Debt consolidation is when you roll multiple debts into one loan with one monthly payment — and a hopefully lower interest rate. This can help you stay organized and possibly save money, especially when you have a pile of debt and it doesn’t seem like you’re making any progress toward repaying what you owe.

Not all debt consolidation loans are the same, though. Understand how they work and weigh the benefits and drawbacks of these loan products before deciding if they make financial sense for you.

What to look for in a debt consolidation loan

A debt consolidation loan is one way to refinance your debt. You apply for a loan for the amount you owe on your existing debts, and if you are approved, you use the funds to pay off your debt balances. Then you’ll pay down the new loan over time.

To find the right option for yourself, evaluate features like the type of loan, its term and if it requires collateral.

  • Loan type: The most common loan types include personal loans, credit cards with an introductory 0 percent APR, 401(k) loans and home equity loans. Some require collateral while others don’t, so it’s worth understanding how each debt product works as it could impact other areas of your finances. Be mindful of the long-term impact of your loan. If you plan to use a credit card with a low introductory rate, for example, make sure you can pay off all or most of your debt before the rate jumps up.
  • Loan terms: Longer loan terms could mean your monthly payments are more affordable, but you should also be mindful of the interest rate since it determines how much you’ll pay the lender to borrow funds. You may find that a shorter repayment period is ideal despite the higher monthly payments because you will pay far less in interest. Evaluate your budget and don’t stretch yourself too thin.
  • Secured versus unsecured: You have to put down collateral with a secured loan. For example, a home equity loan is secured by your home. If you fall behind on payments, the lender can take that collateral to satisfy your unpaid balance. If you don’t want to risk your assets, consider sticking to your unsecured options, such as personal loans and 0 percent APR credit cards. That said, a secured loan often has a lower interest rate, so that can be helpful if you’re working to pay down your debt.

How does a debt consolidation loan work?

Most debt consolidation loans are fixed-rate installment loans, which means the interest rate never changes and you make one predictable payment every month. So if you have three credit cards with different interest rates and minimum payments, you could use a debt consolidation loan to pay off those cards — leaving you with just one monthly payment to manage instead of three.

Let’s say you’re paying down credit card debt. Here’s how a debt consolidation loan can help you save on interest costs:

  • Card 1 has a balance of $5,000 with an APR of 20 percent.
  • Card 2 has a balance of $2,000 with an APR of 25 percent.
  • Card 3 has a balance of $1,000 with an APR of 16 percent.

If you pay down these credit card balances over 12 months, your interest costs would amount to $927. But let’s say you take out a 12-month personal loan for the amount you owe — $8,000 — with a 10 percent APR. If you pay off the loan in one year, you knock down the interest cost to just $440. To calculate the savings on your debt, try using a credit card payoff calculator and a personal loan calculator.

Benefits of a debt consolidation loan

If you’re looking to save money, streamline your monthly payments and circle the payoff date on your calendar, then debt consolidation may be a good fit.

  • Pay down debt quicker. Making the minimum payment on your credit cards can stretch your repayment timeline for years. A debt consolidation loan may put you on a faster track to paying it off, albeit because you’ll likely pay more each month.
  • Save on interest costs. Generally, if you qualify for a lower rate than what you’re paying now, you’ll save on interest costs. As of early November 2022, the average credit card interest rate was 19.04 percent, compared to the average personal loan rate of 13.5 to 15.5 percent for someone with good credit.
  • Simplify your monthly payments. It’s easier to manage one monthly payment than multiple payments with different due dates. This reduces your chances of missing payments, which is good for your credit.
  • Repay on a fixed schedule. Many debt consolidation loans are fixed installment loans, which means you’ll know exactly when you’ll be debt-free. This can help motivate you while you pay down debt.

Risks of a debt consolidation loan

Before moving forward, you’ll need to weigh your immediate needs with your long-term goals. Some people choose to consolidate debt to save money and organize their monthly payments, but there are downsides:

  • It won’t solve all your financial issues. Once you use the debt consolidation loan to pay off your debt, you should avoid using your credit cards again. This increases your overall debt, which can impact your credit and make it harder to pay down your balances.
  • There may be some upfront costs. Some debt consolidation loans come with fees, including origination fees, balance transfer fees, prepayment penalties, annual fees and more. Before taking out the loan, ask the lender whether any apply.
  • You may pay more in interest. This might happen in two ways. Depending on your credit score, debt-to-income ratio and loan amount, you might pay a higher interest rate than you would on the original debt. Or, if you use the debt consolidation loan to lower your monthly payments by stretching out your repayment term, you may end up paying more in interest in the long run.

What to consider before taking out a debt consolidation loan

A debt consolidation loan can be a handy way to group your debts together and lower the amount of interest you pay. But if you don’t qualify for a low enough rate to make it worthwhile, there are some things you should try first.

