Debt Consolidation Loans: How Do They Work and Should You Get One?
Debt consolidation loans could help you fold multiple credit card payments into one consistent monthly payment.
How many times have you organized your closet, pantry, or garage for spring cleaning? It’s natural to want to organize, whether it’s to make things easier to find, feel a sense of accomplishment, or simplify your life.
Did you know that you can also organize your debt? If you’re looking to be smarter about your debt, a debt consolidation loan may be the right solution for you.
Debt consolidation is an effective way to streamline your debt into one fixed payment monthly and potentially access a lower rate. A lower rate could save you money in the long run.
There are different ways to consolidate debt, including personal loans and credit card balance transfers.
Like most things, debt consolidation is a tool in your financial toolbox, but it may not be right for every person or every type of debt.
What’s a Debt Consolidation Loan?
A debt consolidation loan is a way to combine multiple, often high-interest, debts into one payment monthly.
Since debt consolidation loans often have a lower rate than the original debts, the borrower may save money in the long run by paying less in interest, depending on the length of the payback and the type of loan. Additionally, by consolidating debts, the borrower often ends up with a lower overall monthly payment. A common type of debt consolidation loan is a personal loan.
In most cases, any type of debt that doesn’t have collateral, such as credit card balances, can be consolidated. Some loans with collateral may be eligible for debt consolidation, such as an auto loan, but those loans typically have a lower rate than a debt consolidation loan. Unpaid medical debts and some payday loans may also be eligible for consolidation.1 Some benefits of a debt consolidation loan include:2
Savings: Fixed rates are often lower, potentially saving you money.
Convenience: It can be easier to manage one payment rather than multiple.
Flexible Timing: Most debt consolidation loans allow you to choose from multiple repayment time frames. This gives you the opportunity to choose a lower monthly payment over more time or defeat debt faster by choosing a shorter term.
Consistency: A fixed term and payment means you know exactly how much to pay each month and when your loan will be paid off.
When choosing a debt consolidation loan, be sure to understand how the funds will be distributed. Some lenders will pay off your debts directly, while others will provide the funds to you and let you settle up your other accounts.
Is Debt Consolidation Right for Me?
Using a personal loan for debt consolidation can be a great way to save money. Let’s explore an example:3
Debt Consolidation Loan
High-Rate Credit Card
Term: 36 months
Term: 36 months
Monthly Payment: $950
Monthly Payment: $1,073
Total interest paid: $6,342.36
Total interest paid: $10,796.62
Note: These numbers are for illustration purposes only. Actual APR, terms, and monthly payment amounts may vary.
Estimated savings with a debt consolidation loan: $4,454.264
In this example, using a debt consolidation loan lowers the monthly payment AND saves the borrower over four thousand dollars in interest. (An extra savvy borrower may choose to put the difference in payments into a high rate savings account.)
Debt consolidation loans are a great way to tackle credit card debt, but they require the borrower to be disciplined about future spending.
“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.”
While debt consolidation loans are a useful tool, they aren’t right for everyone. For example, if you have a small debt load that you have budgeted for and plan to pay off in the next few months, consolidating your debt may be more work than continuing with your current plan.
Types of Debt Consolidation Loans
There are two primary ways to consolidate debt into one payment monthly: balance transfer offers from credit cards and fixed-rate debt consolidation loans.
Personal Loans for Debt Consolidation
A personal loan is an excellent option for consolidating debt, since they offer fast, reliable access to funding that can be used however you see fit (within the terms, of course).
There’s a common misconception that personal loan rates are as high, or higher, than credit cards. But the truth is, personal loans tend to have lower rates than many credit cards, reducing the interest you pay.5 For example, the average credit card APR in Q1 2023 was 20.09%,6 whereas the average personal loan APR was 11.48% in Q1 2023.7
Personal loans also tend to have fixed rates, which makes budgeting easier for the life of the loan.
Lastly, the approval process for personal loans is fairly quick, with many online lenders funding borrowers in one business day!
Credit Cards with Balance Transfer Offers
Balance transfer promotions are common in the credit card industry. Many balance transfer offers have lower APRs than normal credit cards, with some offering 0% APR.
Balance transfer offers with 0% APR may present an opportunity to consolidate multiple credit card balances into one account with no interest charged during a defined term — think of it like a streaming TV introductory offer where you get the first 12 months at a discounted rate.
These types of offers provide a way to save money on interest if you stick to a payment schedule and pay the transferred balance by the end of the promotional period.8 If you have a significant amount of credit card debt, this option might be for you.
Be warned, these 0% intro APR deals have some catches. First, if you don’t pay the balance by the end of the term, the rate that kicks in can be pretty hefty (remember that average of 20.09% APR we mentioned earlier).
Second, most balance transfer promotions charge a transfer fee,9 usually 3–5% per transfer. For example, if you transferred $5,000, you’d be charged a $150-250 fee.10
Additionally, the transferred balance counts against the credit card’s limit, limiting your purchasing power with that card. Like anything else, it’s important to evaluate all the factors before jumping into a 0% APR offer.
Other Debt Consolidation Options
In addition to balance transfer credit card offers and personal loans, there are a couple other ways to consolidate debt, one of which is a home equity loan. Unfortunately, the option is only available to homeowners.
Unlike the options discussed above, these loans involve collateral and could have long-term financial consequences if you aren’t able to repay them in a timely manner.
Home equity loans allow you to tap into your home’s equity, aka the value of your home minus the amount you owe on it.11
Lenders may approve your loan amount for up to 85% of your home’s equity. In return, your home is collateral, meaning it guarantees the loan. If you’re unable to repay the loan, the bank may seize your home through foreclosure.12
Like a personal loan, home equity loan payments are fixed each month over a set term. These loans may have lower rates than personal loans, however the process to establish a home equity loan can be more complex and time consuming. It may require an appraiser to visit your house and you may have to work with an attorney, depending on the state. These are all factors to consider when choosing the right loan for you.
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 will be the best way to find what fits your situation and goals best. Keep in mind that your credit score, debt-to-income (DTI) ratio, and income can 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 0% APR credit cards), or a prepayment penalty.
If you’re considering a debt consolidation loan, there are a few things you can do to increase your chances of getting a loan approved, such as improving your credit score.
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.