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What is debt consolidation and how does it work?

Debt Consolidation Loan Application
If your debts continue to climb, you may want to consider debt consolidation to help you get everything under control.

/Getty Pictures

If you’re in mounting debt, you’re probably not alone. According recent data from Experian, Americans had an average debt balance of $96,371 in 2021, a 3.9% spike from a year earlier. This figure includes credit card debt, loans and other types of debt.

If you feel overwhelmed with debt, now is the time to take steps to pay it off quickly. There are several online tools that can help you get back on track in a timely manner.

One method is debt consolidation, which allows you to combine multiple debt balances into one account, ideally with a lower interest rate. This way, you can potentially save money on interest, lower your monthly payments, and pay off your debt faster.

Let’s take a closer look at debt consolidation, how it works and how it can help you save money.

What is debt consolidation?

Debt consolidation offers a simple way to tackle debt by consolidating multiple debt accounts into one account, usually a consolidation loan. You can consolidate student loans, credit card debt, unsecured personal loans and other accounts.

To learn more about debt consolidation loans, go to an online marketplace to compare the loan options available to you and determine which one suits your needs.

Not sure if debt consolidation is right for you? Here is a breakdown of the different reasons you might consider consolidating your debt:

  • Simply your finances: The average cardholder has four credit cards, according to Debt.org. Debt consolidation makes it easier to manage your finances by replacing multiple debt accounts with one account, interest rate and monthly payment.

  • Lower your interest rate: Federal Reserve data shows that the average credit card interest rate in 2022 is around 16%, however, cardholders with high debt could pay 20% to 30 % interest or more. In contrast, interest on a debt consolidation loan ranges between 6% and 20% depending on your credit, reports Debt.org. With a reliable income and a good credit score, you may qualify for a consolidation loan with a reduced interest rate, which could lower your monthly payment and shorten your repayment time.

  • Accelerate your repayment schedule: If you qualify, debt consolidation could lower your interest rates while potentially cutting your repayment schedule by several months.

If you’re not sure what range in which your credit score falls, consider filling out an online form – after all, a good or excellent credit score can make a significant difference to you financially. If you are stuck in the mediocre or acceptable range, there is some steps you can take to improve your score.

How does debt consolidation work?

Typically, when you consolidate your debt, you get one big loan that covers all of your combined debt from your other loans and your credit card debt. As a result, you only have to make one payment instead of several. Sounds simple, right?

Keep in mind that debt consolidation loans may come with higher interest rates, additional fees, and longer repayment terms. Before signing up for a debt consolidation loan, review the terms of the loan to make sure you’ll save money in the long run.

Getting a debt consolidation loan usually involves the following steps:

  1. Shop around with multiple lenders to ensure you get the lowest interest rate possible.

  2. Complete a loan application.

  3. Provide any additional documents requested by the lender to verify your income, bank accounts, and other information.

  4. The lender will assess your application, credit report and supporting documents.

  5. The lender will approve or reject your loan application.

  6. If approved, the lender can pay off your debts for you. Sometimes the lender can fund your bank account or give you a line of credit and you pay off your accounts yourself.

Common Types of Debt Consolidation

While there are many ways to consolidate your debt, the most common is to take out a debt consolidation loan to pay off your balances or use a balance transfer credit card.

debt consolidation loan

A debt consolidation loan is a fixed rate installment loan where you repay the loan in monthly installments over a fixed term. To qualify for a debt consolidation loan, you must have a stable income and at least decent credit. To obtain the lowest interest rate, a credit score of 740 and above may be required.

Balance transfer credit card

With good credit, you may qualify for a balance transfer credit card offering a 0% interest introductory period ranging from 12 to 21 months. Experience Ratings. You can transfer all your debts to this card and pay off your balance during the introductory period without interest.

Remember, however, that once the introductory period expires, the annual percentage rate (APR) applies. Also keep in mind that these credit cards come with a balance transfer fee, usually ranging from 3% to 5% of the transfer amount with a minimum fee of $5. If you only have a small amount of debt to transfer, your savings may not exceed the balance transfer fee.

Debt Consolidation Loan Alternatives

Although debt consolidation loans and balance transfer credit cards are commonly used to combat debt, other consolidation options are available, each with varying degrees of risk to consider.

  • Personal loan: Unlike debt consolidation loans, whose primary function is to pay off your debt, personal loans are not tied to a single goal. You can use the funds from a personal loan for a variety of reasons.

  • Home Equity Loans: If you have enough equity in your home, you can access that equity to pay off your debt through a home equity loan or home equity line of credit (HELOC). Home equity loans generally offer lower interest rates than other options, but that’s likely because your home serves as collateral on the loan. A home equity loan is risky because if you fail to repay the loan, you could lose your home.

  • 401(k) loan: It can be tempting to withdraw funds from your retirement plan – mainly because you probably won’t have to pass a credit check – but it could be considered early withdrawal and result in taxes and penalties. A 401(k) loan may be a better option as you can avoid the tax penalty. Consult with your plan administrator before withdrawing money from your pension plan or contact a financial advisor for advice.

  • Debt management plan: You can set up a debt management plan by working with a nonprofit credit counseling agency. In this case, a credit counselor contacts your credit card companies and tries to negotiate lower interest rates and monthly payments, usually three to five years.

  • Debt settlement plan: You should only consider a debt settlement plan as a last resort. A debt settlement plan is different from a debt consolidation loan because a debt relief company negotiates with your creditors to reduce your debts to less than what you owe, rather than transferring your debts on one account. These companies often charge high fees for their service. Debt settlement plans are risky because they can seriously damage your credit and you may have to pay taxes since any forgiven debt is considered taxable income.

Debt consolidation can make sense if it helps simplify your finances and comes with a lower interest rate that can save you money. Remember to review the interest rate, terms and fees before accepting any loan or credit solution.