Understanding Debt Consolidation: What It Is and How It Works

Debt consolidation combines multiple debts, typically high-interest ones like credit cards, into a single loan with one monthly payment. And more consumers are considering debt consolidation, particularly as debt balances rise, according to Experian. The study, released in 2024, found that consumer credit card balances saw a total growth of 17.4% in 2023 to just over $1 trillion. Other debts are on the rise, too, including retail cards and personal loans.

While debt consolidation doesn't eliminate existing debt, a debt consolidation loan can make it easier to manage. Learn about the types of debt consolidation loans available and how they work. 

What is debt consolidation?

Debt consolidation can help you roll your existing debts into one loan you repay over a set amount of time. Ideally, you can get a lower interest rate than you pay now on your debts, and/or you may be able to extend the repayment term to get a lower monthly payment.

Suppose you have multiple bills arriving monthly for credit cards, medical expenses, auto loans, and other debts. It's easy to understand if you feel overwhelmed or worried about missing a due date or being unable to afford all the payments.

Also known as credit card refinancing and bill consolidation, debt consolidation - in combination with spending less and a commitment to budgeting - can help borrowers get off the debt not-so-merry-go-round.

Types of debt consolidation options

Personal loans

Many banks and financial institutions offer personal loans for debt consolidation, which allow you to pay off your debts with one new loan (if you're approved to borrow enough). You'll then make fixed payments toward the new loan. Maximum loan amounts vary by lender, but some offer amounts up to $100,000 or more. The amount you'll qualify for - and at what rate - is largely dependent on your credit profile and income, however.

• Loan amounts: $600 to $100,000
• APRs: Fixed, 7% to 36%
• Repayment periods: 1 to 7 years
• Funding time: As soon as the same day as approval to a week

Debt consolidation loans may help you access lower rates than you're currently paying, particularly if you're dealing with high-interest credit cards or loans. The average rate on a two-year personal loan was 11.92% as of May 2024, according to the Federal Reserve, compared to an average APR of 21.51% for credit cards. You may qualify for a low rate if you have good credit or better (a FICO score of 670 and above) and sufficient income.

Besides having potentially high rates for borrowers with fair or poor credit profiles, another drawback of personal loans is that they may come with upfront fees such as origination fees, which can reach up to 12% of the loan amount. These fees are typically deducted from your loan funds before you receive them, which affects how much you need to borrow to cover your debt.

Home equity loans and HELOCs

If you have sufficient equity in your home, you may be able to consolidate debt with either a home equity loan or home equity line of credit (HELOC). Both are secured using your home as collateral, which can mean lower interest rates compared to other loan types (rates typically start as low as 7% APR).

• Home equity loans: With a home equity loan, you receive a lump sum of funds that you repay in set amounts with a fixed annual percentage rate (APR).
• HELOCs: HELOCs are a type of revolving credit that often feature variable APRs. You can draw from the line up to your credit limit during the draw period, which is often 10 years, before the repayment period begins. You typically have up to 20 years to repay a HELOC. During the draw period, you may be able to make a minimum of interest-only payments, but you'll start paying your principal back during the repayment period.

You typically need at least 15% to 20% equity in your home to qualify to borrow against it. If you have a lot of home equity, you might qualify for a larger loan amount with a home equity loan or HELOC than you would with another loan type. Lenders often allow a maximum combined loan-to-value ratio of 80% to 85%.

There are a few important considerations to keep in mind with these loans. You could lose your home if you miss payments on a loan secured by it. You may struggle to get approved if your debt-to-income ratio is already high. And like other home loans, home equity loans and lines of credit can involve closing costs - often between 2% and 5% of the loan amount - and take up to a month or more for approval and funding.

Balance transfer credit cards

You may be able to transfer balances from multiple credit cards onto a lower-rate card. Some offer promotional rates where interest isn't charged for a specific period of time - as long as 21 months, in some cases.

With a balance transfer credit card, you may be able to reduce your monthly payments by saving on interest, but you could face a much higher APR (as high as nearly 30% in some cases) after the introductory period expires. You'll also likely pay balance transfer fees of 3% to 5% to move the debts onto the card. The transfer fee may cancel out any interest advantages, but the fee may also be capped.

401(k) loan

If your plan allows it, you may be able to borrow against your retirement savings to pay off existing debts with a 401(k) loan. You then repay the loan with interest, paid to yourself, directly into your retirement account. In general, loans are restricted to the lesser of 50% of your vested account balance or $50,000. This may be an option for those with poor credit, as no credit check is required and these loans don't impact your credit.

However, using a 401(k) loan requires strict discipline in repayment, or you could end up paying hefty early distribution penalties and taxes. It's also not for those with insecure employment. You may have to repay the loan within 60 days if you lose your job or change employers. Not all retirement plans allow for 401(k) loans.

Student loan debt consolidation and refinancing

If you have a mix of student loan and credit card debt, or debt from other loans, you may wonder if you can combine all your debts into one. Unfortunately, student loan debt consolidation works differently from other types of loan consolidation, and you can't combine debt from student loans with debt from other forms of credit.

You may be able to combine all your federal student loans into a Direct Consolidation Loan. If you have a mix of federal student loans and private student loans or just private loans, you can try to refinance them as private loans. However, you'll lose crucial protections and access to hardship-driven repayment plans offered for federal student loans if you refinance them as private loans.

How does debt consolidation work?

Debt consolidation requires assessing your current debts, prequalifying with and comparing lenders, applying for and accepting a debt consolidation loan, and paying off creditors.

