How Does Debt Consolidation Work? The Ultimate Beginner’s Guide

Debt consolidation is an excellent way to get relief by reducing the number of payments you owe each month. This helps you make progress on paying down your debt and can potentially save you money on interest costs. Below, we’ll explain how debt consolidation works, how it affects your credit score, and alternatives to consider.

What is debt consolidation?

Debt consolidation is a financial strategy where multiple debts are combined into a single loan or payment. Instead of juggling several bills with different due dates, interest rates, and minimum payments, debt consolidation allows you to streamline your obligations into one manageable monthly payment. 

The primary goal is to simplify your finances, often while securing a lower interest rate, making it easier to pay off your debt over time. Common debts consolidated include credit cards, personal loans, medical bills, and other unsecured debts.

How debt consolidation works

Debt consolidation typically involves taking out a new loan to pay off your debts. Here’s how the process works, step by step:

1. Assess your debts: Gather all the details about the debts you want to consolidate, including balances, interest rates, and monthly payments. Knowing your total debt load is key to selecting the right consolidation method.
2. Choose a consolidation option: You might apply for a personal loan from a bank, use a balance transfer credit card with a 0% introductory rate, or work with a debt consolidation company. Some people also use home equity loans or lines of credit if they have sufficient equity in their home.
3. Apply for the new loan: Once you’ve decided on the best option, you’ll apply for the consolidation loan. Lenders will evaluate your creditworthiness, income, and debt levels before approving your application. A strong credit score may help you secure a better interest rate.
4. Pay off your debts: After approval, the loan funds are either sent to your creditors or deposited into your account. You’ll use these funds to pay off all your debts in full.
5. Make one monthly payment: Now that your debts are consolidated, you’ll focus on making a single monthly payment toward the new loan. Ideally, the interest rate is lower, making it easier to manage and potentially saving you money in the long run.

Debt consolidation is often used to reduce financial stress and simplify repayment, but it’s important to evaluate whether this approach is right for your situation, considering fees, loan terms, and your spending habits.

Types of debt consolidation

Each of the following four debt consolidation options has pros and cons. We’ve ranked them from the best option to what we consider the last resort.

Method	Best for
Personal loan	Borrowers with good credit, a low DTI ratio, and a steady income.
Balance transfer credit card	Borrowers who can qualify for new credit cards and can pay off their balance within the 0% rate introductory period.
Home equity loan/HELOC	Borrowers who have home equity and want a lower interest rate but understand their home is the collateral for the loan.
401(k) loan	Borrowers who understand the risks of borrowing from retirement savings and are confident they can meet repayment obligations, especially if they remain with their current employer for the loan’s duration.

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Best Debt Consolidation Loans

Personal loans 

According to Federal Reserve data, the average finance rate on personal loans is 12.33% as of August 2024, whereas the average interest rate on credit cards is 23.37%. So consolidating your high-interest credit card debt into a personal loan can save you in interest costs.

Balance transfer credit cards

Specific credit cards called balance transfer cards offer 0% financing for a period of time—for example, 18 months. These cards allow you to transfer the balance from your higher-interest cards up to your limit. A fee—such as 3% of your transfer balance—often applies. This is an excellent strategy if you can pay off your debt before the promotional period ends.

Home equity loans

Home equity loans and home equity lines of credit (HELOCs) allow you to borrow against your home equity, which you can use to consolidate your debt. The benefit is you can typically get lower interest rates than many other types of loans. The drawback is that your home is at risk because it’s the collateral for the loan.

401(k) loans

A 401(k) loan allows you to borrow from your own retirement savings without it being treated as a taxable distribution. You may be able to borrow up to 50% of your vested balance, or $50,000, whichever is lower. No tax or penalty applies as long as you repay the loan on time, usually within five years.

However, the risk comes if you leave your job, are terminated, or retire before the loan is repaid in full. You may need to pay the full outstanding balance quickly (often by the next tax deadline). If you don’t, the loan is treated as a distribution, and you may face income taxes and a 10% early withdrawal penalty if you’re under 59 ½.

A 401(k) loan can be useful in certain situations, but it’s important to note that borrowing from your retirement savings reduces the amount invested in your future. 

As with all financial decisions, the “best” option will depend on your financial circumstances. For example, I might recommend a 401(k) loan first to a client who doesn’t feel like they’re disciplined enough to repay a 0% introductory rate credit card within the introductory time period.

Erin Kinkade, CFP®

How to qualify for debt consolidation

Getting a debt consolidation loan will depend on several factors, such as your income, credit score, the amount you want to borrow, and your debt-to-income ratio. Lenders set their own criteria; some specialize in helping consumers with lower-than-average credit scores, so it’s best to find one that aligns with your current needs and personal situation.

