Debt consolidation loans (DCLs) are personal loans that borrowers use to pay off 2 or more existing debts with funds from a single installment plan. They enable borrowers to stop compounding interest, reduce monthly payments, minimize transaction volume, and in some instances save money.

The cost of DCLs can be lower than the combined interest and fees of paid-off accounts, but savings is not the primary reason for consolidation. For example, credit card payoff plans can have higher monthly payments but ultimately cost less interest due to interest on loan origination fees.

Debt consolidation loans are not the same as balance transfers, which are a credit card feature allowing borrowers to move an interest-incurring balance to a credit card with low or zero interest for a limited time.

Summary

Will they hurt your credit?

They can hurt your credit when you use them to pay off other loans because closing an account impact a credit factor concerned with the number of active accounts on your report.

Are they hard to get?

As unsecured debt designed for borrowers in risk of default, debt consolidation loans are among the most challenging to acquire. Some lenders make them accessible by charging high interest rates.

Definition

Debt consolidation loans are debt management tools that allow borrowers to payoff 2 or more other accounts and focus on a single payment.

Purpose

Similarly, the purpose of debt consolidation loans is to convert two or more accounts with problematic payment or interest terms into a single, manageable loan.

Role in Debt Management

Debt consolidation loans are a tool in the debt management. Debt management is the strategic transfer and payment of debt obligations to minimize interest and prevent late payments, which damage credit reports and thereby cost borrowers more in the long run.

Consolidation has two core roles. The first is preventing late payments. For example, borrowers with large credit card debt generally need to pay at least 1.5x the starting minimum payment to have a meaningful impact.

If that monthly payment is too high, it could cause late payments that hurt consumer credit, thereby costing more on future debt. Debt consolidation loans can reduce monthly payments by as much as 17%, although upfront fees that make the total cost of borrowing higher.

The second advantage is simplification. Borrowers with several loans and cards often find it difficult to track and make the various payments on time.

The reality is that at a certain number of accounts, the stress and time required to manage them is not worth minor savings. Consumers turn to debt consolidation loans to simplify the process, even if it means slightly more interest long term.

Two additional simplifications include:

Types

Classic debt consolidation loans are a type of personal loan that borrowers take out for the explicit purpose of consolidating 2 or more other accounts. Explicit here means the borrower tells the lender the purpose of the loan so the lender can craft appropriate terms.

That said, home equity loans and cash-out refinancing can serve as consolidation loans without explicitly mentioning the borrower's intention.

Debt Consolidation Loan (Classic)

Simply put, traditional debt consolidation loans provide a lump sum of cash that borrowers use to payoff outstanding balances on other loans or credit cards. Borrowers must disclose their intent to consolidate debts when they take out the loan. Rates are typically high and length is usually limited to 7 years.

Home Equity Loan

Home equity loans allow borrowers to borrow money against the equity they have earned on their home. Because they use the home as collateral, home equity loans have lower rates than classic DCLs and can have durations up to 30 years or the time remaining on the primary mortgage.

Home equity loans are not the same as a Home Equity Lines of Credit (HELOCs), which is revolving credit and therefore outside the scope of this loan article.

Cash-Out Loans

Cash-out loans allow homeowners to refinance their home at full appraised value. The result for borrowers is a lump sum of cash equal to the difference between the previous mortgage loan and the house's market value. They can use that lump sum to consolidate and pay off other loans.

Rates are usually lower than classic consolidation loans and home equity loans because cash-out structures are secured by the home. They can be as long as 30 years.

Structure

Debt consolidation loans are structured like traditional loans. They provide principal amount at the start of the loan that must be paid back with interest in installments.

Unsecured Loans

Like all personal loans, DCLs are unsecured because they do not fund the purchase of an asset. The absence of collateral means that lenders charge higher interest to mitigate the risk of borrower default.

Their unsecured nature is also what makes them useful as a refinancing tool.

A Refinancing Tool

Debt consolidation loans are refinancing tools and not funding tools. This is a key characteristics that differentiates DCLs from other personal loans.

Lenders accept approximately 13 uses of funds, of which 5 are asset purchases, 7 are major purchases. The other is consolidation, and it sits in a category of its own as a refinancing tool.

Credit Requirements

Lenders generally require a minimum FICO 8 score of 500 for debt consolidation loans. That said, scores of less than 600 may need to provide proof of income and steady employment.

Alternatively, at least 10% of credit builder loans with money upfront accept scores as low as 300. Used correctly, these unsecured CBLs and credit builder cards can save thousands on debt consolidation loans.

Who Should Use Them

Ideal borrowers for debt consolidation loans are consumers with payment or term problems on 2 or more existing loans or credit cards.

Possible issues include:

When to Use Them

Borrowers should refrain from debt consolidation loans in circumstances other than the following.

If these circumstances apply, a consolidation loan is useful when the following conditions also apply.

• Strong home equity allows for cash-out and home equity consolidation
OR
• DCL payments are manageable

AND

• DCL total interest is less than the cost paid-off accounts
OR
• Paying more interest is acceptable to reduce stress and de-motivation

Cost

Debt consolidation loan costs include interest and fees.

#1 Interest Rates

Interest rates vary by provider, but a good rule of thumb is to never accept an APR greater than 35.99%. Most policymakers agree 36% is the point at which loans become predatory. The lower the interest rate, the cheaper the loan.

Interest Free Options

Some lenders offer interest-free debt conso loans, but borrowers should keep in mind that lenders must turn a profit to stay in business and they never provide unsecured debt for free.

Instead, they often charge hefty fees. These fees must be included in APR, but sneaky lenders will promote 0% interest and place the APR in fine print.

