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A debt consolidation loan is a type of personal loan that you use to combine your existing debts into a single debt with one monthly payment.
Using a debt consolidation loan can reduce the total interest you owe and help you pay down debt faster. It can also simplify the payoff process, as you only have one monthly payment to account for in your budget.
Borrowers often use these loans to pay off high-interest credit cards, though you can use them to tackle other debt, like medical bills and payday loans.
The availability and interest rates of debt consolidation loans largely depend on your credit score: The better your score, the more options you have and the lower interest you’ll likely pay.
» MORE: Best debt consolidation loans
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How do debt consolidation loans work?
Debt consolidation loans work by paying off your current debts with a lump sum. Loan amounts usually range from $1,000 to $50,000 with repayment terms from two to seven years.
Let’s say you have four credit cards, each with a $5,000 balance. Instead of making monthly payments on each credit card, you take out a debt consolidation loan for $20,000 and use that money to pay off your credit cards. You’re then left with one monthly payment on your new loan.
Pros and cons of debt consolidation loans
Low rates: Debt consolidation loans can be a lifeline for those sinking in high-interest debt, since they typically offer lower interest rates than most credit cards, depending on your credit score. For example, the average interest rate for credit cards for the second quarter of 2023 was 22.16%, while the average interest rate for a two-year personal loan was 11.48%, according to the Federal Reserve.
Streamlined debt payoff: You can save money on interest, and you can apply those savings to your loan to clear th debt even faster. Consolidated debt may also be easier to manage, since you’re only keeping track of a single, fixed monthly payment.
Potentially high bar to qualify: Borrowers with bad credit (629 credit score or lower) may not qualify for an interest rate lower than the ones on their current debts.
Penalties for missed payments: If you fall behind on payments, you may be charged a late fee, and the missed payment may be reported to the credit bureaus, further hurting your credit score.
» MORE: Debt consolidation loan rates
Are debt consolidation loans a good idea?
A debt consolidation loan is usually a good idea if you can get one with a lower annual percentage rate than the rates on your existing debts and you’re able to make the monthly payments.
Plug your existing debts and credit score into NerdWallet’s debt consolidation calculator to see your consolidation options and calculate your potential savings with a debt consolidation loan.
Debt consolidation also works best if you've already kicked any spending habits. If you keep swiping your credit cards after you've consolidated and freed them up, your credit and finances could suffer.
Do debt consolidation loans hurt your credit score?
Like most forms of credit, a debt consolidation loan will impact your credit score when you apply and as you pay it off.
When you apply for a debt consolidation loan, lenders usually require a hard pull of your credit report, which can temporarily knock down your credit score a few points. And if you use the loans to pay off credit card debt but end up carrying large balances on those cards again while you pay off the loan, your utilization will rise and your score may suffer.
However, taking the loan and a short-term credit score dip might make sense if the loan gives you more manageable payments that you can make on time each month. Payment history accounts for over one-third of your credit score.
Using a debt consolidation loan to pay off revolving debt, like credit cards, can bring your credit utilization down, which may also improve your score.
How to qualify for a debt consolidation loan
Your ability to qualify for a debt consolidation loan depends primarily on your credit score and credit history.
Borrowers with good or excellent credit (690 credit score or higher), little debt and high incomes usually qualify for the lowest rates on debt consolidation loans and have a wider range of lenders to choose from.
Borrowers with bad to fair credit (300 to 689 credit score) are viewed as riskier by lenders and may only qualify for debt consolidation loans from lenders that target bad-credit borrowers.
» COMPARE: Best debt consolidation loans for bad credit
The best way to learn if you qualify for a debt consolidation loan is to go through the steps to pre-qualify. One of the benefits of the pre-qualification process is that it uses a soft credit pull and gives you a sense of the loans and rates available to you without hurting your credit score.
You can pre-qualify for free on NerdWallet and compare loans from online lenders.
How to get a debt consolidation loan
Make a list of all of your debts and monthly payments that you want to consolidate. Any debt consolidation loan you take on should be large enough to cover these debts, and the loan’s interest rate and monthly payment amount should be lower than what you’re currently paying.
