What is a debt consolidation loan — and how can it help you lower your interest rate?
If you’ve accumulated high-interest credit card debt or took out a personal loan when rates were at their highest, it could be a good time to consider a debt consolidation loan. Last week, the Federal Reserve lowered benchmark interest rates by half a percentage point — the first cut it’s made in four years.
It means borrowers are likely to see lower rates on new loans shortly, including on personal loans that offer a way to consolidate your old debts at lower rates and stronger terms, ideally getting you out from under debt more quickly with a lower monthly payment while saving you hundreds or even thousands on interest.
But a debt consolidation loan isn’t the right choice for all borrowers. The fixed rates and payments are less flexible than other types of debt management strategies, and it may be difficult to qualify if you have poor credit or are self-employed. Learn how debt consolidation loans work before you apply, and consider talking with a financial advisor if you need professional advice on managing your debt.
What is a debt consolidation loan — and how does it work?
A debt consolidation loan is a type of personal loan that you can use to manage and pay off high-interest debt, like credit cards. These loans allow you to roll multiple outstanding balances into a new loan at a lower interest rate, using your loan’s lump-sum payment to pay off your original debts. After you’ve paid off your original accounts, you pay back the debt consolidation loan with one fixed, monthly repayment until your term is up.
Terms typically range from three to five years, though you often have the option to make additional repayments if you want to speed along the process. And while the average personal loan rate was around 12% in May 2024, borrowing rates are likely to come down in the wake of the Federal Reserve’s September cut to interest rates.
Dig deeper: What is a personal loan? How it works — and what to know before you apply
When to use a loan for debt consolidation
A debt consolidation loan is best for when you have unsecured debt that you can’t pay off within a year — such as credit cards and high-interest personal loans. Loan amounts can range from under $5,000 to more than $30,000, depending on the lender, though the average consolidation loan tends to be around $10,000.
The best time to use a loan for debt consolidation is when interest rates fall lower than they were when you first took on your debt — especially if you’re consolidating other personal loans. Also, if you plan to use your loan as part of a payoff strategy to retire debt-free, it’s a good idea to get a debt consolidation loan before you leave work. Not only will you enter retirement without the weight of debt, but full-time workers tend to have an easier time qualifying for low rates than retirees on fixed incomes.
Note that you can only use debt consolidation loans for unsecured debt — or debt that's not backed by collateral like your home or car. Folks who want to save on payments on car loans, mortgages or student loans should look into refinancing options for these types of accounts instead. For example, while student loans are usually unsecured, you’ll find more competitive rates with a student loan refinancing company than through a personal loan provider or marketplace.
????Expert tip: For a boost to your credit score, keep your credit cards open after consolidating your debt — even if you don’t plan on using them. That’s because access to credit is the second most important factor in your credit score, just after payment history. If you have an annual-fee credit card that you don’t want to use, ask your card issuer if you can downgrade to a free version, rather than closing the account.
How much can I save by consolidating my debt?
Your savings will depend on how much debt you're carrying and the interest rates on those debts. It also depends on the rates and terms you're able to qualify for on the loan you'll use to consolidate your debts.
Let's say you're carrying $10,000 in debt on two credit cards that average 20% APR. If you consolidated your debts with a personal loan at 12% APR for three years, you could end up saving about $115 on your monthly payment and more than $600 in interest — and that's accounting for a possible 1% origination fee.
Of course, this simple-math scenario doesn't account for minimum payments or fees you might be paying on your card debt, so be sure to calculate your potential savings against your real-life rates, fees and total debt before applying for a personal loan.
Dig deeper: Top 5 debts to prioritize paying off before retirement
Benefits of consolidating debt with a loan
You can save money. If you can qualify a lower rate than your original debts, the total cost of the loan will naturally be lower, even if you take the same amount of time to pay down what you owe. Ideally, you'll save on your monthly payment as well, easing your cash flow for other financial responsibilities.
You can pay down your debt faster. Depending on your loan's terms, more of your repayment will go toward your principal balance, rather than toward interest.
It can improve your credit. Lowering your credit utilization ratio, diversifying the types of credit on your credit report and adding to your history of on-time repayments can boost your credit score.
It makes managing your debt easier. By consolidating multiple debts into one account, you’ll have only a single monthly payment to keep track of, simplifying your finances.
Drawbacks of consolidating debt with a loan
It requires a hard credit check. Most lenders require a hard pull on your credit, which can lower your credit score temporarily by about five points.
Loan repayments are less flexible. Unlike credit cards, you can’t change how much you pay each month. And if there’s a change to your financial situation, most lenders only offer three months of hardship forbearance.
High debt loads won’t qualify. Generally, if your debt is worth more than half of what you make in a year, lenders won’t approve your application and a debt consolidation loan may not be helpful.
Origination fees can eat into your savings. If you can’t find a lender with no fees — or can’t qualify due to your credit score — you may want to consider another option.
It won’t solve underlying money issues. Debt consolidation offers the chance to get better control of your debt, but it won’t fix poor financial habits or challenges. If you don’t think you can pay off your new loan, consider the one-on-one help of a credit counselor certified by the National Foundation for Credit Counseling.
How to find the best debt consolidation loan
There’s no one debt consolidation loan that’s best for everyone. But considering these factors can help you find the right lender for you.