Assess your debts and credit

First, you'll want to review all existing debt, including how many payments you're making monthly. Some types of debt that can be consolidated include:

• Credit card and department store card accounts
• Unsecured personal loans
• Payday loans and other small-dollar loans
• Medical and dental bills
• Past-due bills such as utility bills
• Collection accounts

You can try to consolidate all or some of your debts. Review the interest rates you currently pay and the amounts you owe for each debt to understand what sort of rate you'd need to beat with a debt consolidation loan and how much money you need to request. Use a debt consolidation calculator to help.

Also check your credit, which influences the rates you're offered, at this step. Your bank or credit card provider may let you monitor your score through the app or online platform you use to manage your account. You can check your full credit report for each of the three credit bureaus - Experian, Equifax, and TransUnion - for free at AnnualCreditReport.com. If you can take any steps to clean up your credit, such as disputing errors with the appropriate bureau(s), do so now.

Prequalification

Compare different debt consolidation loans available to you, considering your total payoff amount, current interest rates, and credit profile. You can get prequalification quotes for a personal loan by providing some basic information about your income and borrowing needs. These quotes can show you potential interest rates and approval amounts with no impact on your credit.

Carefully review different lenders for:

• Interest rates: Is your prequalification rate lower than some, all or none of the interest rates you pay currently? Is the interest rate fixed or variable (can it change)?
• Approval and funding timelines: How soon can the funds be approved and sent to your creditors? And how soon can you pay off the loan using the debt consolidation? Faster is better, in both cases - provided your budget allows it.
• Monthly payments: Can you afford the monthly payment? A shorter term may save you on interest in the long run but will mean higher monthly payments, so be sure you can afford the payments for the entirety of the term.
• Fees: How do the fees compare? Do the total fees charged outweigh any savings from a lower interest rate? Many personal loans charge origination fees that can equal up to 12% of the loan amount and are subtracted from the funds before you receive them.
• Savings: Can you get a lower interest rate if you set up automatic payments from your checking account or enroll in electronic statements? Does the lender provide a rate discount for sending loan funds directly to your creditors?

Loan application

When you apply for a debt consolidation loan, you'll be asked how much you want to borrow, how long you need to spend repaying the loan, and what you'll use the funds for. You'll indicate that the purpose is for debt consolidation or credit card consolidation, which is a purpose approved by most lenders. Then, the lender will request personal and financial details, generally including:

• Personal details: Name, date of birth, Social Security number or other ID number, and citizenship status.
• Contact information: Email and phone number.
• Address information: Current address, whether you own or rent, and how long you've lived there.
• Identification: Typically, driver's license information.
• Financial information: Monthly income before taxes, employment status, and monthly expenses.

Lenders may also request documents to verify the information in your application, such as pay stubs to prove your income or utility bills to prove your address.

You may also need to disclose whether you've declared bankruptcy in the past seven years, have any outstanding court judgments, are involved in a lawsuit, or are obligated to make alimony or child support payments.

Review and accept the offer

If you're approved, you'll receive an offer from the lender for a debt consolidation loan. Review the terms and conditions and ensure you can afford the monthly bill for the entire term before signing the offer.

Pay off your debts

After you agree to the loan's terms, the lender may pay off your existing debt by sending payments to your creditors, such as credit card companies and other lenders, directly. Alternatively, the lender may send you the funds to repay your creditors. In either case, it can take up to two weeks for your creditors to apply your payments to your debts.

Pros and cons of debt consolidation

When should you consider debt consolidation?

You might consider debt consolidation if you're making consistent payments toward your debts but find current balances remain stubbornly high due to very high interest rates. Other signs you might need to consider debt consolidation include:

• Losing track of multiple bill due dates and missing deadlines
• Struggling despite negotiating lower payments with creditors
• Exploring assistance options for past-due rent and utility bills, to no avail
• Routinely paying late fees
• Taking damage to your credit

Credit counseling debt management plan

If you don't think debt consolidation is possible or suitable for you but you need support with managing your debt, you might be a good candidate for credit counseling.A nonprofit credit counselor can help you review your current financial situation and develop a plan for repaying your debts. Some credit counseling services also create debt management plans (DMPs).

With a debt management plan, a credit counselor develops a repayment plan with you and your creditors. You send one payment to the credit counseling organization every month, which then pays your creditors according to your plan. DMPs typically apply to unsecured debts, such as credit cards.

A nonprofit credit counseling organization may be a good alternative to debt consolidation if you're someone with poor credit who faces rising interest rates and is racking up late payment fees. To find a reputable credit counseling agency, search the U.S. Trustee Program's directory of approved agencies.

FAQ

How does debt consolidation affect your credit score?

How debt consolidation affects your score depends on the method you choose. If you're interested in a personal loan and choose to prequalify, for example, the lender performs a "soft" credit pull that doesn't impact your score. But if you proceed to formally apply for a loan, most lenders will conduct a hard credit pull, which can temporarily lower your credit score.

Making on-time payments is one of the most significant ways debt consolidation could improve your credit score. The new loan or card decreases the amount of credit you're using compared to your available credit, which can boost your score significantly - provided you don't run up new balances.

Can debt consolidation save you money?

If you can pay off your existing debt more quickly or qualify for a lower interest rate, debt consolidation can save you money. In addition, if making one fixed loan payment each month improves your chances of making your payments on time and reducing your balance, your credit score could improve, too. A credit score boost can help you save money on future loans and credit products - the better your score, the lower your interest rate, generally.

What are the risks of debt consolidation?

There's a chance you won't qualify for a loan big enough to consolidate your debts or be offered a rate that's lower than what you're currently paying. And if you're paying down revolving debt like credit cards, another risk of debt consolidation is access to more credit. If you run up new balances while you're still paying off your consolidation loan, you could end up deeper in debt and damage your credit.