What is a debt consolidation loan?

If you have multiple debts or are carrying high-interest balances, a debt consolidation loan may be worth exploring. This type of loan transfers other debts into one loan to simplify your budget and potentially reduce the overall cost of borrowing. 

Learn more about how debt consolidation works, the different options available, and how to decide if it’s worth it for you.

A debt consolidation loan is a type of personal loan that allows borrowers to pay off multiple existing debt balances by rolling the balances into one loan payment. Some key benefits of a debt consolidation loan can include simplifying your debt payoff and lowering the overall cost of the debt by reducing interest charges. 

Repayment of the debt consolidation loan usually consists of fixed monthly installment payments for a set term.

A personal loan for debt consolidation usually provides a lump sum up front and is paid back with fixed installment payments. What sets debt consolidation apart is that the funds are specifically earmarked to refinance other existing debts such as credit card balances. Some lenders may even offer the option to make those debt payments on your behalf. 

If you can qualify for a personal debt consolidation loan with a lower interest rate than your existing debt’s interest rate, you may save money because you’ll pay less interest in the long term. 

Here’s an example. Let’s say you have one credit card with a $5,000 balance, another with an $8,000 balance, and a third with a $3,000 balance. They all have annual percentage rates (APRs) above 20%, so you’re not seeing much progress by making minimum payments. However, you have a good credit score, so you may be able to qualify for a debt consolidation loan with a lower APR that also covers those three cards. By making a fixed monthly payment, you can focus on a single loan payment and know it has an end date. 

(Note: This is a hypothetical example for illustrative purposes only. Actual rates and terms vary based on creditworthiness, loan amount, and lender.)

Debt consolidation loans can be a type of personal loan, but there are other products that allow you to consolidate debt as well. The amount of your existing debt, the strength of your credit profile, and your repayment budget can help you decide which option is best for you.

Most personal loans for debt consolidation are unsecured, meaning they are not backed by collateral. Instead, the lender assesses your eligibility by reviewing your credit history and verifying your ability to repay the loan. In most cases, interest rates and payments are fixed for the life of the loan.

Homeowners sometimes tap into their home equity to pay off high-interest debts. Two options for doing this are a home equity loan or a home equity line of credit (HELOC). A home equity loan is a second mortgage in which you take a lump-sum payment to pay your debts and then repay it with fixed payments. A HELOC is a revolving credit line that you can draw from as needed for a set period of time. Either approach can be risky because the home serves as collateral, so if you don’t meet your repayment obligations, you can face foreclosure.

Another option is a balance transfer credit card with a 0% introductory APR offer. Some of the most competitive balance transfer card 0% APR promotional periods are between one and two years. Balance transfers typically have a fee of 3% to 5% of the total transfer amount.

You may be able to borrow from your employer-sponsored 401(k) account, though most financial experts consider this a last-resort approach. The disadvantage is that when you use retirement funds to pay off debt, you could miss out on investment growth. You’ll also have to pay yourself back with interest by a set deadline. If you leave your job while you still owe on the 401(k) loan, you may owe income taxes and an early withdrawal penalty on the remaining balance.

A debt consolidation loan won’t necessarily hurt your credit in the long term, though you may see a temporary drop in your credit score initially. How it affects your profile overall depends on how consistently you make on-time payments and whether you manage your paid-off accounts responsibly.

Anytime you apply for a new line of credit, it can trigger a hard inquiry when the lender reviews your credit reports. This causes a small, temporary decrease in your credit score. New credit lines can also lower the average age of your credit, which is a factor in the major credit scoring algorithms. Short-term impacts typically level out over several months.

Because you are using the debt consolidation loan funds to pay off your other debts, it can have long-term credit benefits. These loans can help you make faster progress with your debt payoff, especially if you can lower your interest rate. This drives down your utilization, or the amount of available credit you are using, which is a positive for your credit score. 

Regular payments that are made on time also benefit your score. Plus, because a personal loan for debt consolidation is an installment product, managing the repayment responsibly shows that you can handle a “mix” of credit, which is looked on favorably by the credit scoring models.

Personal debt consolidation loans can be a good tool to help you conquer lingering, high-interest debt, but it’s important to consider both the potential advantages and drawbacks.

• Lower your interest rate and save money: Debt consolidation may reduce total borrowing cost when the new loan’s APR, fees, term, and total repayment are lower than the existing debts. One of the key ways to do that is to qualify for a consolidation loan that has a lower APR than the existing debt. 
• Streamline your finances: Juggling multiple balances can be difficult to manage. If you’re only making minimum payments as well, it can be challenging to make progress. Consolidating debt into one payment simplifies your finances and lets you focus on a single bill. 
• See faster progress on your debt payoff: If you’re paying less interest overall and you make all of your payments, you will be debt-free by the end of the loan term. You can speed up progress even more if you make larger payments to pay the loan off earlier.

• Potential fees: Some debt consolidation tools do have upfront fees such as origination fees on loans, closing costs on home equity products, and balance transfer fees on credit cards. These costs should be factored into your math when deciding if the consolidation is worthwhile. 
• Requires discipline not to run up paid-off credit lines again: Once your credit cards have zero balances and you have one loan to pay back, if you start piling on new debt, you can end up back in the same position with a new loan on top. 
• Must have strong credit to qualify for best rates: The most competitive interest rates usually go to borrowers with good to excellent credit. If you’re not in those tiers, it could be challenging to consolidate to a lower rate than you are paying, and that can remove much of the benefit.

You can get a debt consolidation loan by following these general steps. 

1. Determine if you are eligible. Review your credit profile to see where you stand. Higher credit scores can help you qualify for more competitive rates. You’ll need to meet other lender criteria as well, including having a steady income source. 
2. Figure out how much you need to borrow. List out your existing debts along with their APRs so you can figure out the loan amount you need. Consider paying off debts with higher interest rates if you can’t get a loan large enough to cover everything. 
3. Calculate what monthly payment you can afford. Moving all of your debts into one loan may result in a significant monthly payment. If it’s higher than the total of each debt’s current minimum payment, make sure your budget can handle it. Explore different loan term lengths as well. Shorter terms typically have higher monthly payments but cost less in interest over the life of the loan, while longer terms may lower the monthly payment but accrue more interest. 
4. Compare lender quotes. Once you know how much you want to borrow and what you can afford, you can compare loan options. Get a few offers and compare them side by side. 
5. Apply. When you choose a lender, you can start the application process. Once approved, you can pay off your debts (or specify where the lender should direct payments if they are doing so on your behalf).

A debt consolidation loan can be a good idea for some borrowers. As with most financial decisions, it all depends on your specific situation, ability to qualify for favorable rates and terms, and whether you have a realistic repayment strategy in place. 

If you determine that you can qualify for a debt consolidation loan that would lower your interest rate and help you save money and accelerate repayment, it might be worth moving forward. The key is to make sure you can follow through on your repayment and avoid running up new balances that could put you in a worse situation than you were in originally.