How Do Debt Consolidation Loans Work?
Debt consolidation loans bring all your debts together into one loan. For example, if you have a handful of credit card bills, medical bills, and other unsecured loans that make you feel like you’re drowning, you can combine them into one loan with a debt consolidation loan.
You apply for the loan amount you need and the lender you think offers the best deal. We always recommend applying with at least three lenders so you can compare your options. Most lenders offer a preapproval that doesn’t hurt your credit, so you can see your rate without doing any damage to your credit score.
Once you choose the loan, the lender completes the underwriting process, usually in a day. Next, they disburse the funds to you, but they might do this in one of two ways.
Wire the money to your bank account
If they send the money to your bank account, you’re free to use the funds however you want, but remember your goal. The idea is to use the money to pay off your debts immediately, so they are now wrapped into one loan.
Pay your creditors directly
Many lenders will pay your creditors directly instead of wiring the funds to you. They’ll pay your balances according to the latest payoff you provided them. If there is any difference in the loan amount and what they pay, they will disburse the remaining funds to you.
Once you have the new loan, you make one payment covering all the debts you rolled into it. You don’t have to worry about managing multiple due dates, figuring out which bill you’ll pay when funds are short, or worrying about getting behind.
Most debt consolidation loans have attractive interest rates that allow you to save money on your payments and possibly even pay extra money toward the loan to pay it down faster.
How to Choose the Best Debt Consolidation Loan
#1. Annual Percentage Rates
The APR is the interest rate a lender charge to borrow the funds. While it shouldn’t be the only factor you pay attention to, it is important.
The better your qualifying factors are, the lower the interest rate you’ll get. For example, a borrower with a 650-credit score would likely get a higher interest rate than a borrower with a 710-credit score. The longer you borrow the money, the higher the rate will be too. Play around with the numbers and see which payment you can afford best. While you don’t want to get in over your head, the lower the interest rate, the less the loan will cost.
#2. Compare Loan Fees
Most lenders charge loan fees for a personal loan. They do this for a couple of reasons.
First, the loans are unsecured. This means there’s no collateral. If you default on the loan, they have nothing to fall back on. They charge fees to offset this risk, knowing that they made some money upfront should you not make your payments.
Second, they charge fees to cover their administrative costs. It costs lenders money to underwrite the loan, processes it, and disburse the funds as quickly as possible. The origination fees cover their costs, but that doesn’t mean you should pay excessive fees.
Just like the APR, compare your options from different lenders. Look at the big picture. How much does the loan cost over its entire term? This will help you determine which combination of APR and loan fees makes the most sense.
#3. Online Experience
Today you can get just about any loan online without ever talking to a person. It seems crazy, but it’s highly convenient. You don’t have to worry about someone trying to upsell you or dealing with the hassle of trying to find a time to talk on the phone that works for both of you.
You can apply for the loan online, process it by communicating via your dashboard, and then handle your loan online once it funds.
#4. Fast Funding Times
If you’re in a hurry to get your personal loan funds, you’re in luck. Most debt consolidation loan lenders fund the loan the same day or within a few days of the application. How long your loan takes depends on the complexity of your qualifying factors and the bank’s normal turnaround times. The best personal loan lenders today offer same-day funding if your application is approved by a specific time, but not all do, so always ask first.
How to Get a Debt Consolidation Loan
#1. Review Your Credit
Your credit is the first thing lenders look at when applying for a debt consolidation loan. They need to know that you are financially responsible, have a solid credit history, and aren’t over your head in debt.
Before applying for a debt consolidation loan, get a copy of your free credit report. Check for anything negative that might bring down your score, including:
- Late payments (30 days or more late)
- Credit lines with over 30% of the credit line outstanding
- Mistakes made by the creditor or credit bureaus
- Fraudulent information
- Excessive inquiries
Before applying for a debt consolidation loan, take care of any negative credit you can. Bring late payments current, take care of collections or roll them into your loan, and dispute any errors on your report.
#2. Shop Around and Compare Debt Consolidation Lenders
Once you have your credit situated and your income is stable, apply for a debt consolidation loan with as many as 3 – 5 lenders.
