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Debt Consolidation Loans: Defined And Explained

Victoria Araj8-minute read
February 04, 2022

Struggling to keep up with your bills? You’re not alone. Owing big dollar amounts to several lenders can get confusing. It’s easy to rack up late charges and miss payment due dates when you’re juggling multiple credit cards, personal loan payments and bills from your local doctor and dentist.

There is one common way to simplify your financial life, though – debt consolidation, or the practice of merging multiple debts. When you take out a debt consolidation loan, you work with a single lender that combines some of your debts into one single loan. This loan option leaves you with fewer monthly payments and, hopefully, a lower interest rate on most of your debt.

Let’s take a look at how debt consolidation loans work, when they make sense and the potential pitfalls that come with them.

What Is A Debt Consolidation Loan?

A debt consolidation loan is a type of unsecured loan that you pay back over time with a set monthly payment. Like with other loans, your lender will charge you interest and provide you with a payment schedule. Depending on how large your debt consolidation loan is, you might have 5 years of monthly payments to pay it off or as many as 10 years.

It’s important to keep in mind that debt consolidation loans are examples of unsecured loans. This means that there is no collateral backing your loan. This is different from a mortgage or auto loan. In these loans, your home or car is collateral. If you stop making payments, your lender can take possession of your car or home.

If you stop making payments on a debt consolidation loan, your lender has nothing to take from you. That’s why interest rates tend to be higher on debt consolidation loans than they are on secured loans such as mortgages or auto loans.

How Do Debt Consolidation Loans Work?

When you apply for a debt consolidation loan, your lender will pay off your existing personal loan and credit card debt. Depending on your wishes, the lender might also pay off any medical debt you owe. Your lender will then provide you with a single loan, usually with a fixed rate. You’ll pay this loan off in monthly installments until your entire debt is paid off.

Remember, you can’t consolidate all debt. Only unsecured debt is eligible for consolidation. This includes credit card debt, store credit card debt, personal loans and medical bills. You can’t consolidate auto or mortgage loans.

Student loans are a tricky case. These loans are examples of unsecured debt – but you can’t include federal student loans in a private debt consolidation loan. You can only consolidate these loans with each other through a specialized program designed for federal student loans. However, private student loans can be included in a traditional debt consolidation loan.

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How To Get A Debt Consolidation Loan

When shopping for a debt consolidation loan, you should look to see if you qualify for the lowest interest rate, then find a loan amount and a repayment plan that is right for you. You should also make sure to compare several key features of the loan.

These include your new loan’s interest rate and annual percentage rate, or APR. Your loan’s APR is especially important; it includes both your interest rate and any origination costs or other fees. This makes your APR a better indicator of how much your loan costs than the interest rate alone. A debt consolidation loan could have a higher interest rate but still be less expensive than another loan if its APR is lower.

When comparing debt consolidation loans, it’s best to pay closer attention to APR than interest rates. The loan with the lower APR is typically the less expensive one.

Both your interest rate and APR will be lower if your credit score is higher. Lenders will look at your three-digit credit score when determining whether to approve you for a debt consolidation loan and at what interest rate. The higher your score, the lower your interest rate – and resulting APR – should be.

Lenders will also look at your debts and income level. They want to make sure that your income is high enough to allow you to make your monthly payments on time. The amount of your debt will help determine how high your monthly payments will be. A higher income, of course, will increase your odds of qualifying for a debt consolidation loan.

How Do You Qualify For A Debt Consolidation Loan?

Every lender has its own set of eligibility qualifications and requirements that a borrower must meet before they approve the loan, including: 

  • Residence: Most debt consolidation loans require you to be a resident of the United States. Because an unsecured loan can be a personal loan, non-U.S. citizens are eligible if they meet certain conditions, which vary depending on the lender.
  • Credit history: Lenders will check your credit report and payment history to evaluate what kind of borrower you’ll be. In most cases, a lender will require you to have a credit score of 650; however, some lenders may accept credit scores of 600 or lower.
  • Financial stability: Lenders want to see proof of financial stability. They’re looking for borrowers who are responsible and trustworthy with money; people who are in stable economic situations who can pay back their debt, and on time.
  • Proof of income: Having a steady job is essential when you’re looking for approval. Lenders want to know that you can meet the terms of your loan. To verify your income, they’ll request proof of a steady income through such documentation as pay stubs from your job.

What Are The Benefits Of A Debt Consolidation Loan?

There are many reasons you might consider applying for a debt consolidation loan. Let’s look at a few.

