Debt consolidation: What it is & how it works

The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.

When someone acquires an amount of debt that is challenging to pay off, a debt consolidation loan combines multiple debts, such as credit cards, personal loans and medical bills, into an account with one monthly payment and lender.

When debt becomes hard to pay due to juggling multiple due dates and payments, it might be time to consider debt consolidation. Debt consolidation allows you to compile your high-interest debts into one loan with a single monthly payment and a lower interest rate. Consolidating debts may help you save money in interest payments, which could reduce your total debt.

The idea of debt consolidation may sound appealing to anyone with high-interest debts. However, consolidation isn’t a fix-all for everyone with debt. Let’s look at what debt consolidation is, the types of loans you should apply for and why you should or shouldn’t consider consolidation.

Key takeaways:

  • Debt consolidation can help simplify your financial situation by combining your debts into one loan with a single monthly payment.
  • Consolidating your debt may lower your monthly payments and interest rate.
  • When choosing between debt consolidation and a debt management plan, consider your financial priorities and choose the option that saves you the most in interest costs.

What is debt consolidation?

Debt consolidation is a financial strategy of combining multiple debts into a single loan or credit line. It aims to simplify debt repayment and potentially lower interest rates. By consolidating debts, individuals can manage their finances more effectively and often reduce the total amount they pay over time.

You may consolidate debt through various methods, such as obtaining a personal loan, a balance transfer credit card, a home equity loan or another personal loan. The option that best suits you depends on your circumstances and available options.

How does debt consolidation work?

You have a few options that can help you consolidate your debt, either in the form of a loan or through a new line of credit. Essentially, you’ll take out a loan that covers the entirety of your debts and use it to pay off personal loans, credit cards and other bills that may be piling up.

When you take out a debt consolidation loan, you can pay off other loans and then make a single payment toward your consolidation lender.

How to consolidate debt: 3 types of debt consolidation

While there is a specific debt consolidation loan that one could take out, it is not the only option. Alternatively, one could turn to a balance transfer credit card, a home equity (HELOC) loan or a 401(k) loan. 

Let’s take a look at each of these loans and their pros and cons.

Balance transfer credit card

A balance transfer card is a type of debt consolidation for credit card debt. Balance transfer cards often offer a 0 percent interest rate for an initial promotional period. To consolidate your credit card debt, you can transfer your existing balance from other cards onto this new card and then use the promotional period to pay down your debt without interest. 

Let’s look at an example of what it could cost you to transfer your credit card debts to a single balance transfer card.

Let’s say you have $15,000 in credit card debt across multiple cards. You find a balance transfer card offering 0 percent interest for the first 12 months, but this offer comes with a one-time balance transfer fee that is a percent of the amount that’s transferred. In this situation, you would pay $750 to transfer the balances over. Now it’s up to you to calculate if that $750 fee is more or less than the amount you’d spend in interest fees in that one year.

It’s important to note that balance transfer cards eventually return to a standard interest rate, usually between 19 and 28 percent, after the promotional period ends. Therefore, it is best to pay the balance before the promotional period ends.

Pros of balance transfer credit cards Cons of balance transfer credit cards
Promotional period offers zero interest Transfer fee
Make one monthly payment Only applicable to credit card debt
Potential to decrease credit utilization High interest rates kick in after promotion

Debt consolidation loan

A debt consolidation loan is a personal loan provided by a financial institution like a bank, credit union or online lender. This loan provides you with a lump sum of money that you will use to pay off your debts and the acquired interest. Once creditors are paid off, you will pay a monthly payment with interest to the financial institution from which you borrowed the debt consolidation loan.

With a debt consolidation loan, you can pay off different kinds of debt—from credit cards to medical bills. Please note that a debt consolidation loan may be either secured or unsecured, which will be determined by the institution that provides the loan.

Pros of debt consolidation loans Cons of debt consolidation loans
Potential for lower interest rates Longer repayment terms may result in more interest over time
Simplified repayment plan You may incur up-front fees
Potential to boost credit if payments remain consistent Missing a payment may result in a significant penalty

Home equity line of credit

A home equity line of credit (HELOC) is a revolving credit that allows homeowners to borrow against the equity they have in their property. If you are a homeowner with a decent amount of equity, you can choose to leverage the equity in your home to pay off your existing debts.

