How does debt consolidation work?

Debt consolidation works by rolling your existing balances into a new, larger account with a single monthly payment. It can be especially useful for paying down high-interest debt like credit card balances, which grew by $50 billion in the fourth quarter of 2023 alone, according to the Federal Reserve of New York.

You can consolidate your debt with a personal loan, home equity loan or line of credit, or balance transfer credit card. Once you receive the funds, you pay off your various balances and start making payments on the new loan.

How to consolidate debt with a personal loan

The process of consolidating debt with a personal loan is relatively simple. 

1. After comparing loans and lenders, find a loan you want to apply for.
2. Apply for the loan.
3. Review the loan agreement and sign.
4. Instruct the lender to send funds to your creditors directly or to your bank account (some lenders, like SoFi, provide a 0.25 percentage point rate reduction for direct pay).
5. Pay off your debts (loan funding can be as soon as the day you apply, in some cases, or within a few business days of approval).

For example, let's say you have three credit cards that you owe a total of $12,000 on, and the average interest rate across the cards is 20%. You're making a combined monthly payment of $611 in order to pay them off in two years, which means you'd pay a total of $2,657 in interest.

If you qualified for a personal loan to consolidate your debts with a 14.00% APR, and maintain the two-year timeline,you'd pay $576 per month and a total of $1,828 in interest. That's $829 in savings.

Many lenders allow you to view possible rates, terms, and loan amounts you may qualify for through a process called prequalification. You'll need to enter a few pieces of personal information, such as your name, date of birth, and Social Security number. But prequalification is based off of a soft credit pull, so your credit won't be affected. (Proceeding to apply for a loan, however, will trigger a hard inquiry that can ding your score temporarily by a few points.) Prequalification is not an offer of credit, and your final rate may be higher.

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Types of debt consolidation

Unsecured personal loans

Best if: You have good-to-excellent credit

Unsecured personal loans don't require collateral, so they tend to have higher rates and be more difficult to qualify for than secured options. Their rates are lower on average than credit cards - the average rate on a two-year personal loan as of February 2024 is 12.49%, according to the Federal Reserve, compared to 21.59% for cards - and if you have excellent credit (or your score has improved) you may be able to qualify for a rate lower than what you're currently paying. Repayment terms typically range from one to seven years.

Secured personal loans

Best if: You're comfortable risking an asset

These loans require you to pledge collateral - an asset like a car, savings account, or even the fixtures in your home, in some cases - in order to qualify. They're generally riskier, because you can lose your collateral if you don't make payments, but tend to be easier to qualify for than unsecured loans.

Balance transfer credit cards

Best if: You can pay off your debt in the promotional period

You may be able to qualify for a temporary low or 0% APR when you transfer existing debt onto a balance transfer card. This allows you to pay off your debt without incurring interest, but only during the promotional period (usually anywhere from six to 21 months). Typically, there's a fee of 3% to 5% of your total, and risks include a significantly higher interest rate following the promotional period. Missing payments may also cancel the promotional APR offer.

Home equity loans

Best if: You're comfortable using your home as collateral (and have built up enough equity)

If you have sufficient equity in your home (typically at least 20%), you may be able to consolidate your debt using a home equity loan. Because they're secured by your home - you could lose it if you miss payments - these installment loans tend to have lower rates than unsecured options, though may also come with closing costs (usually 2% to 5%). Repayment terms typically range from five to 30 years.

Home equity lines of credit (HELOCs)

Best if: You want a form of revolving debt (and have a home with sufficient equity to use as collateral)

Similar to home equity loans, HELOCs are secured by your house. But rather than receiving a lump-sum payment, HELOCs have a draw period during which you can borrow repeatedly, up to a set limit, while typically making only interest payments. This is followed by a repayment period that can last up to 20 years. Like home equity loans, HELOCs can also come with closing costs.

401(k) loans

Best if: You want to avoid a credit or income check

These loans allow you to borrow from your workplace retirement account, if your plan allows them. The maximum loan amount is generally 50% of your vested balance or $50,000, whichever is less, and you typically have to repay it within five years. You won't have to undergo a credit or income check, and the interest you pay goes back into your account.You may have to fully repay the loan if you leave or lose your job, however. If you don't pay it back, you'll have to pay tax on the balance, as well as a likely 10% penalty if you're under 59 ½.

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Pros and cons of debt consolidation

Pros

• Streamlines your finances.
• Possibility of qualifying for a lower interest rate.
• On-time payments can improve your credit score, as can decreasing your credit utilization by paying off credit card debt.
• May be able to lower your monthly payment.
• Can help you pay off your debt in less time.

Cons

• May require fees, like balance transfer fees, closing costs, origination fees, or annual fees.
• No guarantee you'll qualify for a lower rate, or for a loan with your ideal terms.
• Won't change underlying spending habits that can cause debt to pile up.

How to apply for a debt consolidation loan

1. Determine your goals: This 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 will give an idea of their credit score requirements. If you have a low score, narrow your search to lenders who specialize in loans for bad credit. Visit AnnualCreditReport.com for free copies of your reports.
3. Choose a lender: Based on your goals and credit score, compare types of loans and lenders. Look for low rates and eligibility requirements you can meet. If you're looking into a personal loan, you can often go through the prequalification process to better gauge the rates and terms that may be available to you from different lenders.
4. Gather the necessary information and apply: Once you're ready to apply, you'll typically need to provide 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. It is at this point that you'll undergo a hard credit inquiry that can affect your score.
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?

A debt consolidation loan may be right for you if:

• Your credit score has improved, 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.

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 could allow debt to pile back up.

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

Alternatives to debt consolidation

Consolidation isn't the only option available for tackling debt, whether you can't qualify for a better loan, your debt has become overwhelming, or you'd like to avoid borrowing.

• Debt management plans: Debt management plans enlist the help of a nonprofit credit counseling agency. The agency helps create a payoff plan, - which typically lasts 3 to 5 years - 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.
• 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, before moving on to the next-smallest debt. The avalanche method prioritizes paying off the debt with the highest interest rate first.
• Increase your income: Negotiating a raise, starting a side hustle, or finding a higher-paying job can help you put more money toward your debt.
• Use a budget: Use a budgeting app, such as You Need A Budget, or create your own tool to ensure you're prioritizing paying down your debt each month.
• Negotiate with your lender: While success is by no means guaranteed, you can explain your situation to your lender and ask for a lower rate.
• Bankruptcy: Bankruptcy is a legal proceeding that can stop collections and eliminate some or all of your debt, but should only be used as a last resort. It can cause your credit score to drop by more than 100 points and will stay on your credit report for 7 to 10 years, depending on the type. Speak with an attorney before pursuing bankruptcy.

Debt consolidation 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 likely 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 or forms of consolidation, like a debt management plan, may require you to close your credit cards being paid off. 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 of debt you have, the interest rate you can qualify for, 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 lower interest rate, or put extra money toward your monthly payments, debt consolidation can speed up the repayment process.

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

Missed (or late) payments will drag down your credit score, making it more difficult to borrow in the future. You'll also push your debt payoff further into the future.