How does debt consolidation work?

Debt consolidation is a popular way to manage and organize high-interest debt. This strategy rolls multiple debts into a single account, often with a lower interest rate, to streamline repayment. Understanding how debt consolidation works is crucial to finding your best approach.

Thankfully, it’s not hard to find someone who’s taken out a debt consolidation loan and can share their experience. Bankrate loans editor Rhys Subitch explains the benefits and shares lessons learned along the way.

What is debt consolidation and how does it work?

Debt consolidation combines multiple loans into one monthly payment. However, it only makes sense if the interest costs of your new loan or line of credit are lower than the interest costs of the debts being consolidated.

To find the best debt consolidation options and optimize your savings, focus first on consolidating the debts with the highest interest rates. Keep your loan term as short as possible. You may be offered an extended loan term, and while this may be more affordable in the moment, you will end up paying more in interest in the long run.

Many debt consolidation loans are fixed-rate, which means the interest rate never changes and you make the same payment every month. So, for example, if you have three credit cards with different interest rates and minimum payments, you could use a debt consolidation loan for credit cards to pay off those balances. You then would have just one monthly payment to manage instead of three.

Debt consolidation vs. personal loan

Debt consolidation is a form of debt refinancing in which the borrower takes out a loan, credit card or line of credit and uses it to pay off other debts. This helps debt repayment as the borrower only has to worry about making a single payment each month. Plus, there’s the potential of saving money down the line if they manage to secure a lower interest rate.

There are several ways to consolidate debt, including personal loans. Personal loans are a type of installment loan, with a fixed rate and repayment term. Some lenders market personal loans specifically for debt consolidation. Debt consolidation loans generally have terms between one and seven years. Many will let you consolidate up to $50,000.

However, debt consolidation isn’t the only way borrowers can use personal loans. Personal loans can be used for almost any purpose, from financing large purchases to home improvement projects.

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

A debt consolidation loan isn’t the best option for everyone. In Subitch’s case, it made sense because it aligned with their long-term financial goals.

“My debt consolidation payment is a fairly large chunk of change,” Subitch says. “In total, my minimum payments would have actually been less than the debt consolidation loan, but it also would have taken significantly longer to pay off the entirety of it.”

A debt consolidation loan is worth considering in certain situations:

• You qualify for a lower interest rate. If you have an excellent or good credit score and plan to consolidate credit card debt, you will likely get a lower interest rate on a debt consolidation loan than you currently have on all your credit cards.
• You want a predictable monthly payment. The interest rate is fixed on most debt consolidation loans, which means a predictable monthly payment that you can work into your budget. However, a debt consolidation loan only makes sense if you can afford the payment.
• You prefer to pay a single creditor each month. Instead of scrambling to pay several creditors by the payment due dates, you’ll only pay one creditor each month. This could make it easier to avoid late payment fees and adverse credit reporting.

However, if you have a bad credit score, it’s unlikely that you’ll qualify for a debt consolidation loan with a lower interest rate than you currently have. It’s also best to avoid taking out a debt consolidation loan if your estimated monthly payment is more than what you can comfortably afford. In this case, you’re better off exploring other options, like contacting creditors to negotiate your debt with a payment arrangement.

How to get a debt consolidation loan

This is how to get a debt consolidation loan in a few easy steps.

1. Pull your credit score. It helps to know your credit so you don’t waste time applying for a loan you won’t get. The better your credit, the more likely you are to receive approval for a competitive rate. If you have a low credit score, consider ways to build credit fast, such as disputing credit errors, catching up on late payments and diversifying the types of accounts you have.
2. Calculate your total debts. Create a list of all of your debts and payments to pinpoint exactly how much you need to borrow for your debt consolidation loan. To calculate your potential savings through consolidation, use a credit card payoff calculator and a personal loan calculator. Ensure you can afford the monthly payments so you do not risk defaulting on your loan.
3. Prequalify. You may not be able to prequalify with all lenders, but you should complete the application process if it is an option. This prequalification only requires a soft credit check, so it will not hurt your credit. If prequalification is not an option, consider contacting the lender directly to obtain whatever details they can share.
4. Compare offers. Once you have compiled all the lender data, compare offers to find the best loans for debt consolidation. The lowest rates tend to come from online banks and lenders, but you may find a favorable loan from a traditional bank or credit union. Confirm that your lender will directly pay creditors to streamline the repayment process.
5. Apply. Now that you have selected a lender, you can apply. Complete the loan application, adding personal details and information for the loan you want. The lender will then request a hard credit check. It typically takes a few days for a decision. If you are not approved, you may have better luck by adding a co-signer or co-borrower to the loan.
6. Receive funds. Funds are typically dispersed within a week unless your lender offers same-day or next-day payments and may be deposited to your account or distributed directly to your creditors. Confirm payment has been made and then prepare to begin making your loan payments, according to the terms of your loan.

How to manage a debt consolidation loan

The most important thing after taking out a debt consolidation loan is to avoid taking on more debt. Extra debt could defeat the purpose of taking the loan in the first place. Likewise, it’s important to stay on top of payments. This ensures you make progress on repayment while protecting your credit score from taking a dip. One way to do this is to schedule automatic payments for your debt consolidation loan.

“Using automatic payments is truly an anxiety buster for me. I don’t have to worry about missing a payment, and it’s one less task each month,” Subitch says. They add that they now only have one payment instead of three and can pay a little extra each month when they have the funds.

Furthermore, some lenders offer a rate discount for using this form of payment, increasing your savings.

However, life is unpredictable. You may experience a hardship that makes it difficult to keep up with your monthly bill. If that happens, it is crucial to be proactive and contact your lender. Though it may seem uncomfortable, lenders often have options to temporarily reduce or pause payments in case of hardship. This, in turn, will keep your account current while you get back on your feet.

Bottom line

Before you commit to debt consolidation, make sure you understand how these loans work, compare debt consolidation loan options, and assess your finances.

“Sit down and work out your budget,” Subitch advises. “Make sure that even if it’s more than your minimum monthly payments, it’s manageable.”

If you can qualify for a debt consolidation loan with a lower interest rate and a reasonable monthly payment, it could be a great way to streamline debt repayment and save money in interest. But if you find that payments are still unmanageable after exploring multiple offers, it may be best to look into options for debt consolidation without a personal loan.