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If you're shouldering high-interest credit card balances or other debts, debt consolidation may be an option. A debt consolidation loan is a personal loan that you use to pay off your other debts. Consolidating may help you make repayment more manageable by reducing your monthly payments, or cheaper if you consolidate into a loan with a lower rate than your debts.
But consolidating has some trade-offs to consider too. Before you apply for a consolidation loan, learn more about how they work, the pros and cons and how to do your research to pick the best offer.
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.
Consolidating your debt may help you lower your monthly payments, reduce the overall cost of your debts or get out of debt faster. To qualify for the lowest interest rates, you'll typically need good credit. But there are offers designed for a range of credit scores.
Learn more: What Credit Score Is Needed for a Personal Loan?
How Debt Consolidation Loans Impact Your Credit
Taking out a debt consolidation loan can have both positive and negative impacts on your credit scores, depending on how you manage the loan. Managed well, consolidating your debts may be good for your credit in the long run.
Ways Debt Consolidation Could Hurt Your Credit
As with any loan, applying for a debt consolidation loan will typically result in a hard inquiry on your credit report. Hard inquiries can cause a small, temporary dip in your credit.
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.
The most significant way a debt consolidation loan could hurt your credit is if you don't make on-time payments each month.
Learn more: Does Debt Consolidation Hurt Your Credit?
Ways Debt Consolidation Could Help Your Credit
Debt consolidation can also improve your credit in a couple of key ways.
First, 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 scores.
Also, folding your credit card balances into a debt consolidation loan can lower your credit utilization rate, which also has a positive impact on your credit.
Pros and Cons of Debt Consolidation
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
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 interest rate 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
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 10% 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:
- 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.
- Research lenders. Experian's debt consolidation loan comparison platform can help you easily browse offers matched to your credit profile. Compare loan rates, fees and terms to find the best offer for you.
- 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.
- Repay the loan. After you receive your consolidation loan funds, use the money to pay off your debts. Make sure to be cautious about borrowing as you repay your loan. Avoid running up new balances on the cards you just paid off, 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. They might also suggest a debt management plan (DMP). With a DMP, the counselor tries to negotiate lower rates with your creditors; you make one monthly payment to the agency, which they then use to pay your creditors.
- Balance transfer card: A balance transfer card with an introductory 0% annual percentage rate (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 investigating 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 which typically entails a third-party company negotiating 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.
Learn more: Risks of Debt Settlement
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 and FICO® Score☉ Θ for free through Experian to see where your credit stands before you apply for a consolidation loan.