5 types of debt consolidation loans

According to an ongoing review of consumer debt by Experian, total consumer debt rose to $17.1 trillion in 2023, up 4.4% from 2022's $16.38 trillion. Coincidentally, interest rates have also increased, especially for credit cards. If you're finding an increased debt load difficult to manage, refinancing debt or consolidating it with a debt consolidation loan can help.

How does debt consolidation work?

Debt consolidation can reduce your interest rates, simplify your accounts, and lower your monthly payments by combining multiple debts into a single loan and payment. Whether you use a personal loan to consolidate debt, a balance transfer to refinance credit card debt, or tap into your home equity, debt consolidation generally proceeds in the following way:

1. Apply for a debt consolidation loan.
2. Once approved, either pay off your creditors with the loan's proceeds or direct the new lender to send money to pay off each of your accounts.
3. Make payments on the new loan.

Debt consolidation works best when you can shift high-interest debt, like credit card debt, to a new loan with a lower interest rate. For example, the average credit card interest rate is 21.59%, according to recent Federal Reserve data, while the average rate on a two-year personal loan is 12.49%.

That's more than a nine percentage point difference. Put another way, if you could reduce the rate you'd pay on $10,000 worth of debt by 9 percentage points over two years, you could save about $1,000 in interest.

Ways to consolidate debt

Pros and cons of debt consolidation

Pros

• Simplified repayment: Consolidating multiple debts into a single loan or payment can simplify your finances by reducing the number of creditors and payments you need to manage each month.
• Potentially lower interest rate: If you qualify for a consolidation loan with a lower rate than your existing debts, you may save money on interest over time.
• Fixed repayment schedule: If you consolidate with an installment loan, you'll have a fixed repayment schedule, making it easier to budget and plan for monthly payments.
• Chance to improve credit score: Successfully managing a consolidation loan and making timely payments can positively impact your credit score over time, as it demonstrates responsible financial behavior.
• Potential debt relief: Consolidation can provide immediate relief from high-interest debts and financial stress, helping you regain control of your finances and work toward becoming debt-free.
• Lower monthly payments: Either a lower interest rate, a longer repayment period, or both can contribute to lower monthly payments.
• Faster debt payoff: If you can secure a lower interest rate but continue to make the same monthly payments toward your debt, you'll pay it off faster.

Cons

• Risk of accumulating more debt: Consolidating your debts doesn't necessarily address underlying spending habits or circumstances that can lead to it piling up again. Accumulating more debt on top of the consolidation loan could leave you in a worse place than you started.
• Potential fees and costs: Some debt consolidation options come with fees or closing costs that add to the overall cost of consolidation. Personal loans may have origination fees, for example, that can increase how much you need to borrow to consolidate, as they're usually deducted from the funds before you receive them.
• Risk of losing collateral: If you use collateral, such as your home or car, to secure a consolidation loan and are unable to repay the debt, you risk losing the collateral.
• No guarantee you'll save money: Depending on your goals for consolidation, you may not necessarily see interest savings. Opting to extend your repayment period for a lower monthly payment, for example, could result in higher total interest costs over time.
• Not suitable for everyone: Debt consolidation may not be the best option for everyone, particularly if you're unable to qualify for a consolidation loan with favorable terms or can't address underlying causes of debt..

Personal loan for debt consolidation

Best for consolidating credit card debt and fixed interest rates

A personal loan is one of the most popular tools for debt consolidation. These are typically fixed-rate installment loans, meaning you receive the money in one lump sum and repay it in fixed monthly payments (installments) over a set period. Repayment terms generally range up to seven years, depending on the lender; annual percentage rates (APRs) can range from around 7% to 36%, depending on your credit profile.

Personal loans could be a good fit if you want a no-fuss, unsecured loan. Unlike a home equity loan for debt consolidation (if you have that option), you generally don't have to provide collateral that the lender can seize if you miss payments. And personal loans can be approved within days - the same day, in some cases - unlike home equity loans.

Simple interest vs. compound interest

Another important benefit is that personal loans have simple interest, while credit cards have compounding interest. This means the interest on a personal loan only applies to your principal balance, which is the amount you initially borrowed.

However, on a credit card, interest is charged on the borrowed amount and on prior interest charges you haven't paid. In other words, interest accrues interest, which can cause your balance to swiftly increase. This is only an issue, however, if you don't pay off your balance each month.

Best debt consolidation lenders

0% APR credit card

Best if you can pay off debt within the introductory period

If you're paying off credit card debt, a 0% APR balance transfer offer can help you get there. A balance transfer is the process of transferring your balance from one credit card to another, typically for a flat fee from 3% to 5% of the transferred amount.

Many credit card issuers offer introductory deals in which you pay 0% on purchases and balance transfers for a certain period - often anywhere from six to 21 months or more. During that time, you won't pay any interest on your balance.

