What Is a Debt Consolidation Loan? How It Works and What It Costs

You paid the minimum on all four credit cards last month. The balances came back looking about the same.

Then a mailer or a bank ad put a phrase in front of you: debt consolidation loan. 

A debt consolidation loan is a distinct product. Here's how a debt consolidation loan works and what it costs.

What is a debt consolidation loan?

A debt consolidation loan is one new loan that replaces multiple existing debts. For example, instead of four balances, four rates, and four due dates, you owe a single lender a fixed amount each month at a single rate, on one schedule. 

In plain English, a debt consolidation loan is a new loan used to pay off debts you already have. Many debt consolidation loans are personal loans. Most personal loans are unsecured. Unsecured means you don’t put up collateral to take out the loan.

A loan is one of several ways to consolidate. Debt consolidation may be right for you in several situations, such as if you qualify for a new loan with a lower interest rate and can afford the payment on the new loan.  Other ways to consolidate debt include credit card balance transfers and home equity loans.

How a debt consolidation loan works

Before you apply, check if you can prequalify. Prequalification lets you check whether you qualify, without hurting your credit score.

From application to payoff, the whole thing runs on three steps.

1. Apply for the loan. If the lender makes you an offer and you accept it, the money arrives as one lump sum. 
2. Use the loan to pay off balances you're consolidating.
3. Repay the new loan in fixed monthly payments, until the term ends.

A personal loan is  what’s called a closed-end loan. The lender gives you all the money at the beginning, and you repay it in set amounts over a specific period. (In contrast, an open-end loan is one that you can borrow from repeatedly, like a credit card.)

Some lenders pay your old creditors directly. Others deposit the money in your account and leave the payoff to you. Feel free to ask lenders how the process of consolidating loans works.

A debt consolidation loan could be ideal when you can get it at a rate lower than you have on existing debts. A lower rate on the same principal could mean less interest across the life of the loan (depending on how long you take to pay off the debt). If the rate you're offered matches what you pay now, you could still simplify your payments, even if you don’t save on interest. Simplification is a valid reason to consolidate.

It generally doesn’t make sense to consolidate to an interest rate that’s higher than what you pay now.

Funding times vary by lender, often within a week of approval. Some lenders, especially online lenders, fund accounts within 24 hours of approval.

How much does a debt consolidation loan cost?

A debt consolidation loan costs two things, mainly: the interest you pay across the life of the loan, and the origination fee some lenders charge to set it up.

Personal loan origination fees range from 0% to 12% of the loan amount. When charged, the fee is deducted from how much you get upfront. A $10,000 loan with a 5% origination fee puts $9,500 in your bank account. You still owe the full $10,000. Several major lenders charge no origination fee at all.

APR (annual percentage rate) is the total yearly cost of borrowing, including the interest rate plus fees. APR is the standard for comparing loan costs because it’s more accurate to compare APRs than to compare interest rates. A low interest rate with a large fee can cost more than a higher rate with no fee. Check APRs when shopping around for the best debt consolidation loans.

Personal loan terms typically run two to seven years. Some lenders offer shorter or longer terms. Careful with terms. Longer terms can look cheaper, but the opposite is usually true. Stretch the same balance across more years, and the monthly payment drops while the total interest you pay rises.

What you need to be eligible for a debt consolidation loan

Lenders are mostly concerned with whether you can afford making another loan payment. To decide whether to lend, they look at your credit score, credit history, annual income, employment status, and debt-to-income ratio. Some fintech lenders also weigh education and employment details.

FICO's tiers run Poor up to 579, Fair 580 to 669, Good 670 to 739, Very Good 740 to 799, and Exceptional 800 and above. Lenders generally treat scores below 620 as higher risk. Below 620, you might find it easier to qualify for secured loans. Or it might make more sense to raise your credit score before applying. For a secured loan, you pledge something valuable as a guarantee (collateral). For example, a car loan is secured by the car. If you don’t repay a secured loan, your lender has the right to sell the collateral to recover what you owe.

Your debt-to-income ratio is every monthly debt payment you make, divided by your gross monthly income. Gross income means what you earn before taxes and other deductions come out. 

CFPB's example: $1,500 for a mortgage, plus $100 for an auto loan, plus $400 for everything else, is $2,000 in debt payments. Against $6,000 in gross income, that's 33%. Ergo, your DTI is 33%. There’s not a hard rule for what debt-to-income ratio you need to take out a loan. It differs by lender. Lower is better.

Prequalification (or prescreening) lets you estimate what loans you could get by triggering a soft inquiry. A soft inquiry does not affect your credit score. Any prequalification offer you receive may not be what you get after officially applying for the loan; actually applying is the only way to know for sure.

Debt consolidation loan vs. debt settlement program: how to tell them apart

Debt consolidation and debt settlement products have similar names but work in very different ways, despite being frequently lumped together under the umbrella of “debt relief.”

A debt consolidation loan means borrowing from a lender and repaying 100% of the balance plus interest and fees. It’s an option when you can afford to repay your debts. Not everyone can qualify for a debt consolidation loan.

A "debt consolidation program" or "debt resolution" offering almost always means debt settlement, and it works nothing like a loan. In a debt settlement program, you stop paying your creditors. A debt settlement company then negotiates with creditors to accept potentially less than the full balance. Non-payment during that stretch may hurt your credit and prompt collection or lawsuits. Debt settlement is an option when you’ve ruled out both full repayment and Chapter 7 bankruptcy. There is no minimum credit score requirement to join a debt settlement program.

When a debt consolidation loan isn't the right tool

Pricing, debt-to-income ratio, and your spending habits may steer you away from this product.

Pricing is top of mind. If the best APR you're offered is close to what you average now, you’d be paying a large fee to simply shuffle your payment around. It’s a potentially expensive way to simplify payments. Generally speaking, it’s best to avoid taking out a debt consolidation loan unless your APR is significantly improved or the extended terms make it possible to make monthly payments you couldn’t afford otherwise.

The size of what you owe is also important. If your debt-to-income ratio is high, you may not qualify for a good debt consolidation loan. 

Debt consolidation in any form includes a risk of adding to your debt. Once your credit cards are paid off, it’s easy to fall into the trap of using them again. If you take out a debt consolidation loan to pay off credit cards, and then you add new balances to those cards, you could end up with more debt than what you started with.

Weigh the pros and cons of a debt consolidation loan to judge this product on its own merits.

Bills Action Plan

1. Work out the average rate of the debts you’d like to consolidate. A consolidation loan should beat this number.
2. Pull your credit reports free at AnnualCreditReport.com and check your scores for free through your bank or credit card online dashboard. Note where your credit standing sits, so you can narrow down lenders fast.
3. Pre-qualify with at least three lenders. Pre-qualification usually doesn't affect your credit score (check with the lender). Compare APRs and term lengths.

Key Terms

APR: the yearly cost of borrowing, including interest and fees. APR is the number to compare offers on, because a low interest rate with a big fee can cost more than it looks.

Origination fee: what a lender charges to set up the loan. The fee usually comes out of the money you receive, so you get less than the amount you borrow.

Unsecured loan: a loan with no collateral behind it. Nothing of yours is pledged, so the lender leans harder on your credit and income.

Debt-to-income ratio (DTI): every monthly debt payment you make, divided by your gross monthly income (what you earn before taxes and other deductions come out). Lenders use it to judge whether you can carry another payment.

Prequalification: a preview of what a lender might offer. A soft inquiry doesn't affect your credit score. Prequalification isn't a final decision.

This article is for general education and isn't financial or legal advice. Your own numbers, your creditors, and your state's laws affect what's available to you.