How Does Debt Consolidation Work? (2024 Guide) (2024)

If you have debt from more than onesource, a debt consolidation loan is one strategy to combine your balances into one loan with a fixed payment. This option can be easier to manage than making several different payments each month, and it may save you money if the interest rate on the debt consolidation loan is lower than the rates on the initial debts.

However, debt consolidation isn’t the right choice for everyone. Use this guide to learn exactly how debt consolidation works and determine whether it’s your best option.

The basic idea behind debt consolidation is that a borrower can combine multiple debts into one payment. The strategy can help to both simplify their monthly finances and make it easier to understand how debt repayment fits into their budget.

Most debt consolidation loans have a fixed interest rate, which means a borrower’s monthly payments are always the same. To save money in the long run, borrowers would ideally find a debt consolidation loan with a lower interest rate than the average of their existing debts. That way you pay less in interest over the life of the loan.

For example, say you have three credit card accounts with the following balances and annual percentage rates (APRs). APR is a measure of the true cost of a loan, including the interest rate and fees.

• $10,000 at 25%
• $7,500 at 28%
• $6,500 at 29%

Your monthly payments on those credit cards would come out to $630 per month, and you wouldn’t pay them off for 89 months. That $24,000 balance would require $55,611.59 in payments.

Now say you could qualify for a five-year, $24,000 personal loan with a 13% APR to consolidate those credit cards. Your monthly payment would be just $546.07, and you’d be out of debt more than two years quicker – and pay a total of $32,764.43. That’s a savings of nearly $23,000.

You can consolidate multiple debts into a single payment in several different ways. Here are a few options to consider.

Balance Transfer

One option is to use a balance transfer to move debt from several credit cards into one. Many cards offer low- or zero-interest promotional rates on balance transfers. However, the promotional rate usually only lasts for a limited time. After that, you may have to pay a much higher interest rate. Additionally, there may be balance transfer fees, and the promotional rate doesn’t apply to new purchases. If you make a new purchase with the card (even during the promotional period), you may have to start paying the standard interest rate on your entire balance: new purchases and the transferred balance included.

Home Equity Loan

Home equity loans can also act as a debt consolidator. With this type of loan, you borrow against the equity in your home, putting your house up as collateral. The money from this loan can then be used to pay off all your other debts. Home equity loans often require regular monthly payments at a fixed interest rate.

Generally, a home equity loan offers a much lower interest rate than a credit card or unsecured personal loan. However, the risk is also greater — if you default on the loan, you could lose your home to foreclosure. Additionally, the closing costs for a home equity loan can be hundreds or thousands of dollars – including home appraisal fees, attorney fees, title search fees and other costs. These often equate to 2% to 5% of the loan amount, paid out of pocket or rolled into the loan.

Personal Debt Consolidation Loan

With a debt consolidation loan, banks, credit unions or other types of lenders pay all your creditors or give you the money to pay them yourself. The new debt is then rolled into a single balance that is then paid off in regular monthly payments.

Debt consolidation loans often come with lower interest rates than credit cards, as well as fixed payments that ensure you know exactly when your debt will be paid off. However, there may be fees involved. You might also have to meet a minimum credit score threshold of around 670 to qualify.

Debt consolidation isn’t the right choice for every financial situation, but it can be extremely useful in certain circ*mstances. The strategy can be a good choice if you have a high amount of credit card debt, especially if it’s spread over multiple cards with high interest rates. Consolidating your debt into a single loan could also simplify your finances and help you stay motivated with a better understanding of when you’ll be debt free.

Consider this scenario to see how debt consolidation could help. Let’s say you have three different credit cards, each with a different balance and interest rate. Card A has a balance of $8,000 at a 20% annual percentage rate (APR), Card B has a balance of $5,000 at a 22% APR and Card C has a balance of $2,000 at an APR of 18%.

If you decide to pay off all these cards in 12 months, your combined monthly payments would be $1,392.41, and you’d pay a total of $1,708.89 in interest. However, if you get a debt consolidation loan for $15,000 at a 12% APR and pay off the loan in 12 months, your monthly payment would be $1,332.73 and you’d pay a total of $992.78 in interest. The personal loan in this case would save you $59.68 per month and $716.11 in total interest.

Debt consolidation could also be helpful if you have multiple loans with variable interest rates. This means that your lender adjusts the rate based on market conditions on a set schedule. Taking out a fixed-rate debt consolidation loan could give you a single monthly payment that never changes. You would just have to adjust your budget to accommodate the new payment. What’s more, a good payment history can increase your credit score.

Before you start the application process for a debt consolidation loan, assess your current financial situation to determine whether this would be the right course of action. Make a note of all the balances and interest rates on all your debt balances and pull your credit score. Having this information available makes it easier to evaluate loan offers to find the best option.

Additionally, consider applying to more than one lender. Take some time to research different lenders, especially if you’re considering various consolidation options, such as a home equity loan and a personal loan. Your bank or credit union may offer debt consolidation programs, so don’t forget to reach out to them, too. Here’s a step-by-step guide:

1. Compare interest rates and term lengths for different lenders and loan offers.
2. Use a loan calculator to see whether any offers save money over your current situation.
3. Make sure to read the terms so you know about any loan origination fees or prepayment penalties.
4. If you’re considering a credit card balance transfer, verify the promotional APR and how long that rate applies.
5. Check your credit score and calculate your debt-to-income ratio. If either seems problematic, look for ways to increase your chances of approval, such as finding a cosigner, requesting a smaller loan or finding a lender that considers additional factors when verifying eligibility.
6. Gather paperwork to complete the loan application (personal identification cards, proof of income or pay stubs, bank statements and other essential documents).
7. Sign the loan closing papers and verify whether your lender will pay your creditors directly or give you the funds to pay off your debts.