Start with the options available to you. Shop around for a range of lenders to get a sense of the APRs, loan amounts and terms that are available. Rates can vary based on your location, loan balance and personal credit history.
Look for low APRs — and not just low interest rates. A loan’s APR — which includes interest and fees — is the easiest way to make an apples-to-apples comparison among different lenders.
Avoid origination fees, if possible. Some lenders charge an origination fee of 1% to 8% of the loan amount. This may be difficult to avoid if you have a high debt load or poor credit, but it’s often rolled into your total loan costs, bumping up the amount you have to repay.
Watch out for prepayment penalties. While it’s uncommon, some lenders charge a penalty for making additional payments to your personal loan. This means you can’t make additional payments toward your loan or pay it off early if you receive a windfall.
Prequalify for your top picks. Fill out a preliminary form on a lender’s website to see the rates, terms and fees you can qualify for based on your personal and financial information.
Compare the total and monthly cost. Once you have three to four loan offers, compare the estimated monthly payments and total loan costs among them. The best loan should give you a little wiggle room in your budget without costing significantly more than the other options.
How to qualify for a debt consolidation loan
While each lender has different requirements, it can be hard to get a debt consolidation loan if you don’t meet the following criteria:
Good or excellent credit — for FICO credit scores, that’s a score of 670 or higher
Debt-to-income ratio under 50%, with a DTI below 36% ideal
Proof of consistent income from a job, pension, Social Security or other sources
U.S. citizen or legal resident
What’s the minimum credit score for a debt consolidation loan?
The minimum credit score for a debt consolidation loan is usually around 670 — which lenders consider to be good credit. However, credit score requirements vary by lender and the state of the lending market in general.
For example, lenders are more flexible with credit score requirements when interest rates are low. That’s because they have more room to charge higher interest rates. When interest rates are low, lenders can afford to be more flexible with eligibility requirements, since the cost of lending is lower.
Alternative ways to save on interest without a personal loan
Debt consolidation loans can be helpful in some situations, but they’re not the only way to save on interest. Consider these alternatives first:
A strong budgeting strategy. What might be a great system for one person could be a mismatch for another. Key is finding a strategy that aligns with your lifestyle and values — and that you'll stick with over the long run. Start with our guide to the five most popular strategies, including who they’re best for and why.
Balance transfer credit cards. With these cards, you can move credit card debt to a new card with a 0% APR introductory rate. This gives you 12 to 18 months to pay down your debt before interest starts accruing again and is great for balances you can pay off within a year.
Home equity loan or HELOCs. If you’re a homeowner, you might be able to tap into your home’s equity to consolidate your debt with fixed rates that can be lower than personal loans. Learn more about how home equity loans and HELOCs work, including benefits and drawbacks.
Autopay discounts. When signing up for a loan, it’s worth asking if your lender offers discounts for automatic payments. Some lenders will reduce your interest rate by around 0.25 percentage points with autopay.
If you’re nearing retirement and aren’t sure which debt-payoff option is the right choice for your budget, financial habits and total debt, consider hiring a trusted retirement advisor to help you manage your finances and plan for the future.
FAQ: Paying down debt, consolidating debt and your finances
Still have questions about no-penalty CDs? Explore these frequently asked questions.
What is the difference between debt consolidation and debt settlement?
Debt consolidation and debt settlement are two types of debt management strategies for paying off high-interest debt, but they differ in key ways. While debt consolidation works to simplify multiple debts into a single payment, ideally at a lower overall interest rate, debt settlement involves negotiating with your creditors to accept less than what you owe, typically on debts that you’re past due on.
You can attempt to negotiate directly with your creditors with a little grit and determination, discussing your hardship and asking directly for new repayment terms. Or you can use a debt settlement company that will negotiate on your behalf, taking a fee of 15% to 25% of your total settled debt — a stiff fee, but one that could be worth it if you don’t feel you have other options. In either case, you’ll want to commit to fully paying off your debt under the new settlement’s terms without any lapses to avoid long-term damage to your credit.
What are the debt snowball and debt avalanche methods?
Debt snowball and debt avalanche are methods designed to help you simplify the way you pay down debt. With these strategies, you focus on one card or loan to pay off in full while making the minimum payment on all your other debts. After you’ve paid off that balance, you start on the next one down your list. Learn more about how these debt-payoff strategies work — and what makes them different.
Is it possible to find a secured personal loan?
The majority of personal loans are unsecured — which means they don’t require any collateral. Yet it’s possible to find a personal loan secured with collateral like a CD or another non-liquid asset — for example, Upgrade is a digital lender that offers a choice of an unsecured loan or one secured with your car. Credit unions and community banks often offer secured personal loans that can be easier to qualify for: If you default on the loan, your lender can take that asset to satisfy what you owe.
Sources
Consumer Credit Outstanding, Federal Reserve. Accessed September 23, 2024.
About the writer
Anna Serio-Ali is a trusted lending expert who specializes in consumer and business financing. A former certified commercial loan officer, Anna's written and edited more than a thousand articles to help Americans strengthen their financial literacy. Her expertise and analysis on personal, student, business and car loans has been featured in Business Insider, CNBC, Nasdaq and ValueWalk, among other publications, and she earned an Expert Contributor in Finance badge from review site Best Company in 2020.
Article edited by Kelly Suzan Waggoner