  • Negotiate with your lenders. Even if you aren’t struggling to keep up with payments, talk to your lenders. They may be willing to lower your interest rate or otherwise adjust your debt to help you pay off what you owe. Ultimately, a lender would rather see you pay off a portion of your debt instead of default, so they may be more willing to negotiate than you think.
  • Pay down smaller debts. Your debt-to-income ratio is a measure of how much of your income goes toward debt each month. Lenders want to see a DTI under 36 percent to ensure you have enough room in your budget to handle payments. By paying down smaller debts before you apply for debt consolidation, you will lower your DTI — and increase your chances of being approved for a good rate.
  • Work on your budget. It may be tough, but you should try to trim your budget as much as possible. Even switching from name-brand to generic grocery items or adjusting your thermostat by a few degrees can free up additional money that can go toward your debt.
  • Find an alternate source of income. Another tip that’s easier said than done. But if you can, increasing your income with a second job, delivery service of online freelance work means you will have more each month to help settle your debts.

Debt consolidation loan interest rates

When you pay back a debt consolidation loan, you’re not just paying back the amount you borrowed — you’ll also pay an additional sum each month in the form of interest. To make a debt consolidation worthwhile, it needs to be the same or less than you would pay on your current debts.

Interest rates on debt consolidation loans generally range from 5.99 percent to 35.99 percent. A higher interest rate will cost you more over the life of the loan than a lower interest rate. Every lender has different criteria for setting rates, so shopping around can help you find the best deal.

Generally, lenders check these factors when deciding your interest rate:

  • Your credit score: Borrowers typically need a credit score in the mid-600s to qualify for a debt consolidation loan, and a higher score should help you get a lower interest rate.
  • Your DTI ratio: Your DTI ratio shows lenders how much of your monthly income goes toward debt payments. Lenders tend to look for a lower DTI ratio.
  • Income: The lender will verify your employment and check that you earn enough to make payments.

If you don’t quite meet the credit requirements, you may be able to find a lender that’s willing to extend you a loan, although likely with a higher interest rate. If you’re in this situation, consider adding a co-signer to the loan. This person promises to take over payments if you fall behind — so they should understand what’s involved before saying yes.

How to apply for a debt consolidation loan

There’s a little legwork involved, but taking these steps will be worth it if it saves you money:

  • Understand your finances. A strong credit score gives you a better chance of qualifying for a debt consolidation loan and getting a good interest rate. Check your credit score before applying to see if it needs work.
  • Compare lender terms. Shopping for the best deal can help you save on debt consolidation. Get quotes from multiple lenders and compare the interest rates, fees, loan terms and monthly payments. The loan with the lowest interest rate doesn’t necessarily mean it’s the best option. You could find that you’ll pay far more in fees for the loan with the lower interest rate than you would if you choose the lender that charges more in interest but fewer fees.
  • Get prequalified. Some lenders offer prequalification, which gives you a sneak peek of the offers you may receive. This is a soft credit pull, which means the prequalification won’t affect your credit score. You can generally get started online by providing some basic information about yourself and your finances.
  • Gather what you need to apply. When applying for a debt consolidation loan, you’ll need the information you used to get prequalified and documentation to prove your income. This could include your recent pay stubs, bank statements or tax returns. Some lenders also request additional information, so it’s worth asking about documentation requirements before applying.

If you are approved, the lender may disburse your loan proceeds to your creditors or send the funds to you. Make sure the original debt is paid off, then work on your new loan. Set up automatic payments or use reminders to make on-time payments every month. If you stick with your plan and don’t incur any new debt, you’ll be debt-free at the end of it.

How to tell if a debt consolidation loan is right for you

A debt consolidation loan is worth considering if:

  • You qualify for a lower interest rate. If you have good or excellent credit and plan to consolidate credit card debt, you’ll likely get a lower interest rate on a debt consolidation loan than you currently have on all your credit cards.
  • You want a predictable monthly payment. The interest rate is fixed on most debt consolidation loans, which means you’ll get a predictable monthly payment that you can work into your budget. But a debt consolidation loan only makes sense if you can afford this amount.
  • You’d prefer to pay a single creditor each month. Instead of scrambling to pay several creditors by the payment due dates, you’ll only pay one creditor each month and can avoid late payment fees and adverse credit reporting.

However, there are instances where it could be more sensible to explore other options. If your credit score is on the lower end, it’s highly unlikely that you’ll qualify for a debt consolidation loan with a lower interest rate than you currently have.

It’s best to avoid taking out a debt consolidation loan if money’s tight or you tend to overspend, making it challenging to afford the monthly loan payments or risk racking up even more debt. In this case, you’re better off reaching out to lenders and creditors to negotiate a payment arrangement that works for your finances.

Bottom line

If you can qualify for a low interest rate, a debt consolidation loan can streamline the process of getting rid of your debt and save you money at the same time. It’s not right for everyone, though.

Before you commit to this path, figure out what it would look like. Explore which loan options you could use and the interest rates and fees that would come with each. That way, you can determine if a debt consolidation loan will help you — or only land you in more financial trouble.

Learn more: