How to consolidate debt

Managing debt has become increasingly challenging for many, as evidenced by a report on household debt from the Federal Reserve. According to the data, "delinquency rates increased in Q1 2024, with 3.2% of outstanding debt in some stage of delinquency." This rise in delinquency highlights that households are dealing with growing financial pressures making effective debt management strategies more critical than ever.

One approach that can help is debt consolidation.

What is debt consolidation?

Debt consolidation is the process of combining multiple debts into a single one with a new annual percentage rate (APR) and repayment term. For example, if you have $10,000 in credit card debt across several cards, you could use a debt consolidation loan to pay off those cards.

While the total debt remains the same, it's now consolidated into a single loan, ideally with a lower interest rate and monthly payment. There are several debt consolidation options, and the best method depends on your individual circumstances.

Learn more: What is debt consolidation?

Compare debt consolidation loan rates

Ways to consolidate debt

Personal loans for debt consolidation

Personal loans are offered by banks, credit unions, and online lenders. They typically come with lower interest rates than credit cards - the average APR on a two-year personal loan was 12.49% versus a credit card at 21.59%, according to the most recent data from the Federal Reserve.

Repayment terms range from two to seven years, depending on the lender. Additionally, the repayment term you choose plays a significant role in determining your monthly payment along with the APR you qualify for. A longer repayment period generally means you'll have a lower monthly payment, but pay more overall in interest. A shorter term, meanwhile, means you'll likely have a higher monthly payment, but pay less interest over the life of the loan.

One benefit of consolidating debt with a personal loan is the speed at which it can be funded. If approved, you could have your debts consolidated within days of applying, and some lenders even offer same-day funding. Additionally, you may qualify for a rate discount if you instruct the lender to remit funds directly to your creditors.

Learn more:

• How to use a personal loan to pay off debt
• Average personal loan interest rates

Balance transfer credit cards

Balance transfer cards can have 0% APR introductory offers that last from six to 21 months or longer. In exchange for paying a balance transfer fee (generally 3% to 5% of the transferred amount), you can avoid interest for the duration of the promotional period.

Since promotional periods aren't as long as the repayment terms of other forms of debt consolidation, monthly payments may need to be higher in order to pay off the amount transferred within the 0% APR period.

Home equity loans and home equity lines of credit

If you own a home that's accumulated equity, you may have the option to borrow against it to pay off some or all of your other debts. You can typically borrow up to 80% equity in your home. For example, if your house is worth $350,000, your maximum loan-to-value ratio would be $280,000 (80% of $350,000). If you already have a mortgage balance of $250,000, your maximum home equity loan amount would be $30,000. Once approved, you can generally use the loan funds as you see fit.

Home equity loans are secured and can last from five to 30 years, which can help lower monthly payments, but could substantially increase the amount you'll pay toward interest if you opt for a longer term.

Rates for secured loans tend to be lower compared to unsecured loans, like personal loans. This makes it crucial to compare rates, terms, and total interest payments for all types of loans you're considering.

Be prepared to go through a longer application and approval process with a home equity loan. Unlike personal loans, they can take a month or more to close.

Retirement loans

If you have money in a 401(k), 403(b) or 457(b) retirement account, you may have the option to take out some of those funds in the form of a loan. These are limited to half of your vested account balance, up to $50,000, and typically come with a five-year repayment requirement. However, some plans allow you to borrow up to $10,000 if half your vested balance is less than $10,000.

A 401(k) loan or other type of retirement loan is generally not advised, as it could set your retirement savings back years. Plus, they can have severe tax consequences if you can't pay back the loan. However, they may be an option if you have bad credit and need a loan, as there is no credit requirement since you are borrowing from your own account.

How to apply for a debt consolidation loan

Before you apply, it's vital to shop debt consolidation lenders and prequalify with more than one to find the best rates and terms. Prequalifying can help you understand if you're likely to qualify, and if so, what your personal loan terms may look like. Plus, it won't impact your credit. (Prequalification is not a promise of your actual rates and terms.)

Then, apply with your preferred lender online, at which point the lender will conduct a hard credit pull that could ding your score by a few points. In addition to personal information like your Social Security number and income, you'll be asked about the debts you want to consolidate, including account numbers, and how much money you want the lender to pay out to each account (if the lender is paying your creditors directly).

Once approved, your debts could be paid off within days and you would begin making payments on the new loan.

Can you consolidate debt with bad credit?

It's possible to consolidate debt with bad credit (a FICO score below 580) — but you may not be able to access the best rates and terms. You can improve your chances of approval by applying with a cosigner or with a co-borrower to get your loan approved. A cosigner is responsible for loan payments if you don't make them, but has no access to the loan funds, while a co-borrower shares responsibility for the loan and has equal access to the funds.

Both co-borrowers and cosigners will likely see their scores drop if you miss payments or default (as will you), so make sure you can comfortably afford the payments. Some lenders also offer secured personal loans, which can be easier to be approved for.

Lenders that consider applicants with bad credit

Alternatives to debt consolidation

Debt management plan (DMP)

A DMP is a structured repayment program designed to help you manage and repay unsecured debts. Reach out to a credit counseling agency for debt management options. If you go this route, a credit counselor may be able to negotiate on your behalf with creditors to lower your payments, remove fees, or reduce your rates.

The repayment plan may have monthly fees, and you'll generally need to close any accounts that will be part of the plan (which could damage your credit).

Debt settlement

Debt settlement sometimes gets confused for a DMP, but it's very different, and generally not advised. Debt settlement typically requires you to pay fees to a company that negotiates with your creditors to reduce your debt, lower the amounts owed, or change the terms to make it more affordable.

However, you may be required to stop making payments as a negotiation tactic, which could severely damage your credit and even open you up to legal action by your creditors. Plus, there's no guarantee the approach will work or that negotiations will be successful.

Negotiate directly with creditors

You can also call your creditors and try to negotiate directly with them for free. Some creditors offer hardship programs, which can temporarily lower or pause your payments. If no hardship programs are offered, you could still attempt to get fees waived, lower your interest rate, or reduce your balances.

Bankruptcy

If you can't see yourself affording payments, or have dug yourself too deep into debt, bankruptcy may be your best choice.

Consult with a credit counselor first, to see if there are other options. If not, find a bankruptcy attorney to see whether you're eligible for Chapter 7 or Chapter 13, and which makes the most sense for your goals and financial situation.

In either case, bankruptcy will have major negative effects on your credit — your score could drop 100 points or more, depending on what your score is when you file. Plus, it can stay on your credit report for up to 10 years for Chapter 7 or seven years for Chapter 13. This option should be considered a last resort due to the negative impacts on your credit.

How to consolidate debt FAQ

How do debt consolidation loans work?

When you get a debt consolidation loan, the funds are used to pay off your existing debts. From there, you'd make payments to your new lender until the debt is paid off. You may also have to pay fees, like origination fees (up to 12%), depending on the lender.

Learn more: How does debt consolidation work?

What is debt relief compared to debt consolidation?

Debt consolidation is often a credit-dependent tool that combines multiple debts into a new single loan with its own rates and terms. With debt relief, a private company attempts to get some of your debts forgiven or have the terms changed. This is also called debt settlement. There is no guarantee of success, however, and debt settlement can have a major negative impact on your credit.

Does debt consolidation hurt your credit?

Opening a new line of credit may cause a small drop in your credit score — usually no more than five points, and usually for only up to a year. But if you're able to make your monthly payments and you use debt consolidation to lower or eliminate your current balances, you should see an increase in your score in the long term.

Related articles:

• Best personal loans
• Best personal loan rates
• Where can I get a personal loan?
• Do personal loans affect your credit score?
• How to get out of debt with bad credit
• Ways to consolidate credit card debt
• Types of debt consolidation loans