What Is a Debt Consolidation Loan?

How Does Debt Consolidation Work?

Debt consolidation works by folding multiple debts into one loan, ideally with a lower interest rate. When you consolidate debt, you apply for a new loan and use it to pay off multiple credit card or loan balances. For example, you could use a consolidation loan to pay off three credit card balances, replacing your minimum payments with just one monthly loan payment.

Debt consolidation can help you lower your monthly bills, pay off debt faster and lower the overall cost of your debt. You'll typically need good credit to qualify for a debt consolidation loan with favorable terms, such as low fees and interest.

Do Debt Consolidation Loans Hurt Your Credit Score?

While a debt consolidation loan can temporarily decrease your credit score when you apply, consolidating debts can be good for your credit in the long run.

As with any loan, applying for a debt consolidation loan will typically result in a hard inquiry on your credit. This can lead to a small, temporary reduction in your credit score. If you're approved for a debt consolidation loan, the new account can lower the average age of your credit accounts, which also impacts your credit.

On the other hand, debt consolidation—when managed properly—can also help your credit score. When you take out a debt consolidation loan, your payments are reported to the credit bureaus. Making on-time payments each month creates a positive payment history on your credit report and can help boost your score. Your payment history has the single largest impact on your credit score. In addition, folding your credit card balances into a debt consolidation loan can lower your credit utilization rate, which also has a positive impact on your score.

Is Debt Consolidation a Good Idea?

While debt consolidation can be a good strategy for paying off debt more efficiently, it isn't right for everyone. Here's what to consider.

Pros of Debt Consolidation

• Simplify your payments. If you're currently making multiple monthly debt payments, consolidating your balances can provide relief and make your bills more manageable. Ideally, you'll have just one loan with a single monthly payment.
• Pay less in interest. If you qualify for a debt consolidation loan with a lower interest rate than your other debts, you'll save money on interest and make debt repayment more affordable.
• Pay off your debt faster. If you refinance your debts into a personal loan with a lower rate of interest and a short repayment term, you could pay off your debt faster. Keep in mind that a short repayment term means larger monthly payments.

Cons of Debt Consolidation

• It may come with high fees. Some debt consolidation loans require you to pay an upfront fee called an origination fee. Origination fees typically range from 1% to 6% of the total loan amount. If you're borrowing $15,000 to pay off debt, for example, a 5% origination fee would cost you $750. This amount is typically subtracted from your approved loan amount.
• It can make debt more expensive. It's important to check that the terms of a debt consolidation loan are better than the terms of the debt you want to pay off. If you consolidate debts into a higher-interest loan, you'll make your debt more expensive.
• You may be in debt longer. If you consolidate your debts into a loan with a longer term or lower monthly payments, you could extend your repayment period. This means staying in debt longer and paying more in interest.

How to Get a Debt Consolidation Loan

Here are steps to take to get a debt consolidation loan:

1. Assess your finances. Make a list of all your outstanding debts, noting the balances, interest rates, minimum monthly payments and due dates for each one. This can help you understand how much you'd need to borrow to consolidate your debt. In addition, look at your budget to determine how large a monthly payment you're able to afford.
2. Research lenders. Try Experian CreditMatch™ to review multiple debt consolidation loans matched with your credit profile. Compare the interest rates, fees and terms of loans to find the best option for your needs.
3. Apply for a debt consolidation loan. You may receive your lender's decision within seconds, or you may need to provide additional information or wait for a response by mail.
4. Repay the loan. After you receive your funds from your debt consolidation loan, use them to pay off your debts. Make sure to be cautious about borrowing as you repay your loan. Avoid running up new credit card balances, as this can leave you deeper in debt.

Alternatives to a Debt Consolidation Loan

A debt consolidation loan can be a beneficial tool for saving money on interest, streamlining payments or getting out of debt faster. But it isn't always the best solution. Here are alternatives to consider.

• Credit counseling: If you need help assessing your finances, budgeting and coming up with a plan for repayment, consider credit counseling. A nonprofit credit counselor can help you come up with a personalized strategy for getting out of debt.
• Balance transfer card: A balance transfer card with an introductory 0% APR allows you to transfer your credit card balances onto a new card and pay no interest for a set period of time. This can be a great option for borrowers with good credit and confidence that they'll repay the balance before interest kicks in.
• Debt payoff strategy: Consider a debt repayment strategy, such as the debt snowball method or the debt avalanche method, which are different ways of prioritizing and paying off balances. To funnel more money toward debts, consider tightening your budget and investigate ways to supplement your income.
• Borrowing from home equity: Homeowners with high equity in their homes may be able to borrow against their equity to pay off debt. Using a home equity loan or home equity line of credit (HELOC) to consolidate your debts can help you save substantial money in interest. But keep in mind that there are risks to borrowing against your home.

What's the Difference Between Debt Settlement and Debt Consolidation?

Debt consolidation and debt settlement are two very different processes with different implications and impacts on your credit.

Debt consolidation is a strategy where you use a loan to pay off other debts. As noted above, this can help you save money and streamline multiple balances into just one loan with one predictable monthly payment. While applying for a debt consolidation loan can lead to a temporary, small dip in your credit score, debt consolidation can help your credit in the long run if you make all payments on time.

Debt settlement, on the other hand, is a risky process in which a third-party company attempts to negotiate your debts down so you pay a reduced amount. The consequences of settlement can be serious and long-lasting. Debt settlement companies often require you to stop paying your lenders, which causes serious damage to your credit. In addition, your lender can take actions such as charging you fees and penalty interest and sending your debts to collections. There's no guarantee that settlement will be successful in reducing your debts.

The Bottom Line

A debt consolidation loan can make repaying debts more efficient and affordable. If you qualify, consolidating your debts allows you to fold multiple balances into just one loan with lower interest. But keep in mind that debt consolidation isn't the only option, and it isn't always the best fit. It also can't get to the root cause of your debts.

While some debt can be unavoidable, if you're carrying high credit card balances or struggling with overspending, address your spending habits first. Track your spending, create a budget and consider credit counseling if you need individualized advice. In addition, check your credit report for free through Experian to see where your credit stands before you consider a consolidation loan.