How does a debt consolidation loan work?

By Gina Freeman

Reviewed by Kimberly Rotter

Aug 27, 2023

Read time: 6 min

Couple paying their bills over a laptop at home.

Key takeaways:

  • Debt consolidation can be a smart financial move if you have multiple high-interest debts.

  • Usually, you consolidate debt by taking on a new loan and using it to pay off multiple smaller debts.

  • The debt consolidation loan should have better terms than the debts you consolidate, or it’s probably not worth taking.

Committed. Smart. Savvy. These words describe someone who’s looking into debt consolidation loans. Consolidating your debt shows that you’re ready to focus on lowering your debt and managing your finances more effectively. Researching your options shows that you have the patience and financial maturity to hold back until you know you’re making the right choice. 

Any loan is a big decision, and that’s especially true when you’re already carrying debt. Once you understand how debt consolidation loans work, you can make a smart choice about the best path forward for you.

Debt consolidation loans work by simplifying your life

Debt consolidation means combining multiple debts. Most of the time, this involves taking on a new loan to pay off multiple smaller debts. Consolidating can make monthly bill paying easier because you have fewer debts to track. Debt consolidation may also deliver other benefits, like a lower payment or a better interest rate. 

Debt consolidation loans

Home equity loans

If you are a homeowner, you could consolidate debt with a home equity loan. A home equity loan is a second mortgage. To get a home equity loan, you need to be a homeowner with enough equity to borrow against. Equity is the difference between the home’s current market value and the amount you still owe on your mortgage. For example, if your home is worth $400,000 and you still owe $170,000 on your mortgage, you have $230,000 in equity. 

All home equity loans are secured loans. You pledge the home as a guarantee that you’ll repay the loan. Because of this guarantee, lenders consider home equity debt consolidation to be fairly low-risk to them. That's why home equity loans have lower interest rates than most other kinds of financing.

The repayment term for a home equity loan is usually between 5 and 30 years. Longer terms can be helpful if your goal is to get the lowest possible payment.

Most home equity loan lenders charge a fee for making the loan (called an origination fee). Because this is a mortgage, your lender may require a property appraisal and title search. It’s possible to get a home equity loan in 10 to 14 days after you apply.

Home equity loans usually have a fixed interest rate, which means predictable payments for the life of the loan.

To get a home equity loan, you need sufficient equity, and you need to meet the lender’s requirements for credit score and income. At Achieve, a home equity loan might be a good way to consolidate debt with bad credit. If you let the lender use all or most of the loan funds to directly pay off other creditors, you can apply with a 640 credit score. Get started here to speak with a mortgage advisor.

Homeowners, get help with your high-interest debt

Use the equity in your home to consolidate debt, lower your monthly payments, and reduce your stress.

Personal loans

You can also use a personal loan to consolidate high-interest credit card debt. Personal loans can be secured or unsecured, but most personal loans are unsecured. That means you don't have to borrow against something valuable that you own. There is no property to appraise, and that speeds things up a lot. If your income and credit meet the lender's guidelines, you could receive your money in as little as 1 to 3 days after you apply. 

Personal loans usually have fixed interest rates and payments that don't change. This helps with budgeting. You can find personal loans in amounts ranging from $1,000 to $50,000 and even more, with repayment terms ranging from 1 year to over 10 years.

To get a personal loan, most lenders require a credit score of at least 620 to 680. You’ll also need to show proof of income. They’ll check your credit to review your other financial obligations so that they can be sure you can afford the payment on the loan you want. To talk to an Achieve loan consultant, start here.

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Balance transfer credit cards

Balance transfers are not debt consolidation loans, but they are an option you might have heard of. Balance transfer credit cards offer an introductory period (usually 6 to 24 months) in which you pay little or no interest on transferred balances. If you’re approved, you can transfer your balances from other credit card accounts. There’s usually a 2-5% fee for each balance transfer.

Balance transfers can be risky. Some people transfer balances to a new card and then make new charges on the old cards. If that happens, you could end up with even more debt than you started with. It’s also tempting to transfer the balance again when the promotional interest rate expires. Moving balances back and forth between cards can quickly turn into a juggling act that’s very hard to keep up‌ with. Eventually, the balls will drop. A balance transfer can give you an opportunity to make some serious headway against your debt, but it should be considered a one-time maneuver and part of a larger plan to get rid of your debt.

The debt consolidation loan process

The debt consolidation process is fairly similar no matter which option you choose. First, you analyze your debt accounts and decide which ones you want to consolidate. Most people choose the debts with the highest interest rates. 

Next, you'll decide what type of consolidation loan suits you best and compare loan rates and terms. In general, there's a trade-off between paying your loan off faster or getting a lower payment.

Once you've selected your loan, you'll apply online, in person, or by phone. Look for lenders that allow you to prequalify for a loan with a soft inquiry that doesn’t affect your credit score. If you're approved, you'll get a list of conditions you have to meet to finalize your loan. That might include submitting documentation like pay stubs and banking information.

