What Is Debt Consolidation and How Does It Work?

How Does Debt Consolidation Work?

Consolidating debt typically involves combining multiple balances into one, usually with a new loan or credit card that offers a lower interest rate and other favorable terms. However, it's also possible to consolidate a single balance.

When taking out a consolidation loan, you'll typically borrow enough to cover the balances you want to consolidate. Then, once you receive the loan proceeds, you'll use them to pay off your other debts. In some cases, lenders may even be willing to pay off your balances directly.

With a credit card, you'll usually request a balance transfer with your new card issuer, who will pay off your included balances directly.

As you consider your debt consolidation options, here are some of the most popular methods and how they differ:

Balance Transfer Credit Card

A balance transfer credit card is a type of credit card that offers an introductory 0% annual percentage rate (APR) promotion, which could last up to 21 months. During this time, you can pay down debt transferred from another credit card—some even allow you to consolidate certain types of loans—without paying any interest. Some of the best balance transfer credit cards also offer welcome bonuses, rewards and other perks.

That said, balance transfer credit cards typically charge an upfront fee of 3% to 5% of the transfer amount. You may also have a deadline by which you need to request the transfer after opening the account to qualify for the 0% intro APR promotion. Finally, you won't find out what your new card's credit limit is until you're approved. Depending on how much debt you have, it may not be sufficient to cover your full balance.

Learn more: Balance Transfer Credit Card Mistakes to Avoid

Debt Consolidation Loan

A debt consolidation loan is a personal loan you can use to pay off credit cards, medical bills and other types of debt. Personal loans don't offer a 0% APR promotion, but if you have good or excellent credit, you may be able to get approved for a lower interest rate than what you're currently paying—especially if you're trying to consolidate credit card debt.

Additionally, personal loans offer a fixed repayment schedule, which can range from one to seven years in most cases. This feature can be particularly beneficial for people with credit card debt who struggle to stick to a payment plan.

Some personal loan companies charge an upfront origination fee, which can range from 1% to 12% of the loan amount. However, you may be able to avoid an origination fee if you have good or excellent credit.

Learn more: How to Get a Debt Consolidation Loan

Home Equity Line of Credit (HELOC)

A HELOC functions similarly to a credit card in that you get access to a revolving line of credit. During the draw period, which can last up to 10 years, you also typically only need to pay interest on the amount you borrow.

If you make it to the repayment period, you'll typically have up to 20 years to pay down your remaining balance. However, if you move before that happens, you'll simply use proceeds from the sale to pay off the debt. Note, however, that if you fail to make payments on a HELOC, you could lose your home.

HELOC interest rates can be low, especially if you have great credit. They're also usually variable, which means that your rate can go down if market rates decrease. However, the opposite is also true. One thing to watch out for as you compare HELOCs is the fees, which can come in the form of closing costs, ranging from 2% to 5% of the loan amount, as well as annual fees and prepayment penalties.

Learn more: What You Need to Know About HELOCs

Home Equity Loan

A home equity loan offers a lump-sum disbursement of a portion of your home equity, which you'll repay over a term of up to 30 years.

Home equity loan rates can be low, especially if you have excellent credit. They're also fixed, which means you don't have to worry about your costs fluctuating over time. As with HELOCs, though, you may face foreclosure if you default on your payments.

As you shop around, you'll want to pay attention to closing costs, which can range from 2% to 5% of the loan amount, and any other potential fees lenders may charge.

Learn more: Home Equity Loans an Increasingly Popular Way to Tap Equity

Debt Consolidation vs. Debt Settlement

Debt settlement is another way to tackle an unwieldy debt burden, but it's not the same as debt consolidation, and it comes with several risks. With debt settlement, you negotiate with your creditors to pay less than what you owe. You can try doing it yourself, or you can hire a debt settlement company to do it for a fee.

Because your payment history is the most important factor in your credit score, settling your debt for less than what you owe can have major negative consequences for your credit score. On top of that, debt settlement companies typically have you stop making payments on your debts while saving up for the settlement amount, which can cause your credit scores to plummet even further.

In contrast, debt consolidation can have an impact on your credit score when you apply and open a new loan or credit card. But as long as you make your payments on time, there likely won't be any long-term damage. In fact, if it helps you avoid late payments and you pay the loan as agreed, debt consolidation can help improve your credit.

Learn more: What's the Difference Between Debt Consolidation and Debt Settlement?

What Credit Score Do You Need for Debt Consolidation?

You generally need a good credit score for debt consolidation to make financial sense. While you can technically qualify for a personal loan with fair or even bad credit, you may have a hard time qualifying for an interest rate that's low enough to help you save money.

As for balance transfer credit cards, most of them require a good credit score or better to get approved. According to FICO, that typically starts at 670, but credit card issuers may have their own minimum score requirements.

Does Debt Consolidation Hurt Your Credit?

Consolidating your debt can cause a slight temporary decrease in your credit score. This is largely due to the hard inquiry the lender makes when you apply for credit and the new credit account, which reduces your average age of accounts.

If you get a balance transfer credit card, your credit could also dip if the transfer results in a high credit utilization rate on your new card. As you pay down the balance, however, your credit score will likely improve.

If you use a consolidation loan to pay off credit card debt, your utilization rate won't be a factor since credit scoring models only consider utilization of revolving credit (such as credit cards). In fact, reducing your utilization rate on your credit cards to 0% can potentially help your credit score.

Pros and Cons of Debt Consolidation

Should You Consolidate Your Debt?

As you weigh the advantages and disadvantages of debt consolidation, think carefully about how they apply to your situation and goals.

Consider consolidating your debt in these scenarios:

• You have high-interest credit card debt. Debt consolidation works best for credit card debt because it offers a lot of potential savings.
• You have great credit. Having a credit score in the 700s or higher will give you the best chance of securing favorable debt consolidation terms.
• You have a payoff plan. If you're thinking about a balance transfer card, consider it only if you can afford to pay off your debt within the promotional period and you have enough discipline to stick to your repayment plan.
• You're taking steps to tackle overspending. If you've gotten on a budget and worked to spend within your means, you're less likely to repeat your mistakes after consolidation.

Consider alternatives to debt consolidation if:

• You want to pay off lower-interest debt. If you have another type of debt you want to pay off, such as a mortgage, auto loan or student loan, look into refinancing that debt for better terms instead of including it in your consolidation.
• You have a bad credit score. You'll have a difficult time getting approved for a lower interest rate than what you're currently paying unless your credit is in good shape.
• You're looking for a temporary fix. Debt consolidation can provide some relief on interest charges and monthly payments. However, if you don't have a long-term plan to eliminate debt, you could just be delaying an inevitable reckoning.
• You haven't addressed your overspending. Consolidating debt doesn't fix the underlying problem behind your high credit card balances. If there's a possibility that you'll rack up more debt on the original cards, figure that out before proceeding.

Review Your Credit Before Applying for Debt Consolidation

In many cases, you can get prequalified for a personal loan or a credit card. But to make sure you have all the information you need to evaluate your options, check your credit score and credit report for free with Experian.

In addition to knowing where you stand, you'll also be able to pinpoint areas of your credit profile that need some work and make some improvements before you start the consolidation process.