What Is a Debt Consolidation Loan? How Do They Work?

Written by Ashley FranklinReviewed by Anders Skagerberg, CFP®Updated: 15th Apr 2022
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Debt consolidation loans are a great way to take control of your finances by consolidating all your high-interest debt into one low-interest loan.

If you’re struggling with too many bills and not enough money, then this is the right option for you. Learn about how debt consolidation loans work, what they can do for you, and why they may be the perfect solution!

What Is Debt Consolidation?

Debt consolidation essentially takes all your debt and combines it into one simple loan. The interest rate on the new consolidated loan should be lower than what you are currently paying to each lender or credit card company.

Debt consolidation can help you manage your finances and save money on interest by creating a new, lower-interest loan to pay off all your higher-interest loans at once. This will let you take control of your finances to save money and get out of debt faster.

>> More: Best Debt Consolidation Loans

What Is a Debt Consolidation Loan?

This type of loan is specifically designed for people trying to consolidate their debts. It can cover multiple loans or credit accounts, so you don’t have to worry about paying different lenders each month.

Debt consolidation loans are perfect for people struggling with too much debt. You can use one loan to pay off all your lenders, which lets you focus on paying down all of your debt at once with a lower interest rate or smaller monthly payment.

How Do Debt Consolidation Loans Work?

Debt consolidation works by taking all your debt and combining it into one larger loan with a lower interest rate than the loans you’re consolidating. This lets you pay off your debts faster and save money in interest over time to prevent the debt from happening again.

You must understand how these loans work and what they are designed for before applying. These types of loans aren’t right for everyone because even though it might be easier to make payments if you have one loan, it can also mean you’ll be paying the debt off for a longer period.

Pros and Cons of Debt Consolidation Loans

Pros:

  • Helps to reduce monthly payments.
  • Can create a fixed interest rate that is lower than the current variable rates.
  • Can be used to lower the overall total of interest paid overtime.
  • A single monthly bill may be easier to manage.
  • Your credit score will improve by making on-time payments each month.

Cons:

  • Debt consolidation loans often require a good credit score to qualify for better rates.
  • Consolidation loans can add additional fees and costs such as origination or application fees, appraisal fees, credit report fees, etc.
  • Increased term length for loan repayment in certain circumstances.
  • Can increase negative net worth by increasing the debt owed and creating new debt.
  • Missed payments will be detrimental to your credit score.

Will Debt Consolidation Impact My Credit Score?

A debt consolidation loan can help improve your credit score and decrease the number of missed payments that negatively impact your credit report each month. If you continue to pay your loan on time, this will lower your overall total for interest paid overtime, which is a good thing!

However, if you miss any payments or make late payments, your credit score will likely decrease. This can be detrimental to future loan applications and other financial opportunities you may have – so make sure to keep on top of payments even if you’re struggling financially!

The length of your credit history will have a large impact on your credit score and can be detrimental to the overall calculation if you close out any of the accounts that were being reported. The age of your accounts is important, so it’s a good idea to keep any open accounts active even if you aren’t using them.

Credit utilization will also play a large role in your credit score. Debt consolidation loans impact credit utilization by increasing the total amount of credit available to you. This can positively impact your score because it makes up 30% of your overall credit score calculation.

What is the Difference Between Debt Consolidation and a Personal Loan?

Debt consolidation combines your debt into one loan that is often easier to manage in terms of payments. This type of personal loan doesn’t always require good credit, so you can still qualify even if your score isn’t great.

On the other hand, a personal loanis often used for short-term financial goals and typically requires good credit to qualify for lower interest rates. This means you need to have excellent or near-perfect credit to get approved. Additionally, a personal loan is typically used for a specific purpose – such as home improvement projects, weddings, or buying a car. A personal loan may have fixed rates and lower interest than debt consolidation but often requires collateral to secure the loan.

How to Consolidate Your Debt: Two Helpful Tricks

One helpful trick to consolidate your debt is to pay off your loans with the highest interest rates first. The easiest way to do this is by obtaining a debt consolidation loan. By paying down your debt, you will build financial momentum, giving you a sense of accomplishment that will motivate future behavior.

The second helpful trick is to use a balance transfer – which can let you consolidate debt by transferring balances from high-interest credit cards onto a new card with lower rates and fees. This gives you some breathing room regarding how long it takes for your debts to be paid off.

However, don’t wait until you’re deeply in debt to consolidate your loans. You can start by figuring out which debts have the highest interest rates, paying them off first, and consolidating with a loan if necessary.

Get a Debt Consolidation Loan

You can apply for a debt consolidation loan to save money on interest and get a lower monthly payment. If you have good credit, it is possible to find great rates for debt consolidation loans through traditional lenders such as banks or credit unions, or through an online service like Payoff or Upgrade.