#2 Origination Fee

Origination fees are are flat administrative fees charged at the start of the loan, usually 5% of the loan amount. Lenders deduct the origination fee from the principal amount before distribution, but borrowers pay interest on the original amount.

For example, imagine a $100 loan with 5% origination fee an 1% interest. The borrower receives $95 ($100 — [5% * $100]) but pays $1 interest the first month (1% * $100) rather than $0.95 (1% * $95).

Due to this structure, borrowers must account for origination fee when requesting loan amount. If they intend to use loan proceeds to pay off the full balance of other accounts, the formula to determine the minimum is [pay off amount] / [1 — Orig. Fee%].

The formula to determine the DCL amount required to settle other debts after origination fee is

[Pay Off Amount] / [1 — Orig. Fee%]

Calculator

Here's a simple loan calculator you can use to understand DCLs. The input fields include amount, interest rate, and loan term. You should also input the origination fee to understand the full cost of borrowing.

Providers

There are three types of debt consolidation loan providers. They are banks, credit unions, and online lenders.

Banks

Some major banks such as Wells Fargo and U.S. Bank provide DCLs. Many more regional banks such as Fifth Third and Santander also provide personal loans for consolidation.

Credit Unions

Credit unions are localized institutions that can provide debt consolidation services. They often work with community financial wellness groups as well.

Online Lenders

Online lenders such as Avant provide debt consolidation loans. The advantage of online lenders is quick distribution, great user interfaces, and transparent terms.

Government

Many consumers search for DCLs from government organizations, but they do not exist. Unlike mortgage loans, government-secured or funded personal loans do not exist because institutions such as Freddie Mac and Fannie Mae do not operate in the personal loan space.

Parties Involved

A debt consolidation loan has at least 1 lender and at least 1 borrower. It's rare for two lenders to work on a single consumer loan, even those as large as mortgages.

It's equally rare for two borrowers to co-borrow on a debt consolidation loan unless the paid-off loans are under a married couple name. It is nevertheless legal and possible to do so as long as the lender agrees.

Renegotiation

Renegotiation is the process in which borrowers request modification to loan terms during the life of the debt consolidation loan. A point of confusion arises because consolidation loans themselves exist because original lenders of the paid-off accounts refuse to renegotiate.

Borrowers can request a change in loan terms (or forbearance on payments). It is the lender, however, who decides whether to oblige.

Recourse

Recourse is a lender's right to pursue borrower assets in the event default. Debt consolidation loan usually qualify as recourse loans, so borrowers should keep this in mind when they borrow.

Target Markets

Debt consolidation loans are available in virtually every modern economy. They have particularly strong presence in Anglo-Saxon countries such as the United States, Canada, the UK, Ireland, Australia, and New Zealand.

They are also prominent in continental Europe across countries such as France (rachat de crédit), Spain (préstamo de consolidación de deuda), and Germany (Darlehen bei Schuldenkonsolidierung).

Alternatives

Consumers considering debt consolidation loans should be aware that there are two prominent alternatives, called balance transfers and credit card payoff plans.

These solutions can be cheaper than debt conso loans depending on borrower credit profile, cash available for monthly payments, and credit card interest rate.

Balance Transfers

Balance transfers are a credit card feature that allows borrowers to move an interest-incurring balance to a credit card with low or zero interest for a limited time. Contrary to popular belief, many card issuers allow the transfer of loans on the credit card, not just other card balances.

Balance transfers are cost-efficient solutions for borrowers with thick credit profiles. Many cards provide interest-free promotional periods, so consumers can delay payment without compounding more debt.

For example, the Discover it® Cash Back Credit Card has 0% interest on balance transfers for the first 15 months from the date of first transfer. There is a fee of 3% on the balance, however.

After the promotional period, the balance will start incurring interest daily. Unlike purchase transactions, it is not exempt from the daily balance. Borrowers should keep this in mind because postponing for the sake of postponing does not eliminate the obligation to repay.

In summary, balance transfers are a strong alternative to debt consolidation loans for borrowers with fair to good credit who want to postpone payments until they increase income.

Credit Card Payoff Plans

A credit card payoff plan is a schedule cardholders use to eliminate credit card debt by making fixed payments above the minimum payment threshold each month.

Given the same interest rate, a credit card payoff plan usually costs less than a consolidation loan but has a higher monthly payment because of the loan's origination fee (usually 5%).

Imagine a combined credit card balance of $6,000 (U.S. average) with an interest rate of 22.77% (U.S. average in Q2 2023) and a minimum payment of 2% of the outstanding balance. A borrower that pays 2.5x the original minimum payment ($308.68) would pay off the card in 2 years and 6 months. Total interest paid is $1,915.39.

Now imagine the borrower uses a debt consolidation loan with the same interest rate to pay off the debt in the same 2 years and 6 months. The loan has a 5% origination fee that's subtracted from the principal at distribution, so she must take $6,316 in order to receive $6,000 (= 95% of $6,316).

The loan monthly payment is $285.45, or 8% lower than the card payments. However, total loan interest is $1,952.12, or 2% higher than the card payoff plan.

The image below (left) illustrates these figures.

However, if the borrower decides to make only 2.0X the original minimum payment ($246.94), then the consolidation loan will have lower monthly payments and lower total cost. The image on the right above demonstrates these figures.

Conclusion

Cost is not the only decisional factor for using debt conso loans. Managing several card and loan payments can be stressful, and some consumers prefer paying slightly more for peace of mind. After all, the added cost for peace of mind in our example above is only $37 overall.