How Does a Debt Consolidation Loan Work? Step-by-Step Guide

A debt consolidation loan is a type of personal loan that you can use to combine multiple debts into one and pay them off in fixed installments. This can benefit you in several ways, from simplifying your debt to saving you money.

Here's a look at the features, types and alternatives to debt consolidation loans to help you decide if it's right for your situation.

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Quick Take

• A debt consolidation loan is a personal loan you take out to pay off two or more higher-interest debts.

• To take out a debt consolidation loan, compare rates and loan details from several lenders, then submit your application. Once your loan has been approved and funded, use the money to pay off your other creditors.

• Debt consolidation loans are best for people who have multiple credit cards or other high-interest debt.

• The loans are usually a poor fit for people in danger of running up their credit cards once they’ve been paid off.

• You typically have 24 to 84 months to repay the loan.

• Annual percentage rates (APRs) range from 6% to 36%, depending on your credit. Many loans also have origination and other fees.

How a Debt Consolidation Loan Works: Step by Step

These are the steps you’ll take to consolidate your debt.

1. Check your credit and debt totals: Look for credit report errors, then get your credit score. Also, total your balances to determine how much you need to borrow to fully consolidate your debt.

2. Compare lenders and get prequalified: Request no-credit-impact prequalifications from several banks, credit unions and/or online lenders. Then compare the rates, loan terms and fees to find the best fit.

3. Apply and get approved: Gather your government-issued photo ID, Social Security number, proof of address and proof of employment and income before you start. Most applications take just a few minutes to complete, and you can be approved the same day.

4. Pay off your debts. Lenders offer one or both of these options:

   • The lender deposits the loan funds into your bank account so that you can pay your creditors. Loans typically take anywhere from one to several days to fund.

   • The lender pays your accounts directly. This option usually takes longer, so you might have to make a minimum payment on each account while waiting for the payoffs to go through.

5. Begin repaying the new loan: Consider setting up autopay to avoid late payments and possibly get an interest rate discount.

What Types of Debt Can You Consolidate?

You can consolidate virtually any type of debt, such as:

• Credit cards

• Personal loans

• Medical bills

• Payday loans

In many cases, debt consolidation loans are deposited into your account as a lump sum of cash, just like a normal personal loan. This allows you to pay off any debts you choose.

Student loans are one of the few types of debt you can’t consolidate with a debt consolidation loan. But you can consolidate federal loans through the Education Department’s Direct Consolidation Loan Program, or refinance your student loans through a private lender.

Types of Debt Consolidation Loans

You can use any one of several loan types to consolidate your debt.

Unsecured Personal Loans

• This is the most common type of debt consolidation loan.

• The lender approves you based on the strength of your credit and income, with no collateral required.

Secured Personal Loans

• A secured loan requires collateral, such as your car title.

• Secured loans are less risky for lenders, so you might have an easier time qualifying and/or getting a competitive rate.

• However, you could lose your property if you get behind on your payments.

Variable vs. Fixed Rates

• A fixed rate stays the same for the whole loan term, so your payment never changes.

• A variable-rate loan often starts with a low introductory rate, which increases after the promotional period ends. The rate can change periodically after that, based on the prime rate or another benchmark.

Quick Example: How Debt Consolidation Can Save — or Cost — You

Here’s a look at how debt consolidation can impact your costs:

Before consolidation

• $3,000 total debt

• Up to $1,884 in interest

• Up to 11 years to repay

Scenario 1: Lower-cost loan — 36 months, 16% APR, $300 fee

• Borrow: $3,300

• Monthly payment: $116

• Payoff time: 3 years

• Interest saved: Around $1,007

Scenario 2: Higher fees and longer term — 72 months, $1,000 fee

• Borrow: $4,000

• Monthly payment: $87

• Payoff time: 6 years

• Extra interest cost: Around $363

Bottom line: Debt consolidation can save money — but higher fees or longer terms can reduce or eliminate those savings.