This will give you a chance to compare your options. Always ask if they do a soft or hard credit pull first, though. If they do a hard credit pull, you’ll get hit with an inquiry on your credit report. Plenty of personal loan lenders like we mentioned above do a soft credit pull, though, allowing you to get offers without hurting your credit.
Look at the big picture when comparing your options. The interest rate is just as important as the fees. Look at the loan’s total cost or your bottom line. You want the loan that costs the least in the end, even if it doesn’t seem like the cheapest option looking at just the APR or fees. It’s a combination of the two that makes the difference.
#3. Pre-Qualify Online
The easiest way to see what you qualify for is to get personal loan pre-qualified online. It takes only a few minutes to apply, and most lenders give you an answer instantly.
You can use the prequalification to compare your loan options. You aren’t committed to a loan if you get prequalified, either. Lenders don’t do a hard credit pull until you commit to a loan and move forward with it; until then, get as many offers as you can and choose the one that’s best for you.
#4. Submit Application and Receive Funding
Once you choose your loan, you submit a formal application, provide the documents they need to complete the underwriting process, such as your income, assets, or employment, and close the loan.
The lender does all the work once you provide the documents they require, and you’ll then receive the funds, sometimes even on the same day.
>> More: How to Apply for a Personal Loan
Why Should You Consolidate Your Debt?
You might wonder why you should consolidate your debt. If you already have loans in place, you may wonder why rock the boat?
Here are a few reasons.
Lower Interest Rates
If you have high-interest consumer debt, you may save money by getting a debt consolidation loan with lower interest rates. If you pay less interest, you’ll save money over the life of the loan. You may even have more money to pay extra toward the loan, getting out of debt even faster.
Simple Repayment Plan
If you are tired of feeling overwhelmed with the number of bills you have, a debt consolidation loan can simplify it for you. You’ll have one bill to pay and manage. This makes it a lot easier to stay on track with your debts and not lose track.
If you sit there and stare at your bills, wondering which one you should pay more money toward each month, or you play Russian Roulette with which loan to pay at all, consolidating your debt can make life a lot easier.
Pay Off Debt Faster
With all your debt in one loan, it’s easy to focus on where your extra money goes. You can laser focus your money on your one loan and pay it down faster. If you’re lucky enough to secure a lower interest rate, too, you’ll pay more money toward principal than before, which helps you pay the loan off faster.
Improved Credit Score
Your credit score comprises five moving pieces, but the two most important are your payment history and credit utilization. When you use a debt consolidation loan, you might improve your payment history since you only have one loan to pay. It’s harder to miss the due date when you have only one loan.
Consolidating your debt also helps your credit utilization. When you pay off your credit cards, it resets your credit utilization to zero, which helps your credit score tremendously if you refrain from using your credit cards anymore but keep them open.
Alternatives to Debt Consolidation Loans
There are a few other options if a debt consolidation doesn’t sit right with you because of the higher interest rate or you don’t qualify.
Home Equity Loans
If you own a home and have equity in it, you can use the equity to pay off your debts. A home equity loan provides you with the equity in one lump sum payment. It’s up to you to pay your creditors with the funds.
The nice thing about home equity loans is the low-interest rates, especially today. You could find a home equity loan with a 3% fixed interest rate. There isn’t much to beat that, but you must have more than 20% equity in your home because you must leave 20% of it untouched.
Home Equity Line of Credit
A home equity line of credit is like a home equity loan, except it’s a line of credit like a credit card rather than a lump sum loan.
You can borrow up to 80% of your home’s value minus any existing mortgages you have on the property. The money sits in a credit line that you can use for any purpose, including paying off your debts.
With a HELOC, you only owe interest on the amount you use from the credit line. You aren’t required to pay the principal back, but you can. If you pay the principal back, you can reuse the funds during the draw period, which lasts ten years. At the end of 10 years, you must pay back the principal plus interest. The repayment period lasts for 20 years.
Debt Relief Services
If you’re in over your head in debt and don’t qualify for any loans, a nonprofit credit counselor may be able to help you put a plan together. They can often negotiate with your creditors to help you get a lower interest rate or more affordable settlement amount to help you get your head above water.