If your credit score isn’t the greatest, there are also other options for debt consolidation loans through alternative lenders that can offer interest rates from 9-36%. Just make sure that you read the fine print and check for hidden fees.

>> More: How to Get a Personal Loan

Use a Balance-Transfer Credit Card

If you can’t get approved for a debt consolidation loan, another option is to use balance transfer offers. Banks and other financial institutions often offer Balance-transfer cards as an incentive to open new accounts with them – which means it could be very easy to qualify!

Keep in mind that different institutions offer different interest rates for these cards, so it’s important to do your research before applying. Some institutions may even waive balance transfer fees to snag you as a customer!

If you don’t have great credit, then there are also other options available through alternative lenders that can offer interest rates from 0% on balances transferred within the first 90 days.

>> More: Requirements to Get a Personal Loan

When Is Debt Consolidation a Smart Financial Move?

If you have high-interest rate debt that costs more in interest than what it’s worth, then it may be time to consolidate. For example, if your credit card has an 18% APR and there are no balance transfer incentives available, then this type of debt consolidation might make sense because the total amount paid for all of your credit card debt combined would be more than what you’d pay in interest on the loan.

Doing this can help with saving money and paying off debts faster – which is why it’s important to balance out how much a lower monthly payment is worth in terms of total interest paid overtime. It may also make sense to consolidate your debt if you have several different loans with various lenders and simplify the process.

When Is Debt Consolidation Not a Good Option?

It’s not always the right choice to consolidate your debt. For instance, if you have a credit card with an introductory 0% APR offer, it may be more beneficial for you to keep this account open and transfer balances to take advantage of the low-interest rate.

Other exceptions were that consolidating debt may not make sense for you if you have small balances on your accounts. If this is the case, it may be better to pay off the smaller amounts of debt before consolidating to save money on interest. Many people also prefer not consolidating their private loans because they want to keep them separate from other types of accounts – especially if they have a good relationship with the lender.

Who Can Qualify for a Debt Consolidation Loan?

Certain requirements need to be met to qualify for a debt consolidation loan. First, you will typically need a job or other documentable source of income to obtain this type of loan. The lender may require proof to approve your application, such as pay stubs.

Your credit score is also important. Most lenders will use your credit score to determine if you are eligible for the loan and what interest rate they should offer you – which is why it’s recommended that people with poor credit scores consider other options such as balance transfer offers.

Another requirement may be a minimum amount of debt needed to qualify. Minimum loan amounts will vary by state but can be as low as $2000.

>> More: Best Personal Loans

How Much Does It Cost to Consolidate Your Debt?

All in all, the fees associated with a debt consolidation loan will depend on your circumstances. Case in point, if you have good credit and meet the lender’s requirements – then it may be very easy for you to qualify without excessive costs or hassles. Debt consolidation loan companies generally charge fees that vary between 15% and 25%. On the other hand, if you don’t meet all of their requirements or your credit is less than stellar, they may require higher interest rates and fees.

It’s also important to consider that some institutions are known for predatory lending practices that lend money at high-interest rates with hidden fees. These types of lenders should be avoided at all costs because you will likely be charged more than necessary for your debt consolidation loan.

Is it Safe to Consolidate Debt?

Debt consolidation is a safe and viable option for people looking to stabilize their debt. However, predatory lenders may try to take advantage of you.

That said, there are ways for consumers to protect themselves from predatory lending practices, such as only working with reputable lenders and making sure that they fully understand the terms before signing any documentation or agreement.

Before taking out a loan, you must do your homework and compare different lenders so that you can find the best one for your needs. Online marketplaces help match borrowers with pre-screened local or national lenders who compete for business based on the merits of their offers and services.

It’s also important to remember that you always have a right to ask questions about how much your loan will cost, including loan origination fees, interest rates, repayment terms, and conditions of any offer before accepting or signing any contracts. You should never agree to let anyone charge excessive fees for debt relief help.

Bottom Line: What Is a Debt Consolidation Loan?

Debt consolidation loans are a financial tool that can help consumers consolidate their debt from multiple accounts into a single loan. The benefits of consolidating your debts include lower interest rates, fewer monthly payments, and an easier payment plan to manage over time – which can help reduce stress and improve credit score ratings.

Debt consolidation is a popular option for people who have too much debt, but it’s important to understand the different types of fees before making any decisions. You should compare lenders and choose one that offers competitive rates with no hidden charges so you can find relief without being taken advantage of or worsening your financial situation.

Ashley Franklin
Ashley Franklin

Ashley Franklin is a professional writer and financial literacy expert. Ashley double-majored in Computer Science and Communications, and she brings her talents to the forefront with writing about personal finance and investing. Having worked with renowned international websites and publications, Ashley has found that there’s no one-size-fits-all solution to financial management. That’s why her articles are all about finding what works for you.