Depending on the lender, you might need a credit score in the mid-600s to qualify for a personal loan. Lenders also tend to prefer a debt-to-income ratio of below 36% and a history of stable employment. The amount you want to borrow and your loan term will also affect your eligibility.

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Tip

Pull your free credit report from AnnualCreditReport before applying for a consolidation loan. Make sure your information is accurate and doesn’t reflect any mistakes or accounts in collection. An accurate report free from adverse accounts can improve your chances of qualifying for a consolidation loan.

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How does debt consolidation affect your credit score?

Debt consolidation can have positive and negative effects on your credit score, depending on how you manage the process.

Pros and cons of debt consolidation

Before you decide to consolidate your debt, weigh the potential risks and benefits.

Pros

• Simplifies payments

  A significant advantage of debt consolidation is that it streamlines your payments into one monthly bill, reducing the complexity of managing multiple due dates and creditors.

• Lower interest rates

  If you qualify for a debt consolidation loan with a lower interest rate than your current debts, you can save money in the long run. This is especially helpful for high-interest credit card debt.

• Fixed repayment schedule

  Debt consolidation loans often come with a set repayment term, so you know exactly how long it will take to pay off your debt. This structure can provide financial clarity and help you stay focused on eliminating debt.

• Potential credit score improvement

  Making consistent on-time payments on your consolidated loan can help boost your credit score over time.

• Lower monthly payments

  Depending on the terms of your loan, consolidating debt can reduce your monthly payments, making it easier to manage your finances on a day-to-day basis.

Cons

• Doesn’t reduce total debt

  Debt consolidation simplifies and potentially lowers interest rates, but it doesn’t reduce the overall amount you owe. It’s still your responsibility to pay off the full balance.

• Potential for more debt

  If you continue to use credit cards or other forms of credit after consolidating, you could find yourself in even more debt, potentially leading to financial instability.

• Fees and costs

  Some debt consolidation loans come with fees, such as origination fees, which can add to the cost of borrowing. You’ll need to factor these in to determine whether consolidation is a financially sound option.

• Risk of damaging credit

  If you miss payments on your debt consolidation loan, it could lower your credit score, undermining the benefits of consolidation.

• Not a solution for everyone

  Debt consolidation is best suited for individuals with good credit who are looking to simplify and lower their interest rates. Those with severe financial challenges or poor credit may not qualify for favorable loan terms, making other options, such as debt settlement or credit counseling, more appropriate.

Considering these pros and cons will help you determine whether debt consolidation is the right financial tool for you.

Is debt consolidation right for you?

Debt consolidation has many benefits, but it still might not be the best choice for everyone. Here are scenarios where debt consolidation would be helpful and situations where other options might be better.

If you…	Consider debt consolidation?
Have multiple high-interest debts, such as credit cards	✅ Consolidating your debt can often save on interest costs.
Struggle to keep track of your bills and due dates	✅ Rolling your debts into one can help streamline your budget and help you get more financially organized.
Have a good credit score	✅ A good credit score can help you qualify for a lower-interest debt consolidation loan.
Can’t make your monthly payments	✅ Debt consolidation can help you by streamlining multiple monthly payments into one lower payment. However, if you struggle to make payments, working with a financial advisor and taking steps to improve your income are wise moves.
Will pay off your current debt in less than 6 months	🤔 Maybe, but compare fees to consolidate the debt with potential interest savings to see which option is better.

When it’s a good idea   

There are several situations where consolidating your debt can help your finances:

• To get a lower interest rate: If you’re eligible for a lower interest rate when consolidating debt, it’s often smart because it can save you significant money over time.
• To simplify your budget: If you can combine several bills into one each month, it’s usually wise. You’ll feel far less stressed, and it will make budgeting much easier.
• When you have good credit: If you have good credit, you may be eligible for better interest rates and loan terms. This can be helpful when applying for a personal loan or a 0% credit card.

When it isn’t right for you

If you’re in a difficult situation where you’re at risk of accruing more debt if you consolidate, debt consolidation might not be the best fit for you. Here are some other examples of when to consider alternatives.

• You still struggle with spending: If you don’t earn enough to cover your expenses, it’s possible that you’ll be at risk of going into debt again, even after consolidating. Instead, work with a financial advisor to get a solid plan and accountability prior to considering debt consolidation.
• There’s no mathematical benefit: Often, consolidating debt improves your interest rate and can lower your monthly payment. However, in some situations, such as if you’ll pay off your debt in the next few months without consolidating, it might not be worth the balance transfer or origination fees.

