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What Is Debt Consolidation?

Dana George
Robin Hartill, CFP
By: Dana George and Robin Hartill, CFP

Our Personal Finance Experts

Ashley Maready
Check IconFact Checked Ashley Maready
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Many Americans carry some form of debt. Debt consolidation can help you break free of high-interest debt before trouble arrives. Here, we'll help you compare online debt consolidation lenders and find out who offers the best terms for your situation.

If you're asking yourself, "What is debt consolidation?" you've come to the right place. We'll tell you what it is, how it works, and how you can decide if it's right for you.

What is debt consolidation?

Debt consolidation is a strategy where you take out a new loan to pay off high-interest debts, such as credit cards and loans. Because the new loan has a lower interest rate than your original debt, you save money on interest charges. Debt consolidation can also help you get out of debt faster by providing you with a timeline for paying off debt.

If you pay off multiple debts with one loan, you'll simplify your monthly payments, too. Instead of paying off multiple credit cards and loans every month, you'll have one simple monthly payment to keep track of.

How does debt consolidation work?

There's more than one way to consolidate debt. Ultimately, each one involves transferring the debt. The difference is where you transfer it to. You have four primary options for debt consolidation.

Balance transfer credit cards

A balance transfer card is one way to consolidate credit card debt. Balance transfer cards offer special promotional interest rates, such as 0% intro APR for a set number of months (typically 12-18). You apply online, tell the new credit card company how much you want transferred and from which cards, and wait for a response. Make sure you have a plan in place to pay the card off before the promotional rate expires as the interest rate will likely rise drastically at that point.

Also, you may be charged a balance transfer fee of 3% to 5%. For example, if you want to transfer $10,000 and the new card charges a 3% transfer fee, the amount you would need to pay off would be $10,300 ($10,000 x 0.03 = 300). There are a very small number of cards that don't charge a balance transfer fee.

Personal loans

Banks, online lenders, and credit unions offer personal loans. You can use the funds from a personal loan to pay off other debt, then focus on simply repaying your loan.

The interest rates on debt consolidation loans are often much lower than those on credit cards. If you use a personal loan to consolidate credit card debt, you'll save money on interest.

Debt consolidation loans charge more in interest than balance transfer credit cards, but these loans have a unique advantage: Loans typically offer repayment terms of between 24 and 60 months. This is significantly longer than the 12-18 months most balance transfer cards offer. If you think you'll need a few years to pay off your debt, a personal loan is a fantastic choice. If you can pay off your debt within 12-18 months and have good credit, a balance transfer card is a better fit.

Home equity loans or lines of credit

If you owe less on your home than it's worth, that means you have equity and can borrow against it. A home equity loan allows you to transfer debt from one lender to another, just like a credit card transfer.

Of course, you will pay more than the 0% interest associated with some credit card promotions, but will almost always get a better interest rate than you would with an unsecured personal loan. That's because your home acts as collateral and lenders view the loan as less risky. It's important to remember that missing home equity loan payments can put your home in jeopardy, so only consider this option if you're confident that you can keep up with the monthly payments.

401(k) loans

Your 401(k) fund is an employer-sponsored retirement fund. If you take out a 401(k) loan, you are essentially borrowing money from yourself. You don't have to go through a credit check to do this and you will pay yourself interest on the debt. Employers create their own rules about borrowing from a 401(k), so you'll need to find out how yours works.

If your plan allows it, you can borrow up to 50% of your 401(k) balance or $50,000, whichever is less. You'll have up to five years to repay the loan. If you don't pay the loan back within five years, the IRS will count the borrowed money as a distribution. You'll owe income tax on the amount that has not yet been repaid. If you are under 59 1/2, you will also owe a 10% early withdrawal penalty.

There are a couple of potential drawbacks to 401(k) loans. First, taking money out of your retirement fund is risky because that's cash you'll need when you retire (and it needs time to grow). Second, if you separate from your employer for any reason, you'll have to repay the full loan balance by tax day for the year you leave your job or risk paying the withdrawal penalty. For example, if you leave your job on Oct. 30, 2023, you'd need to repay the loan by April 15, 2024.

When is debt consolidation a good idea?

Debt consolidation can be a great financial tool, but it isn't right for everybody. It makes sense when you can lower your monthly bill payments or interest rate, to simplify your finances, and -- importantly -- when it's part of a debt payment plan.

If you can check one or more of these boxes, debt consolidation may be a good idea:

You have a plan to avoid future debt. Whatever the circumstances that caused your debt, you need a plan to stay debt free once you pay it off. Before you consolidate your debt, try to analyze your financial situation and make an honest reckoning with the factors that got you there in the first place. Then look at your options and budget to see which route would suit you best. Debt consolidation could be a strong first step toward healthy finances.

