What Is a Debt Consolidation Loan and How Does It Work?

Like many Americans, Shauna was laid off during the COVID-19 pandemic. After running through her meager savings, she turned to credit cards to make ends meet. In three months, she racked up $8,500 in charges across four credit cards.

Shauna is back at work now, but all that credit card debt is really weighing down her budget. Right now, just making the minimum monthly payments is costing her $255 a month. At this rate, it will take her nearly 17 years to pay off the balance — and she doesn’t know how she’ll manage at all if interest rates rise.

For people in Shauna’s position, a debt consolidation loan offers a way out. It’s not a perfect solution for everyone, but it can make things a lot easier for someone juggling multiple payments at high interest.

What Is a Debt Consolidation Loan?

Consolidating your debt means rolling many debts into a single payment. Instead of making payments each month on several credit cards or other loans, you take out one loan to pay off all the other debts. You then make monthly payments on the new loan until it’s paid off.

The main point of a debt consolidation loan is that it can offer more favorable payment terms than your existing debts. For instance, it could have a lower interest rate or a lower monthly payment. Thus, using one allows you to pay less in total and get out of debt faster.

Types of Debt You Can Consolidate With a Loan

You can use a debt consolidation loan to pay off any kind of unsecured debt — that is, loans not backed by any physical asset. However, they’re most useful for debts that have high interest rates or high monthly payments. Examples include:

In some cases, you can consolidate student loans together with other debts. However, the rules around this type of loan can be complicated, so it’s sometimes easier to consolidate student loans separately or find another way to refinance them.

Who Qualifies for Debt Consolidation?

Getting a debt consolidation loan isn’t always easy. Lenders know that people seeking these loans have trouble paying their current debts, so they take extra care to make sure these borrowers can meet the payments on a new loan. Factors they look at include:

• Your Credit Score. Most lenders look for borrowers with good credit. That means a credit score of at least 650 to 700. Some lenders offer debt consolidation loans for borrowers with low credit scores, but they charge higher interest rates.
• Your Credit History. Lenders also look at your credit history. They want to make sure you have no record of negative events like bankruptcy, foreclosure, repossessions, or debts sent to collections.
• Your Income. Many lenders require a certain minimum annual income for this type of loan. They typically ask for a letter from your employer that lists your job title, work history, and salary. 
• Debt-to-Income Ratio. Your debt-to-income ratio, or DTI, is the percentage of your monthly income that goes toward debt payments. You generally need a DTI under 50% to get a debt consolidation loan, and some lenders look for lower ratios than that. 

How Does Debt Consolidation Work?

The most common tool for consolidating debt is a fixed-rate debt consolidation loan. You borrow enough money to pay off your other debts, then pay off the new loan in installments. Typically, the new loan has a lower monthly payment or a shorter repayment term than your existing debt.

Hundreds of lenders offer these types of loans, including traditional banks, credit unions, digital lenders like SoFi, and peer-to-peer lenders. Debt consolidation loans typically have terms of one to five years and can consolidate between $1,000 and $50,000 in debt, but the exact parameters can vary.

Most debt consolidation loans are unsecured loans. Some debt consolidation lenders also offer secured loans backed by an asset such as your home or your car. 

Secured loans can be easier to get, and they may allow you to borrow more money at a lower interest rate. However, even unsecured loans tend to have lower interest rates than credit cards.

Other Types of Debt Consolidation

A fixed-rate loan isn’t the only way to consolidate your debts. Other options exist, but they all have significant downsides. They include:

• Balance Transfers. If you can have only credit card debt, you can pay it off with a 0% balance transfer credit card. You need good credit to get one of these cards, and you can only transfer a limited amount to them. Most also come with balance transfer fees of 3% to 5%. The 0% interest period is typically no longer than 21 months, after which regular APR applies.
• Home Equity Loans. Your home equity is your home’s value minus your mortgage balance. Using a home equity loan or home equity line of credit (HELOC), you can borrow up to 80% of your equity, and sometimes more. Home equity loans and lines of credit tend to have lower interest and longer repayment periods than unsecured loans. But you often need at least 20% equity to get one, and if you fail to meet the payments, you could lose your home. 
• 401(k) Loans. You can take out a 401(k) loan for up to $50,000 or half of your vested account balance, whichever is less. You then have five years to pay it back. These loans are attractive because they have low interest rates and are available to borrowers with poor credit. Their biggest downside is that they put your retirement savings at risk if you don’t pay them back.

How to Get a Debt Consolidation Loan

To take out a debt consolidation loan, start by figuring out how much you need and how big a monthly payment you can afford. Then start looking at loan offers that match these terms. Check out offers from multiple lenders, starting with your current bank or credit card company. 

Some lenders offer instant prequalification for debt consolidation loans online. Using this process makes it easy to compare the actual terms of different loan offers. And it doesn’t hurt your credit score, since getting quotes for a loan doesn’t usually require a hard credit check.

As you compare loan offers, pay particular attention to fees. Some debt consolidation loans come with origination fees that can range from 1% to 8% of the loan, depending on the lender. Lenders may also charge fees for late payments, returned payments, or check processing.