Make sure the loan payment fits within your budget. A debt consolidation loan won’t be helpful if it ends up putting you further into debt.
Know your credit score and the loan amount and interest rate you want, then shop around and compare loans available to you. Check online lenders, credit unions and banks, each of which offer different benefits.
» MORE: 5 steps to get a debt consolidation loan
Other ways to consolidate your debt
Debt consolidation usually involves getting a loan, but other options include refinancing with a 0% interest balance transfer credit card, tapping into your home’s equity or using your 401(k) savings.
Zero-interest credit card: Refinancing your debt with a 0% interest balance transfer card can be useful for smaller debts that you can pay off during the card’s no-interest promotional period, which usually lasts 15 to 21 months. You’ll likely need good or excellent credit to qualify.
» MORE: How do 0% APR credit cards work?
Home equity financing: If you own a house, you could also borrow against your home's equity to pay off your debts. Home equity loans and home equity lines of credit may have low interest rates, but if you stop making payments, you could lose your home.
» MORE: Should you use home equity to pay off debt?
401(k) loan: Some people choose to take a loan from their employer-sponsored retirement account, known as a 401(k) loan. These loans usually have low interest rates, but borrowing from your 401(k) means you’ll miss out on the potential to grow your retirement savings.
» MORE: 5 ways to consolidate credit card debt
As an enthusiast well-versed in the domain of personal finance and debt management, I can confidently share my expertise on the concepts discussed in the article about debt consolidation loans. My knowledge is grounded in a comprehensive understanding of financial instruments and strategies, and I continually stay updated on the latest trends and information in this field.
Let's delve into the core concepts highlighted in the article:
Debt Consolidation Loans Overview:
- A debt consolidation loan is a type of personal loan used to combine existing debts into a single debt with one monthly payment.
- The primary goal is to reduce total interest payments and facilitate faster debt repayment.
- Commonly used to pay off high-interest credit cards, medical bills, or payday loans.
Factors Influencing Loan Availability and Interest Rates:
- Availability and interest rates of debt consolidation loans are closely tied to the borrower's credit score.
- A higher credit score provides more options and often leads to lower interest rates.
Loan Providers and Options:
- The article mentions specific lenders like SoFi, Avant, and Best Egg, along with their respective NerdWallet ratings, APR ranges, and loan amounts.
How Debt Consolidation Loans Work:
- Debt consolidation loans function by paying off existing debts with a lump sum.
- Loan amounts typically range from $1,000 to $50,000, with repayment terms ranging from two to seven years.
- The example scenario involves consolidating credit card balances into a single loan.
Pros and Cons of Debt Consolidation Loans:
- Pros include potentially lower interest rates, streamlined debt payoff, and simplified budgeting.
- Cons involve potential difficulty in qualifying, especially for those with bad credit, and penalties for missed payments.
Evaluation of Debt Consolidation as a Financial Strategy:
- The effectiveness of debt consolidation depends on obtaining a lower annual percentage rate (APR) compared to existing debts.
- The article advises using NerdWallet’s debt consolidation calculator to assess consolidation options and potential savings.
Impact on Credit Score:
- Applying for a debt consolidation loan involves a hard pull on the credit report, causing a temporary dip in the credit score.
- Consistent, on-time payments can positively influence the credit score.
- Qualification depends on factors like credit score, credit history, existing debt, and income.
- Borrowers with good or excellent credit have more options and lower rates.
Steps to Obtain a Debt Consolidation Loan:
- Create a list of debts to consolidate, ensuring the loan amount and interest rate are lower than current payments.
- Ensure the loan payment aligns with the budget.
- Know your credit score, desired loan amount, and interest rate; then compare loans from different lenders.
Alternative Debt Consolidation Methods:
- Other consolidation options include 0% interest balance transfer credit cards, home equity financing, and 401(k) loans.
- Each alternative comes with its own set of considerations and potential risks.
In conclusion, my in-depth knowledge of personal finance allows me to dissect and elaborate on the intricacies of debt consolidation, providing a thorough understanding of its mechanics, benefits, and potential drawbacks.