You can get a lower rate. A debt consolidation loan can benefit you financially if you can lower your interest rate -- for example, to pay off high-interest debt.

Here's an example of how moving a higher interest credit card balance to a lower interest personal loan might work:

Balance Interest rate Payoff at $300 per month Total interest charge
Credit card $10,000 17% 46 months $3,638
Personal loan $10,000 7% 38 months $1,178
Example 1

You can lower your payment. If you are struggling to cover your monthly payments, debt consolidation could give you some breathing room. The caveat is that a longer loan term might cost you more in interest over time.

Using the same example above, let's reduce the monthly payment to $200 and increase the loan term. It would take you 60 months to pay down the balance, but you'd still save money on overall interest compared with your credit card.

Balance Interest rate Payoff at $200 per month Total interest charge
Personal loan $10,000 7% 60 months $1,880
Example 2

You can regain financial sanity. A debt consolidation loan can make sense if you just want to streamline your bills. It can be stressful to juggle multiple bills to pay each month or risk forgetting to pay one. Reducing multiple debts to one can help you stay financially organized. Try to look at the overall cost of the loan -- it might not be worth increasing your overall costs just to simplify the monthly payment.

When is debt consolidation a bad idea?

A debt consolidation loan may not be the right move. If any of the following apply to you, consider alternative solutions.

You risk running up new debt. If you pay off your credit cards with a loan only to charge the credit cards up again, you'll only make your financial (and emotional) situation worse. If you might be tempted to continue to use your cards, think twice about using a loan to pay them off.

A safer strategy is to close all of the credit card accounts when you pay them off with the loan funds. Then commit to only using a debit card or cash until your loan is paid off.

If you're worried that closing all your credit cards will have a negative effect on your credit score, you're right. One factor in calculating your score is the amount of available credit you have. And if you close all your cards, it would drop to zero. But paying off debt is more important (and life-changing) than avoiding a temporary dip in your credit score

Your credit is poor. If you are struggling to keep on top of your debt, your credit score might already be less than stellar. A lot of low-interest personal loans require good or excellent credit, though you can find personal loans for bad credit, too.

A consolidation loan might not be a good strategy if you can't significantly reduce the cost of your existing debt. To research your rate, find lenders online who will do a soft, not hard credit check to give you an idea of what you'll qualify for. Only submit a formal application for a hard credit inquiry when you're sure you need that loan, because hard inquiries ding your credit score.

The consolidation will raise the cost of your debt. As tempting as a low payment might be, steer clear of a consolidation loan that will drag out your debt for such a long repayment period that you end up paying more over time. As we saw in the example above, you'll pay more in interest if you stretch the loan term.

Advantages of debt consolidation

We now know that debt consolidation can lower the interest you pay, ease the hassle of paying bills each month, and help you pay off debt faster. But that's not all. Here are a few other advantages of debt consolidation:

  • There is light at the end of the tunnel because from the day you sign your loan contract, you know precisely when the total debt will be paid off.
  • There's less risk of late payments because you've reduced the number of bills you need to keep track of. If you want to reduce it even more, arrange for the monthly payment to be automatically deducted from your bank account.
  • Paying down credit card debt could improve your credit utilization ratio (provided you don't take on any new debt). This, along with regular loan payments, should help to improve your credit score.

Disadvantages of debt consolidation

The peril of living is that things can always go wrong. Here are some things that can happen to wipe out the potential advantages of debt consolidation:

  • You suddenly feel flush because you've gotten rid of high-interest debt and go on a spending spree.
  • You have debt amnesia and forget how awful it felt to be burdened by revolving debt. As a result, you begin to use your credit cards again and end up in worse shape than before.
  • You consolidate using a 0% balance transfer card, but don't pay the money back during the promotional timeframe and end up paying a high APR. Or, you make late payments, or otherwise break the terms of the credit card agreement, and end up paying a high APR.
  • You take out a loan using collateral to keep the interest rate low and risk losing that collateral if you miss payments.

Alternatives to debt consolidation

If you don't qualify for the loan you want or you decide not to take a consolidation loan for another reason, it may make sense to see if you can pay off debt or manage it differently. Here are some more ideas to consider.

Debt snowball or avalanche

A debt avalanche or debt snowball are both ways to pay down debt. You make the minimum payments on all your debts every month, while paying as much as you can toward one specific debt. In an avalanche, you'll focus on the debt with the highest interest rate. In a snowball, you'll focus on the debt that has the smallest balance.

To make the fastest progress, you'll want to get creative about finding ways to reduce your spending and increase your income.