Once you get a loan, use it to pay off your existing balances in full. If your loan can’t pay all your debts, pay off the highest-interest debts first. But don’t close your old accounts right away — closing too many accounts at once can harm your credit score.

Pros and Cons of Debt Consolidation

Debt consolidation sounds like an ideal choice for someone like Shauna. Right now, she’s barely making the minimum payments on her credit cards and will need years to pay them off. A debt consolidation loan could slash her monthly payments and get her out of debt much faster.

But debt consolidation loans aren’t a cure-all. They come with significant downsides that Shauna would need to weigh before deciding if this is the right solution for her.

Pros of a Debt Consolidation Loan

A debt consolidation loan offers these benefits:

1. Less Bookkeeping. With multiple credit cards and loan payments, it’s easy to lose track. That can lead to missed payment due dates, late fees, and damaged credit. With a debt consolidation loan, you have only one monthly payment to make. And since the amount never varies, you can make the payment automatic so you can’t miss it.
2. Lower Loan Payments. Debt consolidation loans typically have lower interest rates than credit cards and high-interest loans. That means you have a lower monthly payment for the same amount of debt.
3. Less Interest. Not only is the interest lower on a debt consolidation loan, it doesn’t compound the way it does on a credit card. In other words, you don’t pay interest on the interest. These two facts together mean you’ll pay less interest in total on your debt.
4. Faster Payoff. Making the minimum payment on credit cards can stretch debt out for decades. By taking out a fixed-rate loan, you get a guaranteed end date for your debt. And with a lower interest rate, you can become debt-free sooner without raising your payments. (However, this depends on the loan term, as discussed below.) 
5. Freedom From Debt Collectors. With debt consolidation, your new loan pays off your existing debts immediately. That means you no longer need to deal with debt collectors.
6. Possible Boost to Credit. If you take out a new loan but leave your old accounts open, your total available credit will increase. As a result, your credit score will improve. As you pay down your debt, it will improve still more. By contrast, debt relief programs like debt settlement and bankruptcy damage your credit score. 

Cons of a Debt Consolidation Loan

The downsides of using a debt consolidation loan include:

1. Upfront Costs. Some loans come with origination fees or balance transfer fees. In some cases, these fees could add up to more than the savings on interest. In addition, some of your old loans might charge a prepayment penalty for paying them off early.
2. Limited Amount. Debt consolidation loans can only cover a limited amount of debt. With rare exceptions, the maximum is typically $50,000, and some lenders set it lower than this.
3. No Reduction in Debt. Debt consolidation is not the same as debt relief. Unlike debt settlement or forgiveness, it can’t reduce the overall amount you owe.
4. Possible Increase in Total Payments. In most cases, you’ll pay less in total with a debt consolidation loan than you would by keeping existing debts. However, if the loan term on the new loan is longer, it could actually increase your total payments. Even if each individual payment is lower, you could pay more because there are more of them.
5. Possible Damage to Credit. Any time you take out a new loan, it dings your credit score a bit. Also, newer debts aren’t as good for your score as older debts with a longer payment history. This damage could outweigh the benefits of increasing your total available credit, at least in the short term.
6. Risk of Asset Loss. Unsecured loans for debt consolidation are hard to get if you don’t have good credit. Secured loans are easier to obtain, but they put your assets at risk.
7. Not a Fix for Problem Spending. A loan can pay off old debts, but it can’t solve the problems that got you into debt in the first place. If you had a temporary problem with your financial situation, like Shauna, a loan can help you fix it. But if you’re prone to overspending, paying off your existing debts could simply free up more credit for you to spend your way through.

Should You Consolidate Your Debt?

Debt consolidation doesn’t make sense for everyone. It depends on a variety of factors, including:

• Your Credit Score. With good credit, you can qualify for either a 0% balance transfer credit card or a debt consolidation loan with a low interest rate and low monthly payments. With fair or poor credit, you could be stuck with a higher-interest loan or a secured loan that puts your assets at risk.
• Your Income. You need a steady income to qualify for a debt consolidation loan — and to meet the payments once you get it. Ideally, your job should provide enough income to make your monthly payments and have your loan paid off in five years or less.
• Your DTI. For a debt payment plan to work, all your financial obligations, including your loan payments and rent or mortgage, should add up to no more than 50% of your income. If your DTI is higher than that, a loan probably can’t help you. You’re better off seeking debt relief from debt settlement or credit counseling.
• Your Spending Habits. Debt consolidation makes sense for dealing with debts caused by a problem that’s now resolved, such as a temporary job loss or one-time medical bills. But if you have ongoing spending problems, you need to deal with those first. Without a sustainable long-term budget, consolidating your debt will only be a temporary fix.

Final Word

To succeed with a debt consolidation loan, you have to make timely payments. The easiest way to do that is to set up automatic payments. Some debt consolidation lenders offer discounts for borrowers who use this feature.

Even more importantly, you have to avoid racking up new debts to replace the old ones. Switch to debit cards rather than credit cards for everyday purchases so you won’t run up a new balance. Use credit cards only for emergencies, at least until your loan is paid off. 

Most of all, make a budget and stick to it. Figure out ways to keep your spending well within the limits of your income — cutting expenses, earning extra income, or both. By living within your means and breaking bad financial habits, you can avoid falling back into the debt trap in future.