If you’re overrun with debt from credit cards, high-interest loans, or medical bills, you can combine them into one monthly payment by consolidating all your debt. A debt consolidation loan bundles all your various debt into one place with a single monthly payment for potentially lower interest rates and more savings.
In this article:
How does a debt consolidation loan work?
You’ll effectively take out a new loan to pay off your old debt. Debt consolidation loans run anywhere from a few thousand dollars to tens of thousands of dollars, and the repayment terms are usually around two to seven years. Interest rates are typically fixed and vary based on your credit score.
Some debt consolidation loan providers may pay your creditors directly, while others will transfer the funds to you directly so you’ll have to repay your creditors yourself. There might be restrictions as to which types of debt your lender will consolidate; typically only unsecured debts like credit cards, personal loans, medical bills, and sometimes student loans are eligible.
Debt consolidation programs are offered by financial institutions like a bank, credit union, or even credit card company. Debt consolidation companies, so to speak, don’t exactly exist, but are often confused with debt settlement companies, which are something else entirely. For a steep cost, debt settlement companies negotiate on your behalf with your lender to settle debt, or pay less than your total owed amount.
Do debt consolidation loans hurt your credit?
A debt consolidation loan affects your credit score only as much as a normal loan does. When you apply for a loan, mortgage, or credit card, you’ll experience a hard pull or inquiry into your credit history, which typically results in a small but temporary drop in your credit score.
Once you’ve secured the debt consolidation loan, any further impact to your credit depends on how you handle your repayment. You’ll actually have the opportunity to build or improve your credit score if you make timely payments.
But if you’re late with payments, or use a large portion of your available credit — maybe by running up more debt on your credit cards after paying them off with the consolidation loan — then your credit score could suffer.
Just remember that all the normal components that factor into a credit score apply to your debt consolidation loan.
FICO credit scores are determined by the following:
Accounts owed, or your current level of indebtedness
Credit mix, or types of credit used
Length of credit history
Should I get a debt consolidation loan?
With a debt consolidation loan, you could potentially save money with lower interest rates and pay down your debt sooner.
For example, let’s say you pay $240 a month for a $5,000 credit card debt with 18.9% interest rate and $1000 credit card debt with 12.9% interest rate. After securing a debt consolidation loan for $6,000 at a 9% interest rate, you’ll pay only $191 a month for a 36-month term. Your new monthly payment is about $50 less than before, and you’ll save over $2,400 in interest.
Streamlining your bills down to one single payment with a debt consolidation loan might be an attractive feature. However, in some circumstances, you could end up paying more over time because the consolidation loan comes with a long repayment period — typically anywhere from two to seven years.
It’s important to consider your spending behavior when it comes to debt consolidation. Debt consolidation loans don’t offer permanent solutions or eliminate your debt; they simply restructure it. If you have trouble spending within your means, you could simply run into debt again, so it’s important to have a financial strategy in place.
Alternatives to debt consolidation
Credit card balance transfer. This is a DIY method of debt consolidation. You can open a new credit card that offers 0% interest on balance-transfers, and transfer all your various debts onto it. You’ll now pay one monthly bill. Be aware that your interest rates will climb back up after the introductory period.
Take money out of your 401(k). You can get money easily without a credit check or extra fees from your retirement savings account. This might be the right choice if you need funds quickly and plan to pay it back in a short amount of time.
Credit counseling. Nonprofit credit counseling agencies typically offer free resources to help you create a debt management plan.