable | Fixed or variable |
| Repayment period | 1 to 7 years | Open-ended | 5 to 30 years | Up to 20 years (following draw period of 10 to 15 years) | 2 to 5 years |
| Typical fees | Origination fee: 0% to 10% of loan amount | Balance transfer fee: 3% to 5% of amount transferred | Closing costs: 3% to 6% of loan amount | Closing costs: 2% to 5% of loan amount Annual fee: Up to $100 | Setup fee: $25 to $75 Monthly fee: $20 to $70 |
| Collateral requirements | Usually none | None | 15% to 20% home equity | 15% to 20% home equity | None |
| Minimum credit score | 670 (some lenders accept much lower scores, but with higher rates) | 670 | 620 | 620 | None |
| Best for | Affordable, fixed monthly payments | Small balances that can be paid off during 0% APR period | Homeowners with sufficient equity who prefer a fixed rate and set payments | Homeowners with sufficient equity who prefer ongoing access to funds | Poor or thin credit |
When debt consolidation makes sense
There are several scenarios where consolidating multiple debts into a single loan can make sense. You might consider debt consolidation if:
- You have high-interest debt, such as credit cards with high variable rates.
- You could qualify for a lower interest rate than what you’re currently paying.
- You’d save more money on interest than you’d pay in borrowing costs, such as in origination or balance transfer fees.
- You want to simplify your repayment and have just one monthly payment to manage (instead of multiple).
- You have a plan to avoid taking on new debt while you pay off your balance.
- You’re comfortable with a hard credit check and the slight drop in your credit score it can cause.
- You’re not happy with the service you get from your current creditors and want to work with a different company.
While the above situations can make debt consolidation worth the effort, it isn’t the right fit for everyone. For example, if you will only save a minimal amount on interest or don’t want to undergo a hard credit check, then other payoff solutions might be better.
Pros and cons of debt consolidation
Here are the key advantages and disadvantages of debt consolidation to consider:
Pros
- Lower interest rate, saving you money on total cost
- Single monthly payment
- Ability to switch from a variable rate to a fixed rate (or vice versa)
- Can close unwanted accounts
Cons
- Fees may apply (origination or balance transfer fees)
- Typically need good to excellent credit to qualify and to get the best rates
- Will require a hard credit check when you apply
- Having more available credit might tempt you to overspend and accrue more debt
Debt consolidation FAQs
Whether it’s a good idea to consolidate debt or not depends on your circumstances. For example, consolidating debt can be worth it if you could save a substantial amount on interest — like if you consolidate high-interest credit card debt with a more budget-friendly personal loan. Simplifying your finances with one, potentially lower, monthly payment could also be worth the extra effort upfront.
However, debt consolidation likely isn't worth it if you won’t qualify for a lower interest rate, the fees are too high, or you’re likely to go further into debt after paying off your balances. In these situations, you might consider making extra payments to pay off your accounts early instead.
No, it won’t. Debt consolidation is a way to refinance your existing balances into a new loan with a different rate and repayment period. While this strategy won’t erase your debt, you could pay less interest overall if you are able to qualify for a lower rate or switch to a shorter repayment term to get out of debt sooner.
Because debt consolidation involves applying for a new loan, it can temporarily impact your credit score due to the hard credit inquiry and opening of a new credit account. Closing existing loans and credit cards can also impact your credit profile.
Thankfully, your score is likely to rebound if you consistently make on-time payments on your new loan. You can also help your score to recover by maintaining a low credit utilization ratio.
A debt consolidation loan is a type of loan used to combine multiple debts into one, while a debt management plan is a structured repayment program typically managed by a credit counseling agency.
Both debt consolidation loans and debt management plans combine your balances into one monthly payment to potentially help you save money on interest and pay off your debt faster. However, consolidation loans usually require good credit to qualify. They also allow you to decide which accounts to pay off or balances to transfer — so you don’t.
Debt management plans, on the other hand, don’t require a credit check and can be ideal for borrowers with bad credit who can’t get approved for a debt consolidation loan or don’t qualify for an acceptable rate. With a debt management plan, you’ll work with an accredited, non-profit counseling agency that will determine if this approach is beneficial and coordinate payments with your existing creditors.
About the authors
Writer
Josh Patoka has been writing for publications like Fox Business, Forbes Advisor, and USA Today Blueprint for 10+ years.
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