Risks of using a balance transfer for debt consolidation

A balance transfer is ideal if you know you can pay off your debt within the introductory period. In this case, a balance transfer could be your cheapest debt consolidation option. However, because credit cards can have high interest rates and compounding interest, this may not be the right fit if you can't repay your debt within the introductory period. And, if you miss payments, the promotional period may be canceled and the balance subjected to a penalty APR.

0% APR balance transfer cards also aren't suitable for everyone. These cards often require good credit (a FICO score of 670), meaning borrowers with fair or poor credit may need to find an alternative solution.

Home equity loan for debt consolidation

Best if you have home equity and are comfortable using it as collateral

A home equity loan is similar to a personal loan in that it has a fixed interest rate and fixed monthly payments, and can be used for nearly any purpose. But there's one important difference: While a personal loan is usually unsecured, a home equity loan is secured by your home. This means you risk foreclosure if you stop making payments.

Because they are backed by a valuable piece of collateral, home equity loans often have lower interest rates than personal loans (though closing costs can amount to 2% to 5% of the loan amount).

Equity requirement

Home equity loans are often referred to as second mortgages, and you need sufficient home equity to qualify. Generally speaking, lenders prefer that the total of all debt you have on your home does not exceed 80% of its market value.

For example, if your house is worth $350,000, you could borrow up to $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.

HELOC

Best if you prefer a revolving line of credit and are ok with a variable interest rate

A home equity line of credit (HELOC) combines the features of a credit card and a home equity loan. Like a home equity loan, a HELOC is secured by your home and the same general equity requirements apply. But it's not an installment loan you receive in a lump sum.

A HELOC is a revolving credit line. You have access to a certain amount of money, just like with a credit card, but you don't necessarily have to use all of it. However, you must repay with interest on the portion you borrow. Unlike home equity loans, HELOCs usually have variable interest rates, meaning they may fluctuate with market conditions.

HELOC risks

HELOCs can be used for debt consolidation. However, they may not be the best fit. They are often better suited to long-term spending needs like home renovations. Additionally, the variable interest rate is a risk. Even if you start with a low interest rate, it's not guaranteed to stay there. Plus your home is at risk if you default.

Student loan debt consolidation

Best for financing education debt

Student loan debt consolidation and refinancing can offer similar benefits to other debt consolidation. Depending on the type of loans you have and avenue you take, you could get a lower interest rate, lower monthly payment, a payment structure that works better for you, or reduce your number of student loans.

If you have multiple federal student loans, you may be able to combine them into a single loan with a Direct Consolidation Loan. But whether this is worth it depends on the types of loans you're looking to consolidate and your goals for repayment, as you may lose access to certain benefits even with a Direct Consolidation Loan. Before consolidating or refinancing student loans, always check with your student loan servicer to better understand the implications.

Private student loans can't generally be consolidated, but instead refinanced into a new private student loan. Unlike with federal loans, there's generally little downside to refinancing private student loans if you can land a lower fixed interest rate.

401(k) loan

Best if you have a large 401(k) but fair or bad credit

Using a 401(k) loan as a form of debt consolidation involves borrowing against the funds held in your retirement account to pay off existing debts. While it's not a traditional loan in the sense of borrowing from a bank or lender, it can serve the purpose of consolidating multiple debts into a single payment.

One of the primary benefits of using a 401(k) loan for debt consolidation is if you have bad or fair credit. Since the loan is secured by your retirement savings, there's typically no credit check or lengthy approval process required. Compared to some other forms of debt, such as credit cards or personal loans, 401(k) loans may offer lower interest rates as they are usually based on the U.S. prime rate plus 1% to 2%. Meaning, the highest interest rates can go now is around 9.50% to 10.50%.

401(k) loan risks

However, despite some benefits, there are significant risks to borrowing from your 401(k). These include the potential for early withdrawal penalties and taxes if you're unable to repay the loan according to the terms, as well as the long-term impact on your retirement savings.

Before deciding to use a 401(k) loan for debt consolidation, strongly consider alternative options and consult with a financial adviser to ensure it aligns with your overall financial strategy and retirement goals.

How to qualify for debt consolidation

1. Credit score: Your credit score is a critical factor in determining your eligibility for a debt consolidation loan. Lenders prefer borrowers with a good- to- excellent credit score, typically defined as a FICO score of 670 or higher.
2. Credit history: In addition to your credit score, lenders review your credit history to assess your borrowing behavior and repayment habits. A history of missed payments, defaults, or bankruptcy may negatively impact your eligibility for a debt consolidation loan.
3. Income and employment: Lenders assess your income and employment status to ensure you have the financial means to repay the loan. A stable income and steady employment history indicate your ability to make timely payments.
4. Debt-to-income ratio: Your debt-to-income ratio (DTI) compares your monthly debt payments to your gross monthly income. Lenders use this ratio to evaluate your ability to manage additional debt responsibly. A lower DTI indicates that you have more disposable income available to repay the loan. Lenders typically like to see a DTI no higher than 36%.
5. Prequalify: If you are applying for a debt consolidation loan with a lender that allows prequalification, go through the steps to see what your rates could potentially be. Prequalification typically requires a soft credit pull, which does not impact your credit score. The rates you are shown are not final offers and are subject to change once you officially apply.

