A debt consolidation loan is any loan you use to pay off other debt, like credit cards, in order to secure a lower interest rate or monthly payment or both. Personal loans are commonly used to consolidate debt but aren't the only type of debt consolidation loan available. We'll cover how the debt consolidation process works using a personal loan and alternatives to consider.
Debt consolidation loan lenders
Understanding debt consolidation
Debt consolidation is the process of combining your existing debts into one by using a new loan, such as a personal loan, a home equity loan, or a balance transfer credit card, to pay them off. You effectively trade your existing debts for the new loan.
In some cases, debt consolidation can help you secure a lower interest rate, and/or lower your monthly payments, or help you pay off debt more quickly. Regardless of these benefits, one of the biggest advantages of debt consolidation is the fact that it simplifies your finances. Instead of making payments toward several debts each month, you only have one payment to worry about.
On the other hand, debt consolidation isn’t a quick fix for getting out of debt or other financial problems. Consolidating debt doesn’t make it disappear — it just reorganizes it into a (hopefully) more manageable loan and can make it easier to stay on top of your monthly payments.
Expert tip:
"If you use a personal loan to pay off credit card debt, you can swiftly reduce your credit utilization, which could improve your credit score within a month." — Meredith Mangan, Senior Loans Editor, Credible
Debt consolidation example
Let’s say you have three loans totaling $12,000. And you're paying about 19% interest across all three loans. You’ll pay off these loans in 24 months with a combined monthly payment of $605; you'll pay a combined $2,518 in total interest.
However, say you find out you can consolidate your debt with a personal loan that charges only 14.5% interest. With the same repayment term of 24 months, you’d pay off your $12,000 debt with monthly payments of $579, saving you $26 per month. Plus, the new loan's total interest would cost just $1,896, saving you over $700.
What to consider before consolidating debt
As the above example shows, debt consolidation loans can help you save money. But it doesn’t always work out that way — and it’s not best for every situation. Sometimes, debt consolidation won’t be worth the fees and administrative work. Other times, your situation may be at the point where debt relief or a debt management plan is the better option.
Here are some factors to consider before deciding to consolidate your debt.
- Your total amount of debt: If you have a high debt-to-income ratio (DTI), debt consolidation may not be the best idea. In fact, most lenders prefer a DTI no higher than 35%. So a high DTI may make it tough to qualify for a debt consolidation loan at all. If you're drowning in debt, a debt relief strategy is probably a better option.
- Your interest rates: If your current interest rates on your loans are already low, it may not be worth getting a debt consolidation loan. But if you have high interest rates on your debt — prequalify for a personal loan to see if you might get a lower rate.
- Repayment terms: If you have a plan to pay off your current loans within a year, it may not be worth consolidating. The time and fees required to consolidate may not be worth the benefit of doing so. But if you still have years of payments to go, consolidating with a lower interest rate is often worth it.
- Your monthly payment: You should only consolidate if you can afford your new monthly payment. So if you can’t qualify for a loan that offers a manageable monthly payment, consolidating isn’t a good idea.
- Your financial habits: Debt consolidation has the potential to help you get out of debt, but it won’t change your spending habits. If you’re still spending beyond your means, consider addressing the underlying issues before attempting debt consolidation.
Check Out: How To Get Approved for a Personal Loan
Can a debt consolidation loan hurt your credit score?
Debt consolidation can impact your credit score. Whether it has a positive or negative impact depends on your financial habits and the type of debt you're consolidating.
Credit card refinancing
Perhaps the biggest credit bang for your buck comes from consolidating or refinancing credit card debt. If you use a personal loan to pay off credit cards, you can dramatically reduce your credit utilization. Credit utilization is the amount of available credit that you're currently using. When you pay off your cards, you lower your credit utilization ratio, which contributes up to 30% to your FICO credit score. Since creditors typically report balance monthly to the bureaus, you could see a quick credit score boost.
Applying for a loan
Initially, consolidating your debt can have a slight, temporary, negative impact on your credit score. That’s because when you apply for a loan, the lender performs a hard credit check. This credit check temporarily lowers your score by up to 10 points for up to one year.
To avoid being denied a debt consolidation loan, prequalify with several lenders first to see which are most likely to approve your application and what APR you might be approved for.
Making payments
By consolidating your payments into one, debt consolidation could help you keep up with payments more easily. By making payments on time — and eventually paying off your loan — you can gradually improve your credit score. Plus, a debt consolidation loan can diversify your credit mix, which has a small positive impact on your credit score.
Note that if you make late payments, you could hurt your credit score with a debt consolidaiton loan.
Related: Does Paying Off a Loan Help Your Credit Score?
How to apply for a debt consolidation loan
Applying for a debt consolidation loan is similar to applying for other personal loans. But the process can vary by lender. Generally, you can apply and qualify by following these steps:
- Check your credit score: It’ll be easier to qualify for a personal loan with good credit. Check your score before you start applying for an idea of the rates you can get. If your score isn’t great, consider trying to improve it before applying for a new loan.
- Compare lenders and pick a loan: Research different lenders to narrow down your best options. Certain lenders may even let you prequalify for a loan to get a better idea of the interest rate you’re likely to get — without hurting your credit score. When picking a loan, make sure it has terms that work for you. Use a personal loan calculator to estimate monthly payments, and make sure you can afford them.
- Complete the application and get your funds: After choosing a loan, you can typically apply online. You’ll need to provide some documentation, like multiple forms of ID, proof of employment, tax forms, and proof of address. After verifying your information, the lender will approve (or reject) your application. Then it can take a matter of days or weeks, depending on the lender, for you to receive the funds.
Learn More: How To Apply for a Personal Loan
Debt consolidation loan alternatives
A debt consolidation loan isn’t the only way to tackle your debt — and in some cases, it’s not a realistic or helpful option. Below are a few alternatives you may want to consider.
- Balance transfer card: A balance transfer credit card allows you to combine credit card balances onto another card — for a fee. If you can qualify for one, your card could come with an introductory period of 0% interest, which can be extremely valuable if you can aggressively pay down your balance in that time. Keep in mind the APR will likely jump up dramatically at the end of the introductory period.
- Home equity line of credit (HELOC):A HELOC allows you to borrow against the equity you have in your home, making it a secured line of credit. If you have significant equity in your house, this could be a good option. Because HELOCs are secured, they tend to have lower rates than personal debt consolidation loans, but you risk foreclosure if you miss payments.
- Debt management plan: A debt management plan involves working with a nonprofit credit counseling agency. Typically, a debt management plan is for people who want professional help getting a handle on their debt. With a debt management plan, the agency will create a payoff plan, negotiate your interest rates, and handle the payments to your creditors in exchange for a small fee.
FAQ
Can I consolidate all types of debt?
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Can I still use my credit cards after consolidating my debt?
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How long does it take to pay off debt through consolidation?
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