RELATED: See The Ascent's debt snowball calculator to see which debts you should pay off first.

Debt management plan

A debt management plan (DMP) is a formal three- to five-year payoff plan that's administered by a third party, typically a nonprofit credit counseling agency. The administrator will help you restructure your debt (lower the interest rate and waive fees). You will be responsible for making a single monthly payment to the administrator who then distributes the money to each creditor according to a pre-approved plan.

All of the credit cards that you include in the DMP will be closed. Your creditors may monitor your credit report while you're in the program, and you may have to agree not to use any credit products during the payoff period.


If you can prove you don't have enough income to pay your debts, you might be eligible to have them wiped out in a Chapter 7 bankruptcy. Although the court may sell some of your assets to pay your creditors, many Chapter 7 filers get to keep most or all of their personal property.

A Chapter 13 bankruptcy is similar to a debt management plan. You'll make a single monthly payment for three to five years. The court will approve a monthly payment equal to your disposable income, and at the end of the program, any remaining debt is wiped out. In a Chapter 13 bankruptcy, you do not have to sell your assets.

Many people worry about damaging their credit when they file for bankruptcy. But if, like many bankruptcy filers, you're late or in default on your debts, you've already damaged your credit. The bankruptcy might not actually affect your credit score very much. The lower your score, the less it will fall as a result of filing for bankruptcy. However, the bankruptcy will remain on your credit report for up to 10 years.

You can start rebuilding your credit much sooner, though. One option is to apply for a credit card for bad credit. Many of these credit cards are secured credit cards, which means you'll need to pay a security deposit.

The cost to file bankruptcy ranges from a few hundred dollars if you represent yourself to several thousand dollars to be represented by an attorney.

Debt settlement

Debt settlement works by negotiating a lower interest rate, lower balance, and/or lower fees with your creditors. You can do this yourself one account at a time, or you can use a debt settlement company to negotiate multiple debts on your behalf for a fee. If you use a debt settlement company, you'll send them one payment each month. Then, the company makes the agreed-upon disbursements to each of your creditors.

Debt settlement may sound like a debt management program, but there are important differences. For one thing, you'll pay fees to the debt settlement company. Also, your debts will be reported as settled, not as paid in full. That could make it harder for you to qualify for new credit at favorable terms for the first few years after your debt settlement is complete.

Another potential disadvantage is it's common for debt settlement companies to collect your monthly payments for a period of time before negotiating with your creditors. This is because creditors are less motivated to negotiate if your account is current. They might be more willing to work out a deal if they think they might not get any of the money owed to them. In the meantime, anyone reading your credit report will think you've made no effort to meet your obligations -- even though you've been diligently making payments. And all the while, you're hurting your credit. Late payments remain on your credit report for seven years past the date of delinquency.

What do you need to apply for debt consolidation?

If you're going to apply for a debt consolidation loan, it is helpful to have everything you need in front of you, including:

  • Employment history: Lenders want to know that you're not a job-hopper and have steady employment. Be prepared to provide your employer's contact information. They may also ask why you left your last employer.
  • Income verification: Your income will be verified to make sure you have enough earnings to pay all your bills each month. Verification may require access to pay stubs, bank statements, or your tax return from the previous year.
  • Proof of identification: Lenders will ask for proof of ID to make sure you are who you say you are. Proof of ID may include your driver's license and one other piece, such as a voter's registration card or passport.
  • Debt you want to consolidate: Lenders also want a comprehensive list of each debt you want to consolidate, including the names and addresses of creditors and balances owed.

Is debt consolidation right for me?

Very few Americans are immune from money problems. If you are having trouble managing your debt, consolidation may be a simple and cost-effective way to get relief. But only if the advantages are clear.

A debt consolidation loan can be part of a well-planned financial recovery. You might be able to make your debt payments more manageable and save money on interest. The goal should be to get out of debt as soon as possible for the lowest possible cost.


  • Debt consolidation may temporarily ding your credit because you'll incur a hard inquiry when you apply for a new credit card or loan. Obtaining new credit will also lower your average credit age. In the long run, though, debt consolidation could help your credit score, especially if you replace a revolving credit balance with a personal loan. You'll lower your credit utilization ratio, which accounts for 30% of your credit score.

  • It may be worth it to consolidate your debt if you can significantly reduce the amount of interest you're paying. Debt consolidation can also be helpful if you struggle with managing multiple payments and want the simplicity of a single monthly payment.

  • Most likely. If you consolidate debts with a balance transfer or a loan, you'll still be able to use your credit card. However, if your goal is to get out of debt, it's typically best to avoid making additional credit purchases.

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