How does debt consolidation work? What you need to know

Nobody likes having a stack of bills to pay. Everybody wants to make good choices with their money. Under the right circumstances, debt consolidation hits both of those targets.

How does debt consolidation work in practice? You take out a loan or open a credit account, use it to pay off high-interest credit cards and similar debts, and then make a single payment each month. Ideally, the new interest rate is below the average rate you pay now. Debt consolidation doesn’t reduce your debt.

Tracking several due dates over the course of a month takes real effort. One payment doesn’t. That simplicity is a big part of the appeal of debt consolidation.

What debts can you consolidate?

Debt consolidation is most common with unsecured debt, which is debt that carries no collateral. However, the lender that issues your debt consolidation loan or balance transfer card sets the rules on which type of debt you can consolidate.

What can be included in debt consolidation usually includes:

• Credit card balances. Since credit cards typically have high interest rates, people often consolidate credit card debt to save money.

• Unsecured installment loans. Older personal loans and similar fixed-term debts are frequently targets for consolidation.

• Payday loans. These loans can be extremely expensive, with fees that equate to an APR of nearly 400%, according to the Consumer Financial Protection Bureau (CFPB). Debt consolidation is one way to potentially get payday loan debt under control.

• Buy now, pay later (BNPL) accounts. If you have several BNPL accounts you pay every month, you could consolidate them to simplify repayment.

• Medical bills. You can consolidate medical debt, but check out other options first. Some providers offer interest-free payment plans or are willing to negotiate medical bills, and financial assistance may also be an option in certain cases.

Student loans are also unsecured debt, but they work differently. Federal student loans consolidate through the Department of Education’s own program. Federal borrowers who stay in that system keep access to federal repayment protections and forgiveness programs.

A personal loan doesn’t carry those protections, and once you refinance federal debt privately, those options don’t come back. Many lenders, Achieve included, prohibit using loan funds to refinance student debt.

Secured debts usually stay where they are. Mortgages and auto loans typically have lower interest rates than unsecured loans because the lender could take the asset if you default. Consolidating secured debt normally doesn’t save money, and many consolidation lenders prohibit refinancing secured debt, anyway.

Types of debt consolidation loans

Three types of debt consolidation cover many situations.

A personal loan carries no collateral. You borrow a set amount and repay it on a fixed schedule. The lender determines the rate based on factors that include your credit standing, income, and debts. Terms commonly run from two to seven years, which limits total interest. Personal loans often have origination fees ranging from 1% to 10%.

A home equity loan or home equity line of credit (HELOC) is secured by your home. You borrow against your home equity, which is the difference between what your home is worth and what you still owe on the mortgage. Secured borrowing often carries a lower rate than unsecured borrowing because the lender holds a claim on the property. If you don’t make the payments, you could lose your home. Terms typically run longer than those for a personal loan, which could lower the monthly payment but increase the total interest you pay. Closing costs generally range from 3% to 6% of the loan amount.

A balance transfer credit card moves existing card balances onto a new card at a promotional rate for a set period. Issuers usually charge a transfer fee based on the amount you move, with the standard amount being 3% to 5%. When the promotional period ends, the card's standard APR applies to any remaining balance.

The best type of loan for debt consolidation depends on your situation. Personal loans are a flexible option that you can use to consolidate many types of debt, and most personal loans have fixed interest rates. Home equity loans and HELOCs have low rates, so they’re worth considering for homeowners with sufficient equity. Balance transfer cards can provide significant savings on interest if you can pay off the balance within the promotional period.

Here's how personal loans work for debt consolidation

How debt consolidation works, step by step

1. Inventory every balance. Write down each debt you want to consolidate with its balance, minimum payment, and rate. Sort by rate, starting with the highest. You now know how much you'd need to borrow and what rates you pay today. A new loan generally helps when its rate comes in below the weighted average, meaning the average taking into account the size of each debt.

2. Prequalify with a soft credit check. A soft credit check doesn't affect your credit, and many lenders prequalify applicants this way. You learn roughly how much you could borrow from a lender and at what rate. Submitting a formal application triggers a hard credit check, which impacts your credit score. The impact is temporary and usually small, with most only seeing their score drop by a few points.