When a lender approves a HELOC application, they will provide you with a credit limit and a draw period—typically up to 10 years—during which you can access funds from the HELOC. Those looking to consolidate their debts will withdraw funds to pay off other debts and then pay that borrowed money back during the drawing and repayment period.

Pros of home equity line of credit Cons of home equity line of credit
Potential for a lower interest rate Secured payment against your home
Flexible borrowing and repayment during the draw period Potential for a variable interest rate

401(k) loan

Another common loan that people may use to consolidate their debt is a 401(k) loan. This loan allows you to borrow money from your 401(k) retirement savings account and use it to pay down the debt. Then, you pay back the borrowed money to your 401(k) with interest.

While a 401(k) loan is a viable option, you should know that there is a borrowing limit—usually around 50 percent of your saved funds. If you do not have enough in your 401(k) to cover the debt you’ve incurred, you may need to explore one of the above options.

Pros of 401(k) loans Cons of 401(k) loans
Typically no credit check or lengthy application process Reduces the amount of money available for growth
Paid interest goes back into your retirement account Fast repayment obligation upon job change

Debt management plan vs. debt consolidation

You might wonder if debt consolidation or debt management is the better option for your situation. While both are designed to help you pay off your debts soon or with less interest, the two programs are different.

A debt consolidation plan takes all your debt and compiles it into one loan or credit card. The goal is to make payments more manageable and hopefully reduce the amount of interest you have to pay.

Alternatively, a debt management plan involves working with a credit agency to devise an effective repayment plan. The debt management agency may help you negotiate with the creditor for lower interest rates and waive fees. Additionally, the credit counseling agency can make your payments for you, leaving you to make one monthly payment to the agency.

While both options can simplify your debt with one monthly payment, you must find which option works best for your situation and your priorities.

How does debt consolidation affect your credit?

Debt consolidation won’t directly affect your credit, but there are some ways it can indirectly influence your credit:

  • Making payments: Many people pursue debt consolidation so they only have one payment to worry about. This makes paying on time easier and can ultimately improve your payment history. Since 35 percent of your FICO credit score is determined by your payment history, this can result in a significant boost.
  • Triggering a hard inquiry: When you apply for a debt consolidation loan or balance transfer credit card, you’ll likely have a hard inquiry into your credit. A hard inquiry can result in a small— and temporary—dip in your credit score, but as long as you don’t have additional hard inquiries anytime soon, your score should recover quickly.
  • Closing accounts: Your credit history length accounts for 15 percent of your FICO credit score. If you consolidate debt and close many of your existing accounts, you may lower your overall credit history length. This can result in a decrease in your credit score.
  • Increasing credit utilization ratio: If you choose to close your newly paid-off accounts, your credit utilization ratio may increase, which could affect your credit. Ideally, you want to keep your credit utilization below 30 percent.

When is debt consolidation a good idea?

Debt consolidation can be a great option for those who may find themselves struggling to pay off their debt and make monthly payments.

Here are a few circumstances when debt consolidation may be right for you:

  • You have multiple high-interest debts. If you have multiple debts with high interest rates, like credit cards or personal loans, you may choose to consolidate them into a single loan or repayment plan with a lower rate so you can save money on interest payments.
  • Feeling overwhelmed by debt. If your total debt amount is becoming unmanageable and causing stress, consolidating your debts may provide a structured plan to help you regain control and pay off your debts more efficiently.
  • Seeking lower monthly payments. Debt consolidation may allow you to extend your repayment term, reducing monthly payments. This can provide immediate relief to your monthly cash flow and make your debts more affordable.
  • Simplify your financial management. Consolidating your debts allows you to focus on a single payment and eliminates the hassle of managing multiple accounts.

When is debt consolidation not a good option?

Now that you understand when debt consolidation is a good option, let’s look closer at the circumstances in which consolidation may not be right for you.

