What is debt consolidation?

Credit card debt grew 17.4% by $1 trillion in 2023, according to Experian data. At the same time, credit card interest rates increased by over 5%, according to the Federal Reserve - from an average 16.26% in 2022 to 21.59% in February of 2024. 

That adds up to a lot of people paying a lot more in interest on their cards, which is where debt consolidation comes in. Debt consolidation involves paying off multiple debts with a single loan, where the new loan often has a lower interest rate and lower monthly payments. By paying off credit card debt (or any other high-interest debt) with a loan, you can potentially lower your monthly payments, save money on interest, and pay off debt sooner. Here's how.

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 are the most common. Here are a few examples of how debt consolidation can work:

Scenario 1: Faster debt payoff

Let's say you have a couple of high-interest credit cards that you want to pay off in the next three years. Your current credit card accounts are as follows:

Now, let's say you secure a three-year loan of $6,500 with an annual percentage rate (APR) of 17.5%. With these terms, your monthly payment increases to $233, but you'll pay the loan off two years sooner and pay only $1,901 in total interest (over $3,000 less). Budgeting for a slightly higher monthly payment and consolidating your loans can help you get out of debt faster.

Scenario 2: Lower monthly payments

If you need lower monthly payments, a debt consolidation loan with a fixed interest rate and long repayment term might help. High-interest loans, especially if interest compounds or variable rates increase, can have high monthly costs. Let's consider the same credit cards from the prior example with the same total monthly payment of $196.

If you're able to get a $6,500 debt consolidation loan with the same APR of 17.5% but a loan term of five years (instead of three), your payment would drop to $163 per month, saving you $33 monthly. If instead, you chose a seven-year loan term, your monthly payment would drop to $135 per month, saving you $60 per month. In either case, you'd still pay less interest overall - even with a longer loan term.

Scenario 3: Improve credit score

Improving your credit score with a debt consolidation loan is possible by making your payments on-time and in-full. Your payment history makes up most of your FICO credit score (35%). So, staying on top of your payments can help increase your score over time.

In addition to improving your payment history, a debt consolidation loan can improve your credit utilization ratio - almost overnight, in some cases. Your credit utilization ratio is the percentage of available credit you're using on your cards and other lines of credit. This ratio contributes to the amount of debt you have, which impacts 30% of your credit score.

Benefits of debt consolidation

• Lower monthly payment: If your current monthly payment is unaffordable, or you're only able to pay the minimum, a debt consolidation loan could 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, and qualify for a loan with a lower interest rate, you could save money on interest.
• One payment: Instead of having to manage multiple payments, 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 could pay off your debts faster.
• Improve your credit score: If you use a loan to consolidate credit card debt , you can improve your credit score in two ways. One, you increase your available credit, thereby reducing your credit utilization, which accounts for up to 30% of your FICO score. Two, you make on-time payments, which benefits your payment history, which is 35% of your FICO score.

Types of debt consolidation loans

There are a few different types of debt consolidation loans, including personal loans, home equity loans, and balance transfer credit cards. The best one depends on 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 for debt consolidation

Best for multiple high-interest loans, those with good credit, and if you need money quickly

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.

Repayment terms and loan amounts

Repayment terms are generally available from two to seven years, and loan amounts may be available up to $100,000, or more, depending on the lender. Plus, you could be approved (and your debt consolidated) within days of applying.

Interest rates

Personal loan interest rates swing widely, depending on your credit profile. The best available rates may be around 7.00% or lower, while the highest are near 36.00%. If you have bad credit (a FICO score below 580), you may need to apply with a cosigner or get a secured personal loan to qualify or lower your rate.

Creditor-direct payments

If you're approved for a personal loan to pay off debt, most lenders are able to pay your creditors directly, so you don't have to handle those transactions. Plus, some, like Universal Credit and Upgrade, offer discounts when you use a personal loan to consolidate debt and the lender pays your creditors directly.

Balance transfer credit cards

Best for a short repayment period

If you have a good credit score (a 670 FICO score or higher), you may qualify for a balance transfer card with a low or 0% introductory rate.

Repayment terms and interest rates

These promotional periods typically last from 12 to 21 months, after which the rate adjusts to the credit card's standard rate, which can range from around 18.00% to 28.00%, or more.

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.

Creditor-direct payments

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

Best if you have sufficient equity and are comfortable using it as collateral for a low APR

A home equity loan lets you borrow a lump sum of cash based on the amount of equity you have in your home and pay it back over a period of up to 30 years. But you risk foreclosure if you fall behind on payments.

Equity requirement

Generally speaking, lenders require that you maintain a maximum loan-to-value of 80%, meaning the amount of your mortgage plus any home equity you borrow can't exceed 80% of your home's value. But be prepared to wait a month or more for the loan to close, and to pay closing costs of 2% or more.

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 to qualify.

Important: A cash-out refi is rarely a good idea if you can't qualify for a lower interest rate.

Interest rates

Home equity loan interest rates are usually lower than rates on personal loans because your home is used as collateral. Plus, they're typically fixed (meaning, the rate and payment won't change). If you get a home equity line of credit (HELOC), however, the rate will likely be variable, and could increase.

How to consolidate debt

The debt consolidation method you choose depends on a thorough analysis of your situation, what you qualify for, and your preferences. For example, you might choose a personal loan for quick funding or to avoid putting your home at risk, or a home equity loan for a low APR, or a balance transfer offer if you can pay debt off within the promotional period.

1. Evaluate your debts: Review your outstanding balances, including the amount owed, the interest rate, and each debt's status (such as up to date or in default). Prioritize the most expensive loans and those in default or collections since they're likely costing you the most and lowering your credit score.
2. Compare APRs: Compare personal loan APRs and terms with other debt consolidation methods by getting prequalified. 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 score.
3. Choose the right consolidation method: Compare interest rates, monthly payments, loan terms, and whether the new loan has a variable or a fixed rate. You'll have the most options if you have excellent credit and home equity.
4. Apply: Gather necessary documents, 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 need 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, like SoFi which offers a 0.25% interest rate reduction.

Debt consolidation loan rates

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.

What to watch out for

• Balance transfer credit card: Credit card balance transfers can backfire if you don't pay the amount off within the promotional period, and the interest rate adjusts to the card's standard APR. A home equity loan or personal loan can provide years of fixed monthly payments at a fixed interest rate.
• Personal loan for debt consolidation: Personal loans can help you consolidate debt within a matter of days and are available if you don't own a home or have enough equity for a home equity loan. But they may have higher rates than other loan types for debt consolidation.
• Home equity-based loans: Home equity loans and cash-out refinances put your home at risk if you can't make payments. Personal loans and credit card balance transfers do not.

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 higher APR. 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.