3. Compare two or three options. Take the prequalification offers you just got. Run your numbers on a debt payoff calculator before you pick a direction.

4. Select and review a full offer. Choose a loan and check the APR, fees, monthly payment, and the full amount you’ll repay across the term. A longer term gives a smaller monthly payment and a larger total amount you pay. A shorter term has a higher monthly payment but costs less overall. Weigh the total cost against what you'd pay by staying put.

5. Consolidate, then protect the progress. Some lenders offer to pay off your creditors directly. Others send you the loan funds, and you pay your creditors yourself. Autopay keeps the new payment on your debt consolidation loan from slipping, and some lenders trim the rate slightly when you enroll.

That last step carries the most weight. Paid-off cards come with available credit again, and available credit could refill fast.

Open cards after consolidation are worth planning around. If you close them, it could remove the temptation to spend. It also reduces your available credit, which can affect your score. Keeping one card open preserves flexibility for emergencies. Another option is to keep your cards open, but remove them from your wallet and your saved payment methods online so you’re less tempted to use them.

Any of these approaches can work, and the right one depends on your situation. If you also want to stay on top of your debt payoff, the Achieve GOOD app tracks your progress against a payoff plan, so you can watch the balance fall.

What lenders check when you apply 

Every lender sets its own standards. Most assess the same three areas, plus one more for home equity loans and HELOCs.

Your credit standing. Lenders pull your report to evaluate your payment history, how much of your credit you’re using, and how long you've managed credit. Payment history carries the most weight in the major scoring models. A recent missed payment affects your credit more than an old one.

Your debt-to-income ratio. Divide your total monthly debt payments, including housing, by your gross monthly income. Lenders use that figure to judge whether you can absorb another payment. Run yours before you apply on a debt-to-income (DTI) ratio calculator to see where it falls.

Your income and employment. Lenders normally verify what you earn and how steadily you earn it. Self-employed and commission-based applicants should expect requests for more documentation.

Your equity if applying for a home equity loan or HELOC. Home equity lenders require a property valuation, often a full appraisal, to confirm what your property is worth. Home equity applications take longer than personal loan applications as they have a more complex underwriting process. Federal law also gives you three business days after signing to cancel a loan secured by the home you live in, and funds release after that window closes.

Gather these before you start to help move things along faster:

• Government-issued ID

• Proof of address

• Recent pay stubs

• Tax returns, if you're self-employed or earn commission

• W-2s

• Bank statements

• Written explanations for any credit issues

When debt consolidation isn’t the right move

Consolidation may solve a rate problem and a tracking problem. It doesn't solve everything, and four situations could make it the wrong fit.

• The offer doesn't beat your current weighted average rate. You calculated that average in step one. A loan priced above it costs you more, no matter how much simpler one payment might seem.

• The new term runs well past your current payoff date. If you were to stretch repayment from three years to seven, that might drop the monthly payment, but you’re likely to pay far more interest to get that drop. Compare the total repaid and not just the monthly payment.

• You can't cover the new payment reliably. Debt consolidation only works if you keep up with the payments. Missing payments could negatively impact your credit score. If you consolidate debt with a home equity loan or HELOC, the lender could also foreclose on your home if you fall behind on your payments.

• The cards could refill. Consolidation clears your balances without changing whatever produced them. Plenty of borrowers end up carrying the new loan alongside fresh card debt.

Three alternatives cover most of these situations.

• Pay the balances down yourself. The avalanche method targets your highest rate first and costs the least overall. The snowball method targets your smallest balance first so you pay off individual accounts sooner, which some people prefer for motivation. Neither requires an application, a fee, or a credit check. 

• Enroll in a debt management plan. Nonprofit credit counseling agencies negotiate lower rates with your card issuers, and you send one payment to the agency each month. You repay every dollar you owe. Most plans run three to five years. Read about debt management plans to learn more.

• Consider debt settlement. If you can’t repay the full balance on any schedule, settlement means negotiating with creditors, either on your own or with the help of a debt settlement company.