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Debt Consolidation Loans: How Do They Work and Should You Get One?

Debt Consolidation Loans: How Do They Work and Should You Get One?

Jenius Bank Team4/28/2023 • Updated 4/19/2024
Man sitting at a desk holding a credit card.

Debt consolidation loans could help you fold multiple credit card payments into one consistent monthly payment.

Did you know that average American has roughly $7,930 in credit card debt alone?1 When you add student loans, mortgages, car loans, and other types of debt to the picture, paying off what you borrow and staying on top of monthly payments may feel overwhelming.

That’s where debt consolidation loans could help. Let’s take a look at how these loans work, the different types available, and how to decide if using a debt consolidation loan is right for your situation.

Key Takeaways

  • Debt consolidation is an effective way to streamline multiple debts into one fixed monthly payment and potentially lock in a lower rate.

  • There are different ways to consolidate debt, including personal loans, balance transfers, and more.

  • Debt consolidation is just one tool in your financial toolbox, and it may not be right for every person or type of debt. Consider your options and weigh the pros and cons before you apply.

What’s a Debt Consolidation Loan?

A debt consolidation loan, often a personal loan, is a debt that lets you combine multiple balances into one monthly payment. Most often, people use these loans to consolidate high-rate liabilities like credit cards or to combine several student or personal loans into a single monthly payment.

Benefits of a Debt Consolidation Loan

Everyone’s financial situation is unique and that means personal loans may offer different people different benefits. However, there are a few benefits that most people could expect to see when they consolidate their debts, including the following:

  • Savings: Debt consolidation loans often offer lower, fixed rates expressed as Annual Percentage Rate (APR), which could help you save money over the life of the loan by paying less in interest. Additionally, consolidating debts may help borrowers lock in a lower monthly payment.

  • Convenience: Since debt consolidation loans let you roll multiple debts into one, you won’t have to keep track of as many monthly payments. This may make paying your bills easier and more convenient.

  • Flexibility: Most debt consolidation loans allow you to choose from multiple repayment time frames, called terms. This gives you the opportunity to choose a lower monthly payment over a longer period to keep your monthly bills lower or a higher monthly payment over less time to help you pay off debt faster.

When choosing a debt consolidation loan, be sure to understand how the funds are distributed. Some lenders pay off your debts directly, while others give you the funds for you to pay off other accounts yourself.

Debt Consolidation Loan Example

Using a personal loan for debt consolidation could be a great way to save money. Let’s explore an example:2

Debt Consolidation Loan

High-Rate Credit Card

Balance: $27,845

Balance: $27,845

APR: 12.18%

APR: 27.89%

Term: 36 months

Term: 36 months

Monthly Payment: $927

Monthly Payment: $1,150

Total interest paid: $5,535.93

Total interest paid: $13,559.14

Note: These numbers are for illustration purposes only. Actual APR, terms, and monthly payment amounts may vary.

Estimated savings with a debt consolidation loan: $8,042.213

In this example, using a debt consolidation loan lowers the monthly payment and saves the borrower over eight thousand dollars in interest. (An extra savvy borrower may choose to put the difference in payments into a high rate savings account.)

Now, saving on interest doesn’t mean you should then go spend more! Debt consolidation is an opportunity to change future spending habits.

“Customers need to avoid the cardinal sin of debt consolidation loans,” says Jenius Bank President, John Rosenfeld. According to John, the “cardinal sin” is when someone uses a loan to consolidate debt from things like credit cards, but then runs up the balances on those cards all over again.

John adds, “To help yourself avoid this risk, take extra credit cards out of your wallet, especially once they’re paid off. This will force you to think twice before adding back to your debt.”

Types of Debt Consolidation Loans

Consider your options if you’re interested in consolidating your debt. There are several types of debt consolidation loans available and each one works differently. Here are some of the most common options.

Personal Loans

Personal loans are an excellent option for consolidating debt, since they frequently offer fast and reliable access to funding to be used however you see fit. Most personal loans do not restrict the types of purchases you may make with the funds, making them ideal for consolidating different types of debt.

Though many loan myths would suggest that personal loans have higher rates than credit cards, most don’t. In fact, most personal loan rates are significantly lower than what you may get on a credit card. For example, the average personal loan rate in April 2024 was 12.18% APR,4 while the average rate on credit cards was 27.89% APR.5

Furthermore, personal loan rates tend to be fixed, meaning your payment remains the same for the life of the loan, unlike a credit card payment.

Credit Card Balance Transfers

Balance transfers allow you to transfer the balance of one or more credit cards onto a new credit card, ideally with a lower rate.

Many credit card issuers offer low introductory rates for balance transfers to help you save money, and some may even offer you a 0% APR for a set time. That means you won’t pay interest on the balances you transfer until the introductory period is up. Although, pay attention to balance transfer fees!

Home Equity Lines of Credit (HELOC)

If you own a home, you may be able to use your home equity to help you consolidate your debts by opening a home equity line of credit or HELOC. These loans are effectively lines of credit with limits based on a percentage of the equity you have in your home. Depending on your credit score and credit history, lenders may approve you for a line of credit with a limit of up to 85% of your equity.

Like personal loans, HELOCs tend to have lower rates than credit cards, which could help you save money on interest payments.

Is Debt Consolidation Right for Me?

Debt consolidation is a great option for many people, but it’s not the perfect fit for everyone. It’s important to make sure it’s the right choice for your situation and the types of debt you’re considering consolidating. Here are a few things to consider as you weigh your options6:

  • The rates you qualify for: Debt consolidation is best for those who could lock in a lower rate than what they’re currently paying. If your debts have lower rates than the personal loans or balance transfers you qualify for, consolidating isn’t likely going to save you money.

  • The size of your debt: If you have a very small amount of debt, consolidating may not be worthwhile. Remember, some lenders charge origination fees for personal loans, and those fees may eat into your savings. You could be better off just paying down what you owe according to your current repayment schedule.

  • Your credit score: The higher your credit score, the better your chances of qualifying for a low-rate debt consolidation loan. If your score is low, you may not qualify for a low enough rate to justify consolidating your debts.

Debt Consolidation Loan Watch Outs

Before you go forward with a debt consolidation loan, take time to do your homework and compare your options. Before you sign the paperwork, make sure to consider the following:

  • Understand the Terms and Conditions: These include the terms of the loan, like the APR, fees, repayment terms, and borrowing limits.

  • Shop Around for Rates: Comparing offers and rates is a good way to find what fits your situation and goals best. Keep in mind that your credit score, debt-to-income (DTI) ratio, and income affect your rate.

  • Watch for Extra Charges or Fees: Some debt consolidation loans come with added costs, like an origination fee, balance transfer fee (for credit card balance transfers), or a prepayment penalty.

If you’re considering a debt consolidation loan, there are a few things you could do to increase your chances of getting a loan approved, such as improving your credit score.

Final Thoughts

A personal loan is often a smart choice for debt consolidation, as it allows you to streamline your payments and save money with lower rates. Not only could it save you money in the long run, but it may also simplify your life. Feeling more organized and making smarter choices when it comes to debt is a home run in our book.

Borrowing & CreditFinancial Wellness