To improve your chances of qualifying for a debt consolidation loan, improve your credit score, reduce your debt-to-income ratio, and maintain a stable source of income. Additionally, shop around and compare loan estimates from multiple lenders to find the best terms and rates that suit your financial needs.

How to get a debt consolidation loan

1. Assess debts: Assess your existing debts, including credit card balances, personal loans, medical bills, and other outstanding obligations. Make a list of each debt, including the total amount owed, interest rate, and minimum monthly payment.
2. Explore consolidation options: Once you have a clear understanding of your debts, explore various debt consolidation options to determine the best approach. Common consolidation methods include personal loans, 0% balance transfer cards, home equity loans or lines of credit, and 401(k) loans.
3. Apply: Once you've chosen a debt consolidation option, apply for the loan or program and undergo the approval process. Lenders will evaluate factors such as your credit score, income, employment history, and debt-to-income ratio to determine your eligibility and the terms of the consolidation.
4. Pay off existing debts: If approved for a consolidation loan or program, use the funds to pay off your existing debts. This may involve direct payments to creditors or transferring balances to the new loan or credit card.
5. Repay consolidation loan: With your debts consolidated into a single loan or payment, you'll make regular monthly payments according to the terms of the consolidation. This may involve a fixed monthly payment with a personal loan or minimum payments with a balance transfer credit card.
6. Monitor progress: As you repay the consolidation loan or program, monitor your progress and stay committed to your debt repayment plan. Make timely payments, avoid taking on new debt, and consider additional strategies for accelerating debt payoff, such as increasing your monthly payments or making extra payments when possible.

Alternatives to debt consolidation

While debt consolidation can be an effective strategy for managing multiple debts, it's not the only option available.

Budgeting and financial planning

Sometimes, the best way to tackle debt is by creating a realistic budget and sticking to it. By carefully tracking your income and expenses, you can identify areas where you can cut back and allocate more funds toward debt repayment. Once you have an idea of how much you can put toward your debt each month, consider either the debt snowball or avalanche method to identify your payoff priorities.

Increasing income

If your current income is insufficient to cover your expenses and debt payments, consider ways to increase your income. This could involve taking on a part-time job, freelancing or consulting work, selling unused items, or pursuing opportunities for career advancement or education to boost your earning potential.

Credit counseling

Credit counseling agencies offer financial education and counseling services to help individuals manage their debts and improve their financial literacy. A credit counselor can provide personalized advice and assistance with budgeting, debt repayment strategies, and negotiating with creditors. You can reach out to 211.org or the National Foundation for Credit Counseling for more information.

Debt management plan (DMP)

A DMP is a structured repayment plan offered by a credit counseling agency. Under a DMP, you make a single monthly payment to the credit counseling agency, which then distributes the funds to your creditors on your behalf. Creditors may agree to lower interest rates or waive fees as part of the plan, making it easier to pay off your debts over time.

Bankruptcy

In severe cases of financial distress, bankruptcy may be a last-resort option. Filing for bankruptcy can help eliminate or restructure debts, providing a fresh start for you. However, bankruptcy has serious long-term consequences and should only be considered after exploring all other alternatives and consulting with a qualified bankruptcy attorney.

FAQ

Can I still use my credit card after debt consolidation?

As long as you or your credit card issuer hasn't closed the account, you can typically still use your credit card after debt consolidation. If you enroll in a debt management plan, however, you'll likely be required to close any cards covered under the program as a condition of enrollment. This is meant to help prevent you from re-accumulating debt.

How do I get a debt consolidation loan?

You can get a debt consolidation loan by applying directly with any lender that offers the type of product you want. In the case of personal loans and balance transfers, you may be approved relatively quickly (as soon as the same day, in some cases). Secured loans such as home equity loans and HELOCs, however, tend to have longer approval and underwriting periods.

How to get a debt consolidation loan with bad credit

If your credit score is bad (a FICO score below 580), you may still be eligible for debt consolidation, but weigh your options carefully. There are some personal loan lenders that offer bad-credit loans. But if you qualify, it'll likely be for a rate on the high end of the lender's range, meaning consolidation may not actually save you money.

What is credit card refinancing vs. debt consolidation?

Refinancing refers to paying off one debt with another, usually at a lower rate. Meanwhile, debt consolidation refers to paying off multiple debts with one new loan. In both instances, you may be able to save money on interest, lower your monthly payment, and/or simplify your finances.

What kind of debt can you consolidate?

The exact debts you'll be able to consolidate depend on your strategy. For example, it is possible to consolidate student debt, but you won't be able to do so with a personal loan. Consolidation is typically used for high-interest debt, like on credit cards, with personal loans or other methods.