How Does Debt Consolidation Work and Is It Right for You?

Between credit cards, auto loans, personal loans, and other debts, you might be juggling multiple payments to multiple lenders. It can become difficult to keep track of different repayment schedules, balances, and interest rates — and far too easy to miss a payment.

Consolidating your debt can be the key to staying on top of your debt repayment and getting your finances back on track. Here’s how it works and what you need to know if you’re considering this financial option.

What exactly is debt consolidation? 

Debt consolidation is a way of tackling multiple payments on multiple debts. The debt doesn’t disappear, but by combining several debts into a new loan, preferably at a lower interest rate, you could pay off debts faster. You can consolidate debt with lenders that specialize in debt consolidation loans or DIY it with a generalized personal loan from any other banking institution.

How debt consolidation loans work

This loan works best for people with multiple debts who qualify for a lower interest rate. Your own bank or credit union can offer you a personal loan and some online lenders specialize in debt consolidation loans. 

This involves a new loan that incorporates all of your current debts. Some borrowers might prefer a personal loan, which means you’re free to use the funds however you like. But if you’ve earmarked that money for debt payoff, that’s ideally how you’ll use it.  

You can also consider the other type of debt consolidation loan, in which the lender pays off each of your creditors in full. According to your new loan terms, you’ll start making monthly payments to the new lender. Depending on the type of loan, you might have a larger payment but be debt-free sooner.

Related: What is a debt snowball?

Pros of debt consolidation

Before consolidating your debts, make sure this type of loan benefits you. The compelling reasons for debt consolidation don’t apply to everyone. 

Have a single monthly payment

Let’s be honest — no one wants to juggle half a dozen different loans at the same time. Managing different debts with varying interest rates, balances, and due dates can be a hassle and a challenge. Plus, that complication leaves you more susceptible to missed or late payments.

This type of loan solves the headache of paying off multiple debts simultaneously by streamlining your debts into one monthly payment. 

Potentially pay off debt faster

A major benefit of debt consolidation loans is a potentially faster payoff. That’s in part because they can result in a higher monthly payment than the minimums on each account. Plus, if you qualify for a lower overall interest rate, a greater percentage of every payment will go toward the principal instead of interest. 

There’s a bit of a psychological benefit, too. Focusing your debt repayment in one place can motivate you. Something about watching your total debt balance drop each month is exciting, spurring you to keep going. 

Lower interest rate

Typically, you wouldn’t pursue this without assurance of a significantly lower interest rate than what you’re currently paying. Perhaps several years have passed since you first borrowed money, and your credit score has improved. Qualifying for a lower interest rate is one of the primary appeals of debt consolidation. 

If a lender can offer you a lower APR on a consolidation loan, that increases the impact of each monthly payment on the balance. You’ll reach the milestone of becoming debt-free that much faster. 

Here's more about how APR works on a credit card.

Cons of debt consolidation

Debt consolidation loans aren’t necessarily a slam-dunk financial choice, though. Pay attention to some of the possible downsides.

Larger monthly payments

As you consider the benefits of debt consolidation loans, remember your monthly payment may go up. This depends on your particular loan, but if you’re unable to pay each debt in full every month now, consolidation could cause additional problems. 

The outcome you don’t want is to roll your debts into a new loan, and then find yourself unable to afford the monthly payments. 

Be sure to run through your budget to determine how realistic the new loan payment would be. A better option may be another debt repayment strategy, perhaps using the debt snowball (focus on paying off your smallest debts first) or debt avalanche (focus on your highest-interest debts first) to pay off various loans strategically.

Debt consolidation fees

The fees you may need to pay to set up the new account can be a downside as well. Lenders who handle personal debt consolidation loans may charge an origination fee or prepayment fee. 

In the case of someone with a large amount of debt, the fees may be worth it. But for a smaller debt total, any potential savings on interest might not balance out the cost of a new loan. 

It can’t change spending behavior

If you do have a spending problem, be wary of debt consolidation. It is a limited strategy and can’t make you instantly stop making new charges on your accounts. 

Debt consolidation doesn’t help you much if you go right back into debt. Be careful of debt consolidation as a magic button to fix an underlying cash flow or money management problem.

You could pay more in interest

It may sound like a contradiction to mention lower interest rates as a “pro” only to also list it as a “con.” But if you have poor credit that doesn’t qualify you for a lower interest rate, consolidation could result in you paying more in interest over time. 

Alternatively, some people might consolidate debts to get a lower monthly payment. Although this makes the payments more manageable, it could also mean you’ll pay more in interest because you’ll be in debt longer. 

How to tell if a debt consolidation loan is right for you

You can examine your debts and run through this checklist to determine if a debt consolidation loan is best for you.

• Has your credit score improved? That makes you more likely to qualify for a lower interest rate. 
• Is it difficult to keep track of multiple debts to multiple creditors? A single monthly payment can simplify debt repayment. 
• Is your total debt balance fairly large? The benefits of consolidation are more likely to be worthwhile in that case.
• Are you confident in your ability to avoid going back into debt after repaying the loan? Then it can serve your purposes.

If the answer to each of these questions is “yes,” then you’re probably a good candidate for a debt consolidation loan. But if you responded “no” to one or more, there may be better options. 

Related: How to pay off credit card debt

What to look for in a debt consolidation loan

When shopping around for a debt consolidation loan, one key factor is to be sure you can get a lower interest rate. Aside from the convenience of switching to one payment, the rate is what can save you money in the long run.  

You’ll also need to be aware of any fees charged by the lender. Find out how much of your debt can be consolidated and what terms are required by the lender. 

Be sure to calculate how a new loan will impact your finances and decide what will help you reach your goals in a timely way. Seek quotes from several lenders to be sure you’re getting the best offer. 

FAQs

Is debt consolidation a good idea?

Consolidating debt is a good idea for someone who is in control of their spending, has multiple debts wants a simplified repayment plan, and can qualify for a lower interest rate. It’s not wise for all borrowers.

Do debt consolidation loans hurt your credit?

Your credit will be impacted somewhat by a debt consolidation loan. Once you’ve chosen a lender, you’ll submit to a hard credit check, which typically causes a temporary dip in your credit score. 

However, the way you handle repayment of a debt consolidation loan also determines what happens to your credit. Making payments promptly and in full will positively affect your credit, while late payments won’t do you any favors. 

Is debt consolidation the same as debt settlement?

No. Debt consolidation rolls all debts into a single loan, but you still are obligated to pay the debt in full. Debt settlement, also called debt relief, often means hiring a firm to try to renegotiate the terms of your loans. They may try to get the principal or interest rate reduced, which can sound tempting.

Beware of debt settlement firms, though, as many lenders refuse to work with them, and they’re known for encouraging risky behaviors such as stopping payments on debts. They also charge high fees, can’t guarantee results, and your credit may suffer as a result.

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