What is debt consolidation and how does it work?

Debt consolidation can be a helpful way to manage multiple debts by rolling them into a single loan or credit card. But what’s in it for you? Potentially lower interest rates or reduced monthly payments, which can save you money in the long run. Here, we look at how debt consolidation works, the different loan types, and how it might affect your credit score.

Consolidation of debt means combining all your debts into a single monthly payment, making it easier to manage and often lowering the interest you’re paying. Instead of worrying about multiple payments, due dates, and APRs, you take out a new loan or use a balance transfer credit card to pay off your existing debts. If you have a good credit score, you may even qualify for a lower interest rate, which can help you save money and pay off your debts faster.

There are several options for this new loan, including a debt consolidation loan, a balance transfer credit card, or a home equity loan. You can find these through banks, credit unions, or other lenders.

So how does debt consolidation work, exactly?

1. Select a loan with a suitable payoff term and ideally a lower interest rate.
2. Get a loan large enough to cover all your existing debts.
3. Submit your application and await approval from the lender.
4. Once approved, the lender will either pay off your creditors directly or provide you with the funds to do it yourself.
5. Start repaying the lender in monthly installments until the loan is fully paid off.

By consolidating your debts, you only have to worry about one payment instead of several. Plus, if you pay on time — or even pay off the debt faster than expected — it can improve your credit score in the long run.

You might be wondering, “What is debt consolidation typically used for?” People tend to consolidate their debts when they have several forms of high-interest debt, like credit cards, but it can also be used for other types of loans, like student loans, auto loans, or mortgages. It’s really for any situation where it’s becoming a struggle to keep track of your debts, and you want to streamline the payments.

Lenders look at a few key factors to decide if you qualify. One of the main aspects is your credit score. Most lenders require a score of at least 650, but if you’re aiming for the best interest rates and terms, you’ll generally need a score of 700 or higher.

That said, the specific requirements vary from lender to lender. Some may be more flexible and willing to work with those who have lower credit scores (even as low as 580), especially if you have other strong points like a stable income or a low debt-to-income ratio. So, even if your credit isn’t perfect, you still have options—though you may face higher interest rates.

Here’s a quick look at different types of financial institutions and their typical terms:

• Banks tend to offer the best interest rates for debt consolidation loans, but you’ll generally need good credit (690+) to qualify. If you’ve been a customer of the bank for a while, it could be worth asking about their options first.
• Credit unions can be more accommodating for borrowers with fair or bad credit (under 690), and joining is usually quick and affordable. Plus, the advantages of credit unions are a big draw; they often provide personalized service and lower fees compared to other options.
• Online lenders often provide same-day loan approval and funding. However, it is often recommended to compare offers with multiple lenders to find the best deal. While online loans are easy to set up and access, they may come with higher fees or interest rates.

There are two main types of debt consolidation loans: secured and unsecured loans. Secured loans require collateral (like your home or car), whereas unsecured loans, such as personal loans, don’t. Some lenders also offer loans designed specifically for the purpose of consolidating debt.

With debt consolidation loans, you receive a lump sum that you use to pay off your debts, leaving you with just one loan to manage. These loans usually come with fixed rates and terms, so your monthly payment stays the same. This means it’s easier to budget compared to fluctuating credit card payments. Plus, you’ll know exactly when you’ll be debt-free, which can be motivating.

You can apply for various amounts and choose a repayment term that fits your needs, typically between two and seven years. Whether you prefer a fast payoff term or smaller monthly payouts, there are a variety of options available. Once you’re approved, you can typically have the funds sent directly to your creditors or to your bank account.

With a balance transfer credit card, you can move your existing debt onto a new card that offers a low or even 0% introductory APR for a limited time — typically anywhere from six to 21 months. This means you won’t pay any interest on the transferred balance during this promotional period.

Just remember, once the promo period ends, the interest rate can jump significantly, so it is generally recommended to pay down as much as you can before that happens. Also, these cards often come with a balance transfer fee, which is usually a small percentage of the amount you move over. And to qualify for a 0% balance transfer card, you generally need good-to-excellent credit, which means a score of 690 or higher.

By using a balance transfer card, you can usually save a fair amount in interest. And, once you’ve paid off your debt, you might have more flexibility to build up your savings. Consider comparing rates to see if you can find a better return on your money.

If you own your own home, and have built up equity, it can be used as collateral for a debt consolidation loan.

How does it work? As you make mortgage payments and your home’s value increases, your equity — the portion you own — grows. A home equity loan, or home equity line of credit, allows you to borrow against that equity without selling your home. Most lenders let you borrow around 80-85% of your home’s value, minus what you owe on your mortgage. You then receive a lump sum payment and pay it back, typically with a fixed interest rate over a set period, with a term generally ranging between five and 30 years.

Home equity loans can come with a high level of risk — if you can’t repay the loan, you risk losing your home to foreclosure. Also, keep in mind there are often upfront fees, so you might compare total costs when considering this option.

If you’re thinking of using a home equity loan to pay off debt, it can help to talk to a credit counselor first to explore alternatives that don’t put your home at risk.

To begin with, consolidating debt might cause your credit score to drop slightly, because lenders often do a hard inquiry when you take out a new loan. Also, if you use a balance transfer credit card and max it out, your credit score could take a hit until you start paying it down.

That said, as long as you stick to your payment plan, debt consolidation can actually help your credit in the long run. Making on-time payments and lowering your debt can improve your credit utilization ratio, which boosts your score over time. Learning how to budget money, sticking to a budget, and keeping spending under control can also work in your favor.

Some people want to know, “What is debt consolidation going to do for me?” It can help to crunch the numbers. Let’s say you’ve got $10,000 in credit card debt with an average interest rate of around 27.92%.¹ If you’re only making minimum payments, over three years, you could end up paying roughly $4,697 in interest alone, according to the Experian APR calculator.

Now you can compare that with taking out a debt consolidation loan at, say, 12.35% APR (which is the average for a 24-month personal loan, according to recent Federal Reserve data). You’d only pay around $1,957 in interest over the three years. That’s a potential savings of nearly $3,000.

Of course, this example is purely for illustrative purposes; it doesn’t account for any fees or charges, and the exact rate you end up paying will vary depending on your credit score and other factors.

Debt consolidation can be helpful for some to streamline their debts, but it’s not always the best fit for everyone. Here’s a quick look at the pros and cons of consolidating debt to help you decide if it’s right for you.

The bottom line is: debt consolidation isn’t a cure-all. Its main advantage is to make the process of repayment easier and potentially cheaper. But if you still struggle to cover the monthly payments, you could end up right back where you started.

And, remember, there are alternatives. For smaller debts, a debt payoff plan like the debt snowball or avalanche might be more suitable. You could take a close look at your spending habits and interest rates before deciding. If you’re overwhelmed by debt, you might consider a more robust solution like debt relief.

Opting for debt consolidation can make it easier to reach your debt-free goal, so you get to use your money how you really want to. On the Raisin marketplace, you can compare interest rates on a wide range of high-yield savings accounts, CD accounts, and more. Quickly and easily open and fund savings accounts from a range of US partner banks and credit unions by registering for a Raisin login. Then, simply log in to manage it all in one place and watch your savings grow!

The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.

¹ https://www.forbes.com/advisor/credit-cards/average-credit-card-interest-rate/