Debt consolidation loans: What they are and how they work

If you’re trying to manage debt, it might feel counterintuitive to apply for a new loan. But that’s how a debt consolidation loan works: It combines multiple existing debts into a new loan with a single monthly payment. 

A debt consolidation loan won’t erase any part of what you owe. But ideally, it could help simplify payments and set you up with better terms, such as a lower interest rate. Learn more about how debt consolidation loans work and some of their potential pros and cons. Plus, explore other ways to consolidate debt.

What you’ll learn:

• Debt consolidation rolls multiple debts into a single account with one monthly payment.

• Consolidating debt might help save money on monthly payments, interest or both. But it doesn’t eliminate debt.

• Credit card balance transfers are another way to consolidate debt from credit cards and other loans. 

• Typically, you can’t transfer balances between multiple cards from the same issuer.

A debt consolidation loan can be used to combine multiple debts into one new account with a single monthly payment. Debt consolidation doesn’t erase debt, but it may be a helpful tool. It can be especially helpful for high-interest debt. If the debt consolidation loan has a lower interest rate, it may lead to lower monthly payments. Plus, since you’re combining multiple payments into one, it may help you keep track of monthly payments and pay on time.

Debt consolidation loans may be used to pay off existing debts and combine multiple balances into one new loan. But lenders have their own policies, and not all lenders offer debt consolidation loans. So it’s best to read up on the specifics before applying for a loan.

Debt consolidation loans are often a type of installment loan. This means you get the entire loan amount up front and pay it back in regular installments. But that’s not always the case. Balance transfer credit cards are one example of revolving credit that may be used to consolidate debt.

Consolidation won’t eliminate how much you owe. But combining your debt into one monthly payment with better terms could make it easier to pay back. You might be able to consolidate multiple types of debt, including credit card debt, student loans, auto loans, home loans and even medical bills.

Considering potential advantages and risks might help you decide whether debt consolidation is right for you.

Here are a few potential benefits of a debt consolidation loan:

• Find a better annual percentage rate (APR) or interest rate.

• Lower your monthly payments.

• Reduce how long it takes to pay down your debt.

• Use it responsibly to build your credit.

Debt consolidation isn’t right for everyone. Here are a few things to keep in mind when considering whether it’s right for you:

• Debt consolidation won’t eliminate debt.

• There could be fees, longer repayment terms and other costs that make consolidation more expensive.

• Simplifying payments may not necessarily lower your monthly payments.

Before getting a debt consolidation loan, it’s important to think carefully about whether it’s the right option for you. Here are a few steps to consider taking:

Finding a lower interest rate on your current debt is one important thing to consider. If you’re not improving your interest rate or payment terms, it might not be worth it. Comparing the loan offers can help you select the one that works best for your situation. 

If you’re interested in a debt consolidation loan, it might be worth considering:

• Whether the low interest rate lasts a limited time and what it might change to. 

• Whether there are any other fees or costs associated with the consolidation loan.

• Whether the loan term is short enough that you end up paying less over time. 

• Whether another debt consolidation method may work better for you.

If you find a debt consolidation loan that works for you, the next step is to apply. Lenders have their own policies, so the application process may vary. And remember, not all lenders offer debt consolidation loans.

Applying for new lines of credit may impact your credit scores. That’s because new credit applications involve a hard inquiry, which can cause a temporary dip in your scores. However, one hard inquiry typically won’t have as much of an impact as many hard inquiries.

A debt consolidation loan isn’t the right choice for everyone. Here are a few other ways to consolidate debt.

A credit card balance transfer lets you consolidate multiple balances into one credit card account with a new card issuer. And if the new credit card has a lower interest rate than your existing accounts do, it could save you money on interest. Keep in mind that balance transfers may come with a fee.

If you’re in a position to pay off your debt quickly, a balance transfer card with a low introductory rate might be a great option. Just be sure you know how it works and when the introductory rate ends.

If you’re interested in this option, the Consumer Financial Protection Bureau (CFPB) suggests you consider:

• How long introductory interest rates apply to transferred balances.

• Whether a different rate will apply to any new charges you make.

• How your rate could change over time and what it could cost you if you don’t pay off your debt before rates change.

• Whether there are any balance transfer fees.

• How a balance transfer could affect your credit.

If you have equity in your home, a home equity loan is a possible option for paying off existing debt. 

Home equity loans are a type of secured loan that may offer a lower interest rate because your home is used as collateral. But this could also make it risky: If you can’t pay back the loan, you could face foreclosure on your home.

If you’re not ready to take out a new line of credit, there are also some debt payoff strategies that it may help to know about.

One is the debt avalanche method. This strategy involves paying off your highest interest rate debt first, then moving on to the debt with the next highest interest rate and so on. 

There’s also the debt snowball method, which focuses on paying off the debt with the smallest balance first, then the next smallest balance and so on. 

These are just two debt payoff strategies to consider. As with any financial decision, it’s important to think through all your options and make the choice that’s right for you.

Another way to consolidate debt is through a debt management plan. In general, a lump-sum payment is made each month to an organization, which then distributes it among creditors.

But it’s important to be careful about the type of organization you reach out to for help. According to the CFPB, most credit counseling companies are nonprofit organizations. And they can offer legitimate support. Credit counselors can do things like give advice, help with budgeting and organize debt management plans. 

To find reputable credit counseling services, the CFPB says you can try the Financial Counseling Association of America or the National Foundation for Credit Counseling. Or, check the U.S. Department of Justice’s list of approved credit counselors. 

There are also less-reputable debt settlement companies to be aware of. 

Working with for-profit debt settlement companies can be risky, according to the CFPB. They often charge expensive debt settlement fees and may encourage clients to stop paying their credit card bills altogether. This could impact their credit scores and result in late fees and other penalties. Any savings could be wiped out by those additional costs. 

Ultimately, the CFPB says that debt settlement companies could leave you in deeper debt than where you started. So before working with a debt settlement company, be sure to do your research.

Here’s more information about consolidating debt.

If you have multiple debts, consolidation might be something to consider. A good way to start is by exploring different debt consolidation options and understanding the interest rates and costs involved.

Debt consolidation loans might be one option. If a credit card balance transfer is part of your plans, check out low-intro APR cards from Capital One.