Debt consolidation loans: when they save money and when they do not
A debt consolidation loan pays off several debts, usually credit cards, and leaves you with one loan and one monthly payment. It can lower your interest rate and give you a fixed payoff date. It can also cost more if the term is long or the fees are high, and it does nothing about the spending that created the debt.
The ways to consolidate
The FTC lists the main routes: a personal consolidation loan from a bank, credit union or finance company; a home equity loan or line of credit; or a second mortgage. Loans secured by your home usually carry lower rates, but if you cannot keep up the payments you could lose the house.
A 0% balance transfer credit card is another option for smaller balances you can clear within the promotional period. Watch the transfer fee, usually a few percent of the balance, and make sure the offer is a true 0% rate rather than deferred interest.
Run the numbers before you sign
- List each debt with its balance, APR and monthly payment.
- Get consolidation offers and note the APR, term and every fee, including any origination fee taken from the loan amount.
- Compare total cost to payoff, not just the monthly payment. Stretching five years of card debt into a seven-year loan can lower the payment and still cost more.
A worked example
Suppose you owe $12,000 across three cards at an average of about 24% APR and pay $450 a month. At that pace, payoff takes several years and costs thousands in interest.
A three-year consolidation loan at 12% APR with a 3% origination fee would need a monthly payment of roughly $410 on a loan large enough to cover the fee. Total interest falls sharply and you have a fixed end date. A seven-year term at the same rate would cut the payment further but add back much of the interest saving. The shortest term you can afford comfortably is usually the best value.
When it works
- Your new APR is clearly lower than the weighted average of your debts.
- You can afford the fixed payment comfortably.
- You stop adding new balances to the cards you paid off.
- Your credit is good enough to qualify for a meaningfully lower rate.
The biggest risk is behavioral: cleared cards fill up again, and you end up with the loan and new card debt. Some people keep the old cards open for their credit history but remove them from wallets and online stores.
When it does not
- The best rate you can get is close to what you pay now.
- High origination fees cancel out the interest saving.
- The term is so long that total cost rises.
- The underlying problem is income below expenses; a new loan will not fix that.
Effect on your credit
Applying causes a hard inquiry and a small, temporary dip. Paying off cards lowers your credit utilization, which can raise your score, especially if you keep the cards open with zero balances. On-time loan payments build history over time.
Alternatives
- Credit counseling: a reputable nonprofit counselor reviews your budget and may suggest a debt management plan, where the agency negotiates lower rates and you make one payment to it. The FTC warns to be wary of anyone who pushes a plan before a detailed review or charges large upfront fees.
- Debt settlement: companies negotiate to pay less than you owe, usually after you stop paying creditors. This carries serious risks, including late fees, lawsuits, credit damage and tax on forgiven amounts.
- The avalanche or snowball method: paying extra on one debt at a time without new borrowing. Avalanche targets the highest APR first and saves the most; snowball targets the smallest balance first for quick wins.
- Talking to your creditors: card issuers sometimes offer hardship programs with reduced rates or payments.
Avoiding consolidation scams
Debt relief is a common target for fraud. Be cautious of companies that:
- charge fees before they have settled or reduced any of your debts
- guarantee they can make your debt disappear
- tell you to stop communicating with your creditors
- pressure you to decide immediately
The FTC advises checking any credit counseling agency or debt relief company with your state attorney general and consumer protection agency before signing up.
Before you apply
Check your credit report for errors, prequalify with several lenders using soft checks, and read the fee schedule. Set the loan payments to automatic so you never miss one.
Common questions
Does debt consolidation hurt your credit?
There is a small temporary dip from the inquiry. Lower utilization and on-time payments often help over time.
Can I consolidate with bad credit?
Possibly, but rates may be too high to save money. Credit counseling may be a better option.
Should I close the cards I paid off?
Closing them can raise your utilization ratio. If you trust yourself not to use them, keeping them open usually helps your score.