Pay Off Your Credit Card Balance

Paying off credit card debt is one of the most common reasons people turn to debt consolidation loans. Consolidating your credit card payments into a single loan will increase the odds that you won’t miss any monthly payments. It’s easier to keep track of one payment than juggling multiple ones each month. And if you make your credit card payments on time, you’ll boost your three-digit credit score.

Having too much credit card debt could hurt your credit score, and steadily paying this debt down each month can also help you improve this key number. Remember that lenders look carefully at your credit score when determining if you qualify for mortgages, credit cards, auto loans and personal loans. You want your credit score to be as high as possible.

Get A Lower Interest Rate

Credit card debt comes with high interest rates. Your personal loan might come with a higher rate, too. The hope is that when you consolidate this debt into one single loan, your lender will provide you with an interest rate that’s lower than the average rate you’re paying on your current unsecured debt.

This can save you hundreds of dollars as you pay down your debt each month.

Lower Your Monthly Payment

Struggling with cash flow? Is it a challenge to afford all your monthly payments? Depending on the length of your debt consolidation loan, you might be able to lower your total payments, providing some relief to your monthly budget. The longer your loan term – the more months you have to pay back what you owe – the less you’ll owe each month.

Keep in mind that you’ll pay more in interest the longer you take to pay back your loan. You’ll have to study your budget to determine whether it’s more important to pay less in interest or make a smaller payment each month.

Your lender might even be able to convince some of your creditors to reduce what you owe. That, too, could leave you with a lower monthly payment.

Get Shorter Loan Terms

By consolidating your debt, you could reduce the number of months it takes to pay it all back. This will depend on how much you can afford to spend on your debt consolidation loan each month, but if you can consolidate into a short-term loan, you could save money in interest payments.

It's Time To Free Yourself From Credit Card Debt.

Apply for a personal loan in just a few simple steps.

Average Debt Consolidation Loan Rates

The APR you’ll get on a debt consolidation loan depends on your credit score, but you can expect an APR ranging from 5% if your credit is stellar to 24% or more if your credit is less impressive. A debt consolidation loan could be a good choice if its APR is lower than the average APR on your existing debt.

Debt Consolidation Loan FAQs

Can I use a personal loan for debt consolidation?

You can use a personal loan for whatever you’d like, including paying off your credit cards or other existing debt. When you qualify for a personal loan, your lender will provide you with a lump sum payment that you pay back each month with interest. You can use that payment to pay off your other debts. The key, again, is to make sure that the APR of your personal loan is lower than the average APR of your debts.

Can I get a debt consolidation loan with bad credit?

You don’t need perfect credit to qualify for a debt consolidation loan. Most people who apply for these loans have average to bad credit. That’s because most people don’t consider these loans until they’ve generated a high amount of debt or missed several monthly payments. High credit card debt and missed payments will hurt borrowers’ credit scores. Lenders know this. It’s why the interest rates with debt consolidation loans tend to be higher: These loans are at higher risk, so lenders charge more for them.

If you’re worried about the loan affecting your credit score, consider asking a family member to co-sign your loan with you. Having a co-signer can ease lenders’ concerns, but it’s a risk for your co-signer. If you don’t make your payments, your co-signer is responsible for them. And if you pay late, it hurts not only your credit score but your co-signer’s, too.

What role does DTI play?

You can improve your odds for qualifying for a debt consolidation loan, too, by lowering your debt-to-income ratio, or DTI. This ratio measures how much of your gross monthly income your monthly debts consume. By paying down as much of your debt as you can, you’ll lower your DTI. Lenders vary, but most want your total monthly debts to equal no more than 43% of your gross monthly income.

Are there debt consolidation loans for student loan debt?

You can consolidate student loan debt, but it’s a bit more complicated than consolidating other unsecured debts. Federal student loans can’t be consolidated with other debts, but you can consolidate all your federal student loans into one Direct Consolidation Loan.

This way, you can make one monthly payment on all these loans. Private student loans – those originated by private lenders – are a different matter. You can consolidate these loans with other debt. You can’t, though, combine private and federal student loans into the same debt consolidation loan.

The Bottom Line

A debt consolidation loan could help you gain control over your debt, but it won’t automatically solve your financial problems. If you continue to overspend even after taking out one of these loans, you’ll simply run up more debt.

If you have additional questions about personal finance issues, visit our personal finance learning center. We have plenty of answers.

It's Time To Free Yourself From Credit Card Debt.

Apply for a personal loan in just a few simple steps.

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    Victoria Araj

    Victoria Araj is a Section Editor for Rocket Mortgage and held roles in mortgage banking, public relations and more in her 15+ years with the company. She holds a bachelor’s degree in journalism with an emphasis in political science from Michigan State University, and a master’s degree in public administration from the University of Michigan.