  • The debt isn’t the only problem. If there is an underlying issue like overspending and a lack of budgeting, debt consolidation may not solve the problem. Before consolidation, you may try addressing the root cause so you do not accumulate new debts on top of the consolidated loan.
  • The terms of the loan outweigh the benefits. If the terms of the consolidated loan, such as interest rates, fees or repayment periods, are not favorable compared to the existing debts, consolidation may not provide any financial benefit.
  • The consolidation loan requires collateral. If a consolidation loan asks for collateral, such as a house or car, it may be best to continue paying down your debts as is. Risking your property may not be wise if you miss a payment.
  • A longer repayment term results in spending more in interest. While most consolidation loans offer a lower interest rate, you may need to calculate whether you save money in interest payments over time. Paying a lower interest rate over a longer period can cost more than a higher rate for a shorter amount of time.
  • Bad credit results in unfavorable terms. If you currently have bad credit, it could be difficult to find a willing lender. If a lender happens to accept your application, be sure to double-check that the terms of the loan will help your situation.

How to consolidate debt: FAQ

If you’re considering debt consolidation, you might have a few outstanding questions. That’s why we’re here to answer a few of the most frequently asked questions about how to consolidate debt.

Can I consolidate all my debt into one payment?

Yes. Depending on the kind of debt you’re in, there are various options for those hoping to simplify their finances and pay off multiple debts in one monthly payment. To do this, you will need to be approved for a personal or a balance transfer credit card.

If you seek out a personal loan, you will use the money granted to pay off your debt, so you only have to pay back the personal loan in a single monthly payment. For those with credit card debt, you may choose to transfer multiple debts to a balance transfer credit card with a lower interest rate. Compiling all your credit card debt into one credit account allows you to make only monthly payments.

How can I consolidate my debt easily?

While there are various options available for consolidating debt, one of the most common and easiest ways is to get approved for a debt consolidation loan from a financial institution. These loans may have more flexible qualification criteria and more favorable terms for debt consolidation purposes than other loan options.

Is it good for your credit to consolidate debt?

Credit consolidation can both positively and negatively impact your credit, but many of its negative impacts may be considered minor or only temporary. As for positive impact, your credit can improve as you consistently make on-time payments toward your consolidated debt. Since payment history makes up a large percentage of your credit score, you’ll see improvements over time.

How long does a debt consolidation stay on your credit report?

As with any loan, a debt consolidation loan will stay on your credit as long as it is open. As long as you continue making on-time payments, your credit report will show you’re in good standing with the loan. However, a missed payment could stay on your credit report even after the loan is closed. In fact, most negative items stay on credit reports for up to seven years.

 It’s no secret that debt and missed payments can cause our credit to dip. When you need credit help, Lexington Law Firm could assist you with the errors that could be poorly affecting your credit. We offer credit monitoring and credit education services to protect your credit and help you get it into shape. To learn more about how we can assist you in your credit journey, get a free credit assessment today.

Note: Articles have only been reviewed by the indicated attorney, not written by them. The information provided on this website does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client or fiduciary relationship between the reader, user, or browser and website owner, authors, reviewers, contributors, contributing firms, or their respective agents or employers.

Reviewed By

Nature Lewis

Associate Attorney

Before joining Lexington Law as an Associate Attorney, Nature Lewis managed a successful practice representing tenants in Maricopa County. Through her representation of tenants, Nature gained experience in Federal law, Family law, Probate, Consumer protection and Civil law. She received numerous accolades for her dedication to Tenant Protection in Arizona, including, John P. Frank Advocate for Justice Award in 2016, Top 50 Pro Bono Attorney of 2015, New Tenant Attorney of the Year in 2015 and Maricopa County Attorney of the Month in March 2015. Nature continued her dedication to pro bono work while volunteering at Community Legal Services’ Volunteer Lawyer’s Program and assisting victims of Domestic Violence at the local shelter. Nature is passionate about providing free knowledge to the underserved community and continues to hold free seminars about tenant rights and plans to incorporate consumer rights in her free seminars. Nature is a wife and mother of 5 children. She and her husband have been married for 24 years and enjoy traveling internationally, watching movies and promoting their indie published comic books!