Once the lender has everything it needs, it will finalize and fund your loan. In most cases, the lender transfers the money to your bank account. However, some lenders pay your creditors directly when you consolidate debt.

The inner workings of a debt consolidation loan

The right debt consolidation solution depends on the amount of your debt and on whether you’re looking to lower your payments or pay less total interest. 

These three consumers—Daisy, Blake, and Fred—each have a different goal and amount of debt. 

Daisy has just $5,000 in credit card debt spread across four accounts at an average rate of 27%. She’s unhappy with the interest rate and the fact that her balance hardly drops after paying $213 a month. 

Daisy chooses a balance transfer card with a 5% fee and 18 interest-free months. If she increases her payment to $278 and avoids adding any new charges to this card, she could clear her balance in 18 months.  

Example daisy - how a debt consolidation loan works

Blake has $13,000 in credit card debt at 30% interest. And he has rolled over a $2,000 auto title loan several times. Each title loan renewal costs $250. (Note that title lenders don’t generally charge a straightforward interest rate. Instead, you’d pay high finance or rollover fees every two or four weeks. These charges equate to about 300% per year.)

Example Blake: how does a debt consolidation work

By wrapping his credit card debt and auto title loan into a personal loan, Blake can save on interest, escape his high-fee title loan, and cut his monthly payment by over $200. Personal loan fees can be paid up front, wrapped into the new loan, or come out of the loan proceeds. The payment in this example assumes that Blake wraps the fees into the loan for a total amount of $15,750.

Fred owes $25,000 in credit card debt at an average rate of 29%, and he pays $600 per month. He also needs about $25,000 for dental work. His home equity loan serves two purposes—to bring down the monthly cost of his debts from $604 to $309, and to provide another $25,000 for another $303 per month.

Example Fred - How a debt consolidation loan works

Debt consolidation loan considerations

Debt consolidation isn't right for everyone or every situation. Here are some considerations that might mean a debt consolidation loan isn’t the best path forward.

  • Not everyone can qualify for a debt consolidation loan.

  • Only homeowners with sufficient equity can get a home equity loan.

  • A personal loan might not be big enough to meet your needs.

  • Debt consolidation doesn’t address spending problems. If you can't stop using your credit cards, adding a new loan to the mix could make things worse.

Don't consolidate if you can't get a real benefit. If the interest rate isn't better than your existing accounts, or the loan costs too much, look into other options.

Leave debt behind, so you can move forward

Get rid of your debt and free up your cash flow without a loan or great credit.

If you can’t afford the payment on a new loan or debt consolidation isn't in the cards for some other reason, you're not completely stuck. Debt resolution can reduce what you have to pay to clear your unsecured debt. Debt resolution means negotiating with your creditors. You or someone working for you asks them to accept less than you owe and forgive the rest. You can get a free debt assessment and talk with an Achieve debt consultant who can help you determine if debt resolution might be right for you.

Gina Freeman - Author

Gina Freeman has been covering personal finance topics for over 20 years. She loves helping consumers understand tough topics and make confident decisions. Her professional history includes mortgage lending, credit scoring, taxes, and bankruptcy. Gina has a BS in financial management from the University of Nevada.

kim rotter 2022 2

Kimberly is Achieve’s senior editor. She is a financial counselor accredited by the Association for Financial Counseling & Planning Education®, and a mortgage expert for The Motley Fool. She owns and manages a 350-writer content agency.

Frequently asked questions

A debt consolidation loan can have positive and negative effects on your credit score. At first, your score will likely take a small hit. That's because applying for a new loan generates a credit inquiry. Each inquiry can have a small, temporary negative effect on your score. Also, the average age of your credit accounts is a factor that affects your score. Adding a new credit account lowers the average age of your accounts. 

But paying off credit card debt lowers your credit utilization. Utilization is your credit card debt compared to your credit limits. If you have a $900 balance on a credit card with a $1,000 limit, your utilization is 90%. Lower utilization is better for your credit. Paying off credit card balances with a personal loan or home equity loan could have a positive impact on your credit. 

Also, every on-time payment that you make on your new loan contributes to a healthy credit profile. Your payment history is the single most important factor that influences your credit score.

A home equity loan is a mortgage. Your house is the collateral (guarantee) for the loan. Home equity loans usually offer the lowest interest rates, but can cost more to set up and take longer to get. Home equity loans may offer the lowest payments because their terms can be as long as 30 years.

A personal loan usually doesn't require collateral. Personal loan interest rates run higher than home equity loans but almost always lower than credit cards. Personal loan terms range from 1 year to over 10 years.

Debt consolidation can help your finances if you are disciplined and careful. If you can get a lower interest rate, that frees up more money to pay off your debt faster. If your goal is a smaller payment, use it to get your finances under control. Put money away for an emergency fund. Take care of necessities you may have put off—like a car repair or medical procedure. Then commit to paying off the consolidation loan as fast as you can without borrowing any more.

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