What is a debt consolidation loan and how does it work?
November 28, 2023 8 min read
If you’re trying to manage debt, it might seem strange to apply for a new loan or credit card account. But that’s how debt consolidation works: Existing debts are, in essence, combined by paying them off with new debt to create a single monthly payment.
Debt consolidation won’t erase what you owe, but ideally you set yourself up with better terms, such as a lower interest rate to save money. Use this guide to learn more about debt consolidation, including more about how it works, methods for consolidating debt, and some potential pros and cons.
Debt consolidation rolls multiple debts into a single account with one monthly payment.
Consolidating debt might help save money on monthly payments, interest or both.
Consolidating debt won’t erase it.
A debt consolidation loan is a popular option to consolidate debts but not the only one.
What is debt consolidation?
Debt consolidation involves combining multiple debts into one new account with a single monthly payment. It doesn’t erase debt. But combining debts could reduce the number of monthly payments. And if the new loan has a lower interest rate, it may lead to lower monthly payments.
How does debt consolidation work?
When you consolidate debt, you open a new line of credit or take out a loan to pay off existing debts. Seeing an example may help you better understand debt consolidation.
Debt consolidation example
National credit bureau Experian® offers this example of how debt consolidation can work:
Say you have a total credit card debt of $10,000, an average interest rate of 22% and minimum payments that total $400 each month. If you pay only the minimum, it would take you 184 months to pay off your debt. This means you’d end up paying $8,275.44 in interest on that debt.
Now say you pay off that debt with a $10,000 consolidation loan. It has an interest rate of 11% and a fixed monthly payment of $217. That means you can pay off the new loan in 60 months and save more than $5,200 in interest.
If the consolidated loan has a lower annual percentage rate (APR) than your other loans, you might save money. However, be aware of low APR “teaser” rates that revert to a higher APR after an introductory period, which could cost you more in the long run.
What kind of debt can you consolidate?
Debt consolidation loans are generally for paying off high-interest debt. You might be able to consolidate multiple types of debt, including credit card debt, auto loans, home loans and even medical bills. Take a closer look at some common forms of debt you may be able to consolidate:
Credit card debt consolidation can be done through a balance transfer or a loan. If a credit card or loan has a lower interest rate than the original credit card accounts, it might be possible to lower payments.
Depending on the type of student loans, a single loan with one servicer or lender might make it simpler to manage debt. It might also offer more favorable loan terms.
But there may be drawbacks to consolidating student loans. According to the Department of Education, consolidating federal loans could cause you to lose some benefits. It could also end up increasing the total amount you owe or extending how long it takes to pay off everything.
Pros and cons of debt consolidation
Considering potential advantages and risks might help you decide whether debt consolidation is right for you.
Advantages of consolidating debt
A debt consolidation loan might be a good idea if you’re able to:
Find a better APR or interest rate.
Lower your monthly payments.
Reduce how long it takes to pay down your debt.
Use it responsibly to build your credit.
Risks of debt consolidation
Debt consolidation isn’t right for everyone. Here are a few things to keep in mind when considering whether it’s right for you:
Debt consolidation alone won’t eliminate debt.
There could be upfront fees, longer repayment terms or other costs that make consolidation more expensive.
Simplifying payments may not necessarily make the payments lower each month.
When to consider debt consolidation
A debt consolidation loan can be a smart move if it saves you money or if it makes it easier to track and make payments on time. Finding a lower interest rate on your current debt is one important thing to consider.
If you’re not improving your interest rate or payment terms, it might not be worth it. Comparing the loan offers can help you select the one that works best for your situation.
If you’re interested in a debt consolidation loan, it might be worth considering:
Whether the low interest rate lasts a limited time and what it might change to.
Whether there are any other fees or costs associated with the consolidation loan.
Whether the loan term is short enough that you end up paying less over time.
Alternative ways to consolidate debt
There are a few other ways you can consolidate your debts.
Credit card balance transfer
A credit card balance transfer lets you consolidate multiple balances into one credit card account with a new card issuer. And if the credit card has a lower interest rate than your existing accounts do, it could save you money on interest. Remember that balance transfers usually generate a fee based on a percentage of the balance you are moving, which also must be factored into your evaluation.
Some issuers may offer low introductory rates on credit cards. If you’re in a position to pay off your debt quickly, a balance transfer might be a great option. If there is an introductory rate, just be sure you know how it works and when it ends.
If you’re interested in this option, the Consumer Financial Protection Bureau (CFPB) suggests you consider:
How long introductory interest rates apply to transferred balances.
Whether a different rate will apply to any new charges you make.
How your rate could change over time—and what it could cost you—if you don’t pay off your debt.
Whether there are any balance transfer fees.
Debt consolidation programs
Another way to consolidate debt is through a debt management plan. In general, a lump-sum payment is made each month to an organization, which then distributes it among creditors.
But it’s important to be careful about the type of organization you reach out to for help. Nonprofit credit counseling agencies can offer support. But so can less-reputable debt settlement companies.
Working with debt settlement companies can be risky, according to the CFPB. That’s because these companies often charge expensive debt settlement fees. They also typically encourage clients to stop paying bills altogether, which may keep you from being able to use your credit cards in the future. It can also result in late fees and other penalties.
Unless the company actually settles your debt, any savings could be wiped out by those additional costs. And your credit scores could be negatively affected, too. Ultimately, the CFPB says that debt settlement companies could leave you in deeper debt than where you started.
Before working with a credit counseling agency or debt settlement company, be sure to do your research. For example, you could check the Better Business Bureau to see whether previous customers have filed complaints against a company.
Home equity loans and lines of credit
If you have equity in your home, a home equity loan or a home equity line of credit might be options to pay off existing debt. This type of secured loan may offer a lower interest rate because your home is used as collateral. This could also make it risky: If you can’t pay back the loan, you could face foreclosure on your home.
There might be high closing costs with a home equity loan. And if you use your home equity for a loan, it might not be there if you end up needing it in an emergency.
Debt consolidation loan FAQ
Here’s more information about consolidating debt.
How are debt consolidation interest rates determined?
The better your credit scores are, the lower your debt consolidation interest rate might be. You can check your credit for free with CreditWise from Capital One, which gives you your VantageScore® 3.0 credit score and TransUnion® credit report. Using CreditWise won’t hurt your scores. And it’s free for everyone.
You can also get free credit reports from each of the three major credit bureaus by visiting AnnualCreditReport.com.
Does debt consolidation hurt your credit?
In the short term, a debt consolidation loan might negatively impact your credit scores. One reason is a debt consolidation loan requires a hard inquiry. Over the long term, however, making monthly payments on time can help your credit scores. Check out this guide to personal loans and learn how balance transfers might affect your credit.
CreditWise can help too. You can use the Credit Score Simulator to see how scenarios, including applying for a loan or paying off debt, might affect your credit scores.
What else should I keep in mind when consolidating debt?
Before consolidating your debts, be sure to understand a few things about:
- Your debt: You can then take steps to make a budget, adjust the way you spend and potentially change your financial habits for the better.
- Your credit scores: New credit applications could have an impact on your credit scores.
- Your timeline: There’s no quick fix. Some debt settlement companies might charge you upfront with the promise that they can make your debt go away. But as the CFPB explains, debt settlement companies could leave you in deeper debt than where you started.
Debt consolidation in a nutshell
If you have multiple debts, consolidation might be something to consider. A good way to start is by exploring the different debt consolidation options and understanding the interest rates and costs involved.
If a credit card balance transfer is part of your plans, you could check out low-intro APR cards from Capital One.