How Do Debt Consolidation Loans Work? A Simple Guide

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A debt consolidation loan is a type of personal loan that you can use to combine multiple debts into one and pay them off in fixed installments. This can benefit you in several ways, from simplifying your debt to saving you money.

So how do debt consolidation loans work? Here’s a look at the pros and cons of debt consolidation to help you decide if it’s right for your situation.

What Types of Debt Can You Consolidate?

You can consolidate virtually any type of debt, such as:

• Credit cards
• Personal loans
• Medical bills
• Payday loans

In many cases, debt consolidation loans are deposited into your account as a lump sum of cash, just like a normal personal loan. This allows you to pay off any debts you choose.

When You Shouldn’t Consolidate Debt

It may not be wise to consolidate certain debts with a personal loan. For example, there are special programs to consolidate student loan debt.

Some financial institutions may approve you for a debt consolidation loan — but then require that they pay your creditors directly. In other words, the money never touches your hands — you’ll send the bank all account numbers you’d like paid off, and they’ll do it for you. This way the bank knows for certain that you’re using the loan in the way that you indicated.

It’s worth noting that most banks stipulate that you can’t take out a debt consolidation loan to pay debt you owe to them. For example, if you take out a debt consolidation loan with Bank of America, you can’t pay your Bank of America credit cards with it.

Benefits of Debt Consolidation Loans

For someone with multiple balances, debt consolidation offers several benefits:

• Your monthly bill may decrease: If you’ve got multiple monthly minimum payments, you might well be paying a fortune just to keep your accounts current. Consolidating your debts into one loan can in many cases dramatically lower your monthly minimum payment.
• Your debts are easier to track: Juggling the monthly payments of many different accounts can feel disorganized and lead to a mistake like a missed payment. Roll your payments into one to alleviate the mental gymnastics associated with paying your bills. Plus, an installment loan gives you a clear end-date to when your debt will be paid off.
• Your credit score may increase: When you use an installment loan to consolidate credit card debt, your credit utilization — one of the weightiest factors of your credit score — will sharply decrease. Your credit score could shoot up within a month.
• Your interest payments will likely reduce: Personal loans often have interest rates that are significantly lower than credit cards. Paying down credit cards with a personal loan is a great way to escape high APR.

Drawbacks to Consider Before Consolidating

For all the perks of debt consolidation loans, they’re far from a no-brainer. Here are some things to watch out for:

• Extra fees: Some personal loans may ding you with fees at the beginning and end of your loan. For example, some banks charge arbitrary origination fees upon account opening. And some penalize you for paying off your loan early, which in turn, saves money on interest.
• Enables you to get further into debt: If you overspend by nature, a debt consolidation loan won’t do you any favors. You’ll find yourself with newly zeroed-out credit cards, which can entice you to begin spending again. Max out your credit cards again, and you’ll find yourself with both credit card payments and debt consolidation loan payments each month.
• Interest rates may occasionally be higher: Make sure the APR for your debt consolidation loan is lower than the APR you’re currently paying on your other loans — otherwise it could prove to be more expensive in the long run.

How To Apply for a Debt Consolidation Loan

Applying for a debt consolidation loan is similar to opening any other loan:

1. Check your credit report
2. Compare loans from various banks, credit unions, etc. — and get prequalified if you can.
3. Gather relevant information, such as your Social Security number, street address, even occasionally paystubs.
4. Formally apply for the loan.

If you’re approved, you can use the funds to pay off your existing debts. You’ll then begin making one fixed monthly payment to the new lender. Loan terms usually range from two to seven years.

Alternative Ways to Consolidate Debt

A debt consolidation loan isn’t the only way to dig yourself out of debt. In some scenarios, the best debt consolidation loans may not be a personal loan.

Balance Transfer Credit Cards

For example, many balance transfer credit cards come with 0% intro APR for many months. Some will give you up to two years to pay down your principal interest-free. This strategy can be extremely powerful, but it’s best for those with good credit. That’s because you can’t transfer to the card more debt than your credit limit will allow.

So if you’re only approved for a $2,000 credit line, that won’t be very helpful in consolidating $25,000 of debt.

Use Home Equity

If you’re a homeowner, you may liquidate some of your home’s equity to pay down your high-interest debt. To do this, you can take out a home equity loan or utilize a home equity line of credit (HELOC). It’s a bit risky, though, as failure to pay back this loan can put you at risk of losing your home.[x]

Find a Debt Management Plan

If you believe you need professional help, seek a Debt Management Plan (DMP) through a nonprofit credit counseling agency. It can result in lower total debt and one digestible monthly payment — though it typically requires you to cancel all credit cards associated with the DMP. Counselors will help you to decide the best course of action.

Who Should Consider a Debt Consolidation Loan?

You should consider a debt consolidation loan if you:

• Have multiple high-interest debts, like credit cards or payday loans
• Have at least a fair credit score, which is at least 580 as defined by FICO. Otherwise, you’ll have an extremely hard time being approved for anything other than predatory loans.
• Want to simplify your payments into one monthly bill
• Are committed to avoiding new debt while paying off your current loan. Be wary, though — if you haven’t corrected the mindset of overspending, a debt consolidation loan can do more harm than good to your finances.

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