Benefits of Debt Consolidation Loans

For someone with multiple balances, debt consolidation offers several benefits:

• Consolidation can dramatically lower your monthly minimum payment.

• Rolling your payments into one makes your budget easier to manage and gives you a clear payoff date.

• Consolidating credit card debt reduces credit utilization — one of the weightiest factors of your credit score. Your credit score could increase within a month.

• Personal loans often have lower interest rates than credit cards, so consolidation is a great way to escape high APRs.

Drawbacks of Debt Consolidation Loans

For all the perks of debt consolidation loans, they're far from a no-brainer.

• Some personal loans charge loan origination fees and/or penalize you for paying off your loan early.

• If you overspend by nature, newly zeroed-out credit cards can entice you to begin spending again.

• Interest rates may occasionally be higher than rates on the debts you want to consolidate.

When You Shouldn’t Consolidate Debt

These situations can make debt consolidation a poor fit.

• You don’t qualify for a better interest rate than you’re already paying.

• A longer loan term and/or high fees cancel out the benefit of consolidating.

• You struggle to control spending that could run up your credit cards again.

How To Apply for a Debt Consolidation Loan

Applying for a debt consolidation loan is similar to opening any other loan. Here’s how to do it.

1. Check your credit report: Look for errors that need to be corrected before you apply for the loan.

2. Compare loans: Consider various banks, credit unions and online lenders.

3. Gather relevant information and documents: You'll likely need your Social Security number, government-issued photo ID, address, paystubs and bank statements.

4. Formally apply for the loan: You can do it by phone or in person, but an online application takes just a few minutes and is the fastest way.

5. Once approved, review the terms of the loans: Look over the rate, your payment amount and due dates, plus processing fee and origination fee amounts, if applicable. If everything looks OK, follow the lender’s instructions for accepting and finalizing the loan.

6. Watch for the funds to reach your account: That typically happens within a few days. If the lender is paying the creditors directly, watch your accounts for the payments. Make any minimum payments due in the meantime.

Eligibility Checklist

Here are the eligibility criteria for debt consolidation loans:

• Age 18 or older

• Social Security number

• Proof of employment

• Proof of income

• Acceptable debt-to-income (DTI) ratio if you’ll receive the loan funds and pay off the creditors yourself.

Alternatives to Debt Consolidation Loans

In some scenarios, the best debt consolidation loan may not be a personal loan.

Who Should Consider a Debt Consolidation Loan?

A debt consolidation loan can save you hundreds or thousands of dollars in interest, but it’s not the best choice for everyone.

Good Fit If

• You have multiple high-interest debts, like credit cards or payday loans.

• You have at least a fair credit score, which is at least 580 as defined by FICO.

• You want to simplify your payments into one monthly bill.

• You’re committed to avoiding new debt while paying off your current loan.

Not a Good Fit If

• You don’t qualify for a lower rate than you’re paying on your debt.

• You have mostly student loan debt.

• You haven't corrected an overspending mindset.

Debt Consolidation Loan FAQs

What credit score do I need?

Every lender has its own requirements, but you’ll need at least a 580 FICO score to get a decent rate.

Can I consolidate student loans?

Yes, with the federal program for federal loans, or by refinancing private loans through a student loan lender.

Will the lender pay creditors directly?

Some lenders will. If yours doesn’t, you can pay them yourself using the loan proceeds.

How long does funding take?

Loan funding can take anywhere from the same day to several days.

Will this hurt my credit?

Initially, perhaps, because the loan will temporarily increase your credit utilization. But you’ll see improvement once you’ve paid off the other debts. Timely loan payments could further boost your score.

Is interest tax-deductible?

No. Interest on debt-consolidation loans isn’t deductible.

Sarah Hostetler contributed to the reporting for this article.

Photo credit: PeopleImages / Getty Images/iStockphoto