If you are experiencing unstable income, making a commitment to a new payment might not be in your best interest, and other options may be more suitable. 

To add to the point about determining the mathematical benefit, if the fees and costs associated with the consolidation negate the benefit by adding to your debt balance, it may be better to make a payoff plan with your current obligations in place.

Erin Kinkade, CFP®

Debt consolidation vs. alternatives

When considering debt consolidation, it’s important to compare it to other financial solutions that may better suit your situation. Two common alternatives to debt consolidation are debt settlement and bankruptcy. Each option has its own benefits and drawbacks, so understanding how they work is crucial in making the best choice for your financial health.

Debt consolidation vs. debt settlement

Debt consolidation	Debt settlement
Can reduce interest rate but not total debt	Can reduce total debt
Less significant credit score risks than debt settlement	More significant credit score risks
Best for those who want to simplify their debt and reduce interest	Best for those struggling with significant debt who can’t keep up with payments

Debt consolidation involves combining multiple debts into a single loan with the aim of simplifying payments and often securing a lower interest rate. It doesn’t reduce the total amount of debt but makes it more manageable over time. You’re still responsible for repaying the full amount owed, but ideally at a lower interest rate, which could save you money in the long run.

Debt settlement involves negotiating with creditors to pay less than what you owe. Companies such as National Debt Relief specialize in this process. Typically, you stop making payments to your creditors and instead deposit money into a separate account managed by the debt settlement company. 

Once enough funds accumulate, the company negotiates with creditors to accept a lump-sum payment that is less than the original debt. Debt settlement can significantly reduce the amount you owe, but it comes with risks, including damage to your credit score and potential tax liabilities on the forgiven amount.

Debt settlement is often best for those struggling with significant debt and unable to keep up with minimum payments. Debt consolidation may be better for those who can still manage payments but want to simplify and reduce their interest costs.

Debt consolidation vs. bankruptcy

Debt consolidation	Bankruptcy
Can reduce interest rate but not total debt	Can eliminate debt
Much less significant credit score risks than bankruptcy	Significant credit score risks
Keep your assets	May need to sell some of your assets
Best for those who want to simplify their debt and reduce interest	Best as a last resort for those with severe difficulty repaying debt

Another alternative is bankruptcy, which can offer relief from overwhelming debt but has long-term consequences for your credit and financial future. 

• Chapter 7 bankruptcy can discharge most unsecured debts, offering a fresh start, but you may need to sell off some assets. 
• Chapter 13 bankruptcy involves creating a repayment plan, allowing you to keep your assets while paying down debt over a set period.

Compared to debt consolidation, bankruptcy has a more severe impact on your credit score and remains on your credit report for up to 10 years, whereas debt consolidation typically affects your credit score only if you miss payments or open new credit accounts.

Debt consolidation vs. credit counseling

Debt consolidation	Credit counseling
You obtain the loan and pay off debts on your own	Work with a counselor at a nonprofit agency, who will contact your creditors to negotiate lower rates or fees and help you create a plan
May involve taking out credit (a loan or balance transfer credit card)	Doesn’t require taking out a new loan or line of credit
Best for those who want to simplify their debt and reduce interest	Excellent alternative to debt consolidation for those who don’t want to take out a new loan or need professional guidance

Credit counseling is another alternative where you work with a nonprofit agency to create a debt management plan (DMP). The credit counselor negotiates with your creditors to potentially reduce interest rates and consolidate your payments, but you’ll still repay the full debt. Unlike debt settlement, credit counseling aims to help you repay your debts in full, often within three to five years, and it can be less harmful to your credit score.

Debt consolidation is a solid option if you want to manage your debt more efficiently and pay it off in full. Debt settlement, bankruptcy, or credit counseling may be better suited for individuals facing more severe financial challenges and needing debt reduction or forgiveness.

Real-life examples and success stories

Here are two real-life examples of women who used debt consolidation as a strategy to lower their monthly payments, streamline their finances, and pay off debt faster.

Dyana Marie

Dyana Marie, a personal finance YouTuber with over 42,000 subscribers, explained that she used a 0% credit card to consolidate her high-interest debt and pay it off faster. She had a low income, making $15 per hour as a single mother to a little girl, and she wasn’t making progress with her minimum debt payments.

So, she opened a credit card that offered 0% interest for 18 months and consolidated her high-interest debt. By aggressively paying down the balance before the 0% introductory period ended, she paid off her debt in full. On her channel, she gave her followers tips on which cards to use and what to be aware of, such as balance transfer fees.

Choncé Maddox

Choncé Maddox, the founder of My Debt Epiphany, has been featured on “Good Morning America” and other media outlets for paying off $50,000 of debt a few years ago. Earlier this year, though, after juggling hospital bills and other debt payments, Choncé accidentally missed a payment date for one of her bills.