Balance Transfer Credit Card
You may qualify for a 0% APR balance transfer credit card if you have decent credit. If you pay the balance off before the introductory rate’s expiration, you can get out of debt, paying no interest. Be careful, though; if you don’t pay it off, the interest may accrue back from the start of the balance transfer and at a much higher rate.
Some 401K plans allow a hardship loan that allows you to pay off your debts with the proceeds. You’ll have to pay yourself back with interest, but you don’t have to worry about whether or not you qualify since it’s not a loan from a bank.
How Much Can I Save with Debt Consolidation?
There isn’t a magic number that everyone saves with debt consolidation. The exact amount you save depends on how much you lower your interest rate, and what personal loan fees you pay. It also depends on how fast you pay off your debt. If you’re able to pay it off sooner than the term expires, you’ll save even more money than if you made only the minimum payments.
How Do You Qualify for a Debt Consolidation Loan?
Every debt consolidation loan has different qualifying requirements. Find out the loan’s minimum credit score, maximum debt ratio, and minimum income requirements. Overall, most debt consolidation loans are easy to get, but some lenders are tougher than others, like any loan.
Will a Debt Consolidation Loan Hurt My Credit Score?
A debt consolidation loan will only hurt your credit score when you accept the loan. It doesn’t hurt your score when you shop around to get the best rates. They don’t even show up as credit inquiries. When you choose a loan, though, it shows up as a credit inquiry, and it may lower your score a little bit because it’s a new credit line that lowers your credit age.
Are Debt Consolidation Loans Safe to Use?
Any loan has its risks, which is why understanding the loan’s terms, costs, and requirements is important. Typically, debt consolidation loans are safe to use as long as you swear off all other debt. Lock up your credit cards and freeze your credit, so you aren’t tempted to take out any new credit and put yourself into debt again.
Do I Have to Consolidation All of My Debt?
You aren’t under any obligation to consolidate any debt, let alone all of it. You are free to wrap some of your debts into the loan and not others or put it all into the loan to get out of debt for good.
Average Debt Consolidation Loan Rates
Debt consolidation loan rates can get quite high. You’ll find some as low as 5% – 6%, but they are hard to come by. On average, you may pay 7% – 10%, depending on your qualifying factors. To get anything lower, you’ll need great credit and choose the shortest term the lender offers.
How Do You Get a Debt Consolidation Loan with Bad Credit?
You can get a debt consolidation loan with bad credit, but you’ll pay for it. You’ll have higher fees and interest rates to make up for the risk. The good news is, though, that a debt consolidation loan can help you improve your credit after a few months of on-time payments if you manage to keep yourself out of any other debt.
Summary: Best Debt Consolidation Loans
- Payoff: Best Overall Debt Consolidation Loan
- Upgrade: Best Overall Debt Consolidation Loan
- Upstart: Best Debt Consolidation Loan with Flexible Requirements
- LightStream: Best Debt Consolidation Loan for Low Rates
- Best Egg: Best for Secured Debt Consolidation Loans
- LendingClub: Best Peer-to-Peer Debt Consolidation Loans
- FreedomPlus: Best Debt Consolidation Loans for Low Rates
- Avant: Best Bad Credit Debt Consolidation Loan
- Rocket Loans: Best Overall Debt Consolidation Loan
- SoFi Personal Loans: Best Debt Consolidation Loan for Low Fees
Bottom Line: Best Debt Consolidation Loans
Debt consolidation loans can be a great way to get your debt under control. It’s a way to help yourself out of debt without filing bankruptcy or paying excessive interest and fees. Shop around to get the most attractive loan terms, including the lowest rates and fees. Always read the fine print and know the loan’s bottom line before accepting a debt consolidation loan.
To select the best debt consolidations loans, we reviewed over 25+ lenders. Our unbiased evaluation includes reviewing the lender’s online experience, credit score requirements, income requirements, transparency, rates, fees, funding times, and security. Read our personal rating methodology and editorial guidelines for more information about our impartial review process.