Debt consolidation can offer many benefits, but there are also some disadvantages.

Pros of Debt Consolidation Loans

• Potentially faster repayment: You may pay off your debt faster, especially if the alternative is making minimum payments on multiple credit card balances.
• One monthly payment: Instead of making multiple payments each month, you’ll only have one, which can reduce your chance of missing payments.
• Fixed interest rate: Many debt consolidation loans have a fixed interest rate and repayment term, so you’ll know exactly how much your payments will be and when your loan will be paid off.
• Potentially less money toward interest: If your loan has a lower interest rate than the other debts, you’ll likely save money in the long run.
• Potentially increased credit score: A debt consolidation program can help improve your credit score if you make all your payments on time.

Cons of Debt Consolidation Loans

• Qualification restrictions: You may not be able to qualify for a debt consolidation loan if your debt-to-income ratio is high.
• Fees and penalties: Many debt consolidation loans have associated costs, such as balance transfer fees, origination fees, annual fees and prepayment penalties.
• Longer repayment periods affect interest: If you use a debt consolidation loan to stretch out the repayment period on your loans, you may end up paying more in interest in the long run — even if the new loan has a lower interest rate than the original debts.
• A single solution: Getting a debt consolidation loan usually doesn’t address the underlying issues behind your debt, such as excessive spending.

If you’re not sure that a debt consolidation loan is the right choice for your situation, you may want to consider another option for managing debt. You could create a do-it-yourself (DIY) plan to repay your debt. With this option, it may take you longer to become debt-free than if you got a debt consolidation loan, but you wouldn’t have to go through the time and hassle of applying for one.

There are two popular methods for DIY debt repayment: avalanche and snowball.

• Avalanche: With the avalanche method, you choose the debt with the highest interest rate and pay it off as quickly as possible (while still making minimum payments on your other loans). Once that loan is paid off, you take the money you were using for those payments and apply it toward the loan with the next-highest interest rate, and so on.
• Snowball: The snowball method is the opposite. You start with the debt that has the smallest balance, and once you’ve paid it off, use that money toward the next-highest balance. While the avalanche method can save you more money on interest, the snowball method can help you stay motivated since you can quickly see progress on your overall debt.

Another option is to work with a credit counselor to develop a realistic debt management plan that works for you and your creditors. A credit counselor can provide expert advice and manage your relationship with the companies you owe. With a repayment plan, you’ll transfer the money for your debt payments to a designated account each month, and the credit counselor will use those funds to pay your creditors. You can often find reliable credit counseling services through a credit union or the U.S. Cooperative Extension Service.

The key to getting out of debt is choosing the best strategy for you. If you feel overwhelmed by making multiple payments every month, you can get that down to a single payment through a debt management plan or consolidation loan. If a loan wouldn’t significantly lower your interest rate (or you aren’t sure you’d qualify for one), working with a credit counselor to develop a debt management plan may be the best option.

If you can consistently make monthly payments on all your loans and want a solid strategy to pay them off as quickly as possible, a DIY repayment plan may work well for you. If it’s important to you to save money on interest, the avalanche method might be best. If you feel like some early wins would help you stay motivated to repay all your loans, the snowball approach may be the right call.

Once you get your debt consolidation loan (or choose another repayment strategy), staying on track with your plan is critical for getting out of debt. Consider setting up automatic payments through your bank so you don’t miss any due dates. Creating a comprehensive budget can help ensure you have the money to make your payments, and tracking your progress can help you stay motivated. While you’re getting out of debt, avoid signing up for new high-interest debt, such as credit cards or a high-interest personal loan.

Avoiding Potential Pitfalls

Getting a debt consolidation loan isn’t always a comprehensive, permanent solution to debt. It doesn’t necessarily address the underlying issues that contributed to the debt in the first place. Revisit your spending habits and identify any areas that are problematic, such as impulse purchases. Create a realistic and detailed budget to avoid accruing new debt.

A debt consolidation loan can be a good solution for getting out of debt. This strategy eliminates multiple monthly payments and may save you money if you can get a loan with a lower interest rate than your existing debts. Most lenders consider your credit score and debt-to-income ratio (DTI) when determining your eligibility for a personal debt consolidation loan. DTI measures your monthly earnings against all existing loan payments, like student loans, auto loans or credit cards.

However, a debt consolidation loan isn’t right for every situation. In some cases, a home equity loan, credit card balance transfer, debt management plan or DIY repayment strategy might make more sense. Explore all the available options to choose the one that’s right for your circ*mstances. Whichever strategy you choose to repay your debt, take the time to identify the underlying causes so you can avoid new debt in the future.

Jen Hubley Luckwaldt Editor

Jen Hubley Luckwaldt is an editor and writer with a focus on personal finance and careers. A small business owner for over a decade, Jen helps publications and brands make financial content accessible to readers. Through her clients, Jen’s writing has been syndicated to CNBC, Insider, Yahoo Finance, and many local newspapers. She is a regular contributor to Career Tool Belt and Career Cloud.