Determined to get more organized and streamline her finances once again, Choncé took out a $10,000 personal loan. She used her loan to pay off several bills, including all her medical bills, and rolled everything into one payment. Choncé explained that even though her loan term is five years, she is on track to pay off the balance in full by January 2025 at the latest.

How to manage a debt consolidation loan

Once you get a debt consolidation loan, here’s how to manage it to stay on track and even pay it off early.

1. Set up automatic payments: To make sure you don’t miss a payment, set up automatic payments. Check to make sure the money comes out of your account each month.
2. Pay extra: Whenever you can, pay extra on your loan. Even adding $25 or $50 to your loan payment each month can save you significant interest fees over time.
3. Create a budget: Creating a budget and monitoring your spending each month helps you stay on track with your bills. Making payments on time every time also helps your payment history on your credit report.
4. Avoid additional debt: One of the best ways to ensure you pay off your debt consolidation loan as soon as possible is to avoid going into debt again. Adding new debt means adding more monthly payments, which reduces the amount of cash you can divert to paying down your consolidation loan.
5. Look for refinancing opportunities: If interest rates drop, you might be able to refinance your debt consolidation loan into another loan at a lower interest rate. This can help you save money on interest and allow you to make more progress when paying down your principal. 

Debt consolidation tools and resources 

If you want to consolidate your debt, here is a list of tools and resources that can help you.

• Debt consolidation calculator: You can use a debt consolidation calculator online to compare monthly payments, total interest costs, and more. That can help you determine whether it’s worthwhile to move forward with the debt consolidation process.
• Loan comparison websites: An online marketplace such as Credible allows you to view multiple lending options at once. You can use Credible to refinance student loans or to compare personal loan options to consolidate other debt.
• Budgeting apps: Several budgeting apps, such as Empower, PocketGuard, YNAB, Every Dollar, and many more, allow you to track your spending. Some of these apps are free, and others charge fees. Monitoring your spending can help show you how much money you can redirect toward extra debt payments.
• Certified Financial Planners (CFPs): Working with a financial planner can help you create a strategy to pay down debt and plan for your long-term future. The XY Planning Network is a solid resource to find fee-only financial advisors who are fiduciaries.

Common questions about debt consolidation

Can I still use my credit card after debt consolidation?

Once you consolidate your debts, continuing to use your credit card could undermine your efforts to become debt-free. Though it’s possible, most debt consolidation plans, especially those involving a loan, aim to help you reduce debt, not accumulate more. We recommend that you avoid using your credit card after consolidating debt. This could lead to more financial strain and debt over time.

What happens to all the debts with a debt consolidation loan?

When you take out a debt consolidation loan, the funds from that loan are used to pay off your debts in full. So your debts, such as credit card balances or personal loans, are effectively zeroed out, and you’re left with a single loan to repay. You’ll now make one monthly payment to the lender that provided the consolidation loan, ideally with a lower interest rate.

Is a debt consolidation program worth it?

Whether a debt consolidation program is worth it depends on your personal financial situation. If you’re struggling to manage multiple payments and high-interest debt, consolidation can simplify your finances and save you money through lower interest rates.

However, it’s important to compare fees, interest rates, and loan terms to ensure you’re not paying more in the long run. Depending on your financial goals and needs, it’s also worth considering other alternatives, such as credit counseling or debt settlement.

Can I buy a house after debt consolidation?

Yes, you can still buy a house after debt consolidation, but your ability to qualify for a mortgage will depend on your financial situation and credit score. 

If consolidating debt helps you improve your credit score by reducing your overall debt-to-income ratio, it could make it easier to qualify for a mortgage. However, if the consolidation process harms your credit (such as missed payments or applying for too much credit at once), it may delay your ability to purchase a home.

What is the average fee for debt consolidation?

The average fee for debt consolidation varies depending on the method. Many personal loans don’t have upfront fees, but some lenders charge origination fees, which can range from 1% to 5% of the loan amount. 

Debt consolidation programs through companies may charge fees for managing your consolidation or negotiating with creditors, usually ranging from 15% to 25% of the total debt. Be sure to research any potential fees and compare different options before committing.

How long does debt consolidation stay on your credit?

A debt consolidation loan itself doesn’t remain on your credit report indefinitely, but the hard inquiry from applying for the loan can affect your credit score for about two years. Any late payments or defaults prior to consolidating your debts can remain on your credit report for up to seven years. 

If debt consolidation helps you maintain on-time payments and reduce your overall debt, it can have a positive long-term effect on your credit score.