Debt Consolidation Loan: How It Works and When It Helps

A debt consolidation loan is a personal loan you use to pay off other debts, usually credit cards. Instead of several payments with several due dates and interest rates, you make one payment on one loan. The point isn’t to make the debt disappear. The point is to pay less interest, get a clear payoff date, or both.

The short answer

A consolidation loan helps when the new loan’s APR, including fees, is lower than the rate you’re paying now, and when you stop adding new debt. It doesn’t help if the rate is about the same, if fees eat the savings, or if the cards fill back up.

A worked example

This uses made-up numbers. Say you owe $15,000 across credit cards at an example 24% APR.

• If you keep paying $450 a month on the cards: it takes about 55 months, and you pay about $10,000 in interest.
• If you use a consolidation loan at an example 14% APR over 48 months: the payment is about $410 a month, and you pay about $4,700 in interest.

In this example, the loan has a lower monthly payment, a fixed end date and roughly $5,300 less interest.

Now add a fee. If the loan has a 5% origination fee, you’d need to borrow about $15,790 to end up with $15,000 after the fee. The payment becomes about $431 a month, and the total you repay is about $20,700, so the cost of borrowing is about $5,700 including the fee. That’s still well under the roughly $10,000 in the example, but the fee turns a $4,700 interest cost into $5,700. Always compare the APR and the amount you actually receive.

When consolidation tends to help

• Your card rates are much higher than the loan APR you can get.
• Your income is steady and you can handle a fixed payment.
• You want a set payoff date.
• You’re committed to not running the cards back up.

When it may not help

• The loan APR isn’t meaningfully lower than your current rates.
• Your debt is too large for your income, even at a lower rate. In that case, ask a nonprofit credit counselor about a debt management plan, or read about debt settlement and its risks.
• The debt came from spending that hasn’t changed.
• Fees would cancel out most of the savings.

The risks

• Running the cards back up. This is the most common way consolidation backfires. You end up with the loan payment and new card balances.
• A longer term can cost more. A lower monthly payment spread over more years can cost more in total interest, even at a lower rate.
• Fees. Origination fees reduce the money you receive.
• Using your home to consolidate. A home equity loan can offer a lower rate, but it turns unsecured debt into debt secured by your home. See personal loan vs. home equity loan.
• Credit impact. A hard inquiry and a new account can lower your score briefly.

Other ways to consolidate

• A balance transfer card. Some cards offer a low or 0% introductory rate. They often charge a transfer fee, and the rate usually rises after the introductory period, so you need a plan to pay the balance down in time.
• A nonprofit debt management plan. A credit counseling agency may negotiate lower rates with your creditors and collect one payment from you. This isn’t a loan. See how it compares.
• A home equity loan or HELOC. Often lower rates, but your home is the collateral.

Steps to take

1. List every debt with its balance, rate and minimum payment.
2. Get offers for a consolidation loan and compare them by APR, fees and total cost. See how to compare personal loan offers.
3. Do the math against your current plan, as in the example above.
4. If you go ahead, pay off the cards right away, and make a plan to keep the balances at zero.

This article is for general information and isn’t financial, tax or legal advice. Example rates, fees and payments are illustrations, not offers.