How to consolidate debt so you can be debt free faster and save money on interest charges.
What is a debt consolidation loan?
A debt consolidation loan is a personal loan that’s specifically used to combine multiple debts into a single monthly payment. You take out a loan and use the funds you receive to pay off multiple debts of the same type. This offers several advantages:
- It simplifies repayment, so you only have one bill to worry about
- In many cases, it lowers the interest rate applied to the debt, so you save money
- It may lower your monthly payment and it always offers fixed monthly payments, which are easier to manage in your budget
- You can get out of debt faster, even though you may pay less each month, because it makes debt repayment more efficient
What types of debt can I consolidate with a personal loan?
In general, you can use debt consolidation loans for two types of debt:
- Credit card debt
- Student loan debt
In general, you must keep each type of debt separate. So, if you have credit cards and student loans to repay, you may need two consolidation loans. However, with credit card consolidation you may be able to include other unsecured debt, such as out-of-pocket medical bills, personal loans and store credit lines.
How does a debt consolidation loan work?
Consolidation loans don’t always work the exact same way. Specifically, Federal Direct consolidation loans are unique. But this is what you can generally expect:
- You apply for a loan in an amount that covers all the debt you wish to consolidate.
- Once approved, the funds from the loan are distributed to pay off all those debts.
- This leaves only the loan to repay.
How to use a credit card debt consolidation loan
Credit card debt consolidation loans are the most common. They offer low interest rates and fixed monthly payments that are often lower than what you pay now. Reduced interest charges mean you can often get out of debt faster, even though you pay less each month.
- You apply for a loan that large enough to cover your credit card debts and other obligations you want to pay off.
- You choose a term that offers monthly payments that fit your budget; 36 to 60 payments is recommended.
- The lender reviews your debts and credit to see if you qualify, based on your credit score and debt-to-income (DTI) ratio.
- If approved, the interest rate will be based on your credit score.
- Your DTI must be below 41% to get approved; if your ratio is only below 41% once all your other debts are repaid, then the lender will require direct disbursement. This means they send the money directly to your other creditors instead of giving it to you.
- This zeros out your credit card balances, leaving only the loan to repay.
How to use private student loan debt consolidation
When it comes to student loans, there may be two ways to consolidate, depending on what type of loans you hold. If you have federal loans, you can use federal or private debt consolidation loans for them. If you have private loans, then you have to use private consolidation.
Private consolidation loans work similarly to credit card debt consolidation loans, just for a different type of debt.
- You apply for a loan that covers all student loans you wish to pay off; this can include both federal and private loans.
- You chose a term that offers monthly payments that work for your budget; again, you generally want to keep the term at less than 60 payments.
- The lender reviews your debts and credit to see if you qualify.
- The interest rate is based on your credit score, although student consolidation loans tend to offer lower rates than what you can get for credit card debt.
- Again, your debt-to-income ratio matters for approval and how the money gets disbursed, once you’re approved.
- Once approved, funds from the loan are used to pay off your existing loans, leaving only the consolidation loan to repay.
How a Federal Direct consolidation loan works
This process works differently than other types of consolidation, because it’s a federal student loan relief option. Here’s what you need to know:
- You apply for a Federal Direct consolidation loan; the amount should be enough to pay off all the federal loans you want to consolidate.
- To qualify, you must have at least one Direct consolidation loan amongst the loans you have for consolidation. Your credit score is not a factor for qualification.
- Federal Direct consolidation always has a 10-year term; the monthly payments depend on the amount of debt consolidated.
- The interest rate is calculated by taking a “weighted average” of the rates on your existing loans.
- Once approved, the funds are disbursed to pay off your other federal loans.
Using a Federal Direct consolidation loan has the added benefit of making more of your debts eligible for federal repayment plans. It may also be necessary to ensure all your loans qualify for student loan forgiveness, if you work in the public service sector.
Debt Consolidation Loan FAQ
Are debt consolidation loans a good idea?
This depends on your financial situation, but it many cases, they can be the best solution. If you have multiple debts to repay and your budget is spread too thin, consolidation loans can be extremely beneficial.
You roll your debts into a single monthly payment and make debt repayment more efficient. As a result, you can pay less and still get out of debt faster. You save both money and time.
Can I get a debt consolidation loan with bad credit?
Yes, but bad credit is one of the factors that may make a consolidation loan less beneficial. For Federal Direct consolidation loans, credit score is not a factor for qualification. So, even if you have a 500 FICO score you can consolidate student loan debt, as long as it originated from a federal program.
For credit card debt and private student loan consolidation, your credit score doesn’t just impact loan approval. It determines the interest rate you qualify to receive on the new loan. If the rate is too high, it doesn’t provide the cost savings you need. The monthly payments will be higher, as well.
Always make sure to calculate loan costs carefully when looking for debt solutions. Consider monthly payment and total interest charges; weigh this against what you’re paying now. If the loan doesn’t offer monthly savings or reduce your total interest charges, you may be better off with another solution.
Explore the full range of solutions for credit card debt »
Find more solutions for student loan debt »
Do debt consolidation loans hurt your credit?
When used correctly, debt consolidation loans should improve your credit rather than hurt your credit. A consolidation loan pays off your balances in-full, so it’s good for your credit history. It also improves your credit utilization ratio – the ratio that measures credit use versus total credit limit. These are the two biggest factors used to calculate credit score. So, a consolidation loan can be extremely beneficial for your credit.
However, if you consolidate in the wrong circumstances and can’t keep up with the payments, default will hurt your credit. You can also damage your score if you don’t keep up with the minimum payment requirements on your debts during underwriting. Before you receive loan approval, make sure to meet all assigned payments on your debts; otherwise, you can create missed payments in your credit history
What does direct disbursement on a debt consolidation loan mean?
Direct disbursement simply refers to when the lender requires that they send the money directly to your other lenders. This requirement depends on your debt-to-income ratio.
In order to qualify for any loan, your DTI must be below 41% with the new loan payments factored in. But consolidation loans are used to pay off debt, so it changes your DTI.
- If your DTI with the new loan AND your existing debts is below 41%, the lender will disburse the funds from the consolidation loan to you. Then you send the money to pay off your other debts.
- However, if your DTI is only below 41% once the other loans are paid off, the lender will require direct disbursement
What is the best debt consolidation loan for federal student loans?
This depends on your financial situation, needs and goals.
- If you work in a public service profession that qualifies for student loan forgiveness (teaching, nursing, first responders), you almost always want to use a Federal Direct consolidation loan
- If you’re facing financial hardship and need the lowest monthly payments possible, Federal Direct consolidation is also the best option; consolidate, then enroll in a hardship-based repayment plan, such as Pay as You Earn
- On the other hand, if your main goal is faster repayment and to save money on interest charges, go for private consolidation
When are debt consolidation loans bad?
- When they increase, rather than decrease total interest charges
- If the loan increases your monthly payments to an amount you can’t afford to meet comfortably
- If you don’t have steady income to meet the fixed monthly payments
Private student loan debt consolidation is also bad if you ever think you may need a federal relief option or loan forgiveness. A private consolidation loan effectively converts federal student debt to private. So, it no longer qualifies for federal relief options.
Where can I get a loan to consolidate my debt?
If you want to use a Federal Direct consolidation you can apply for it through studentloans.gov. For private student loans and credit cards, you can go through any traditional lender:
- Credit unions
- Online lenders
- Loan comparison websites
It’s best to explore loans from several different lenders to find the best rates and terms. If you don’t go through a loan comparison site, check with several different lenders on your own. A lower rate is always better. Also watch out for early repayment or prepayment penalties; you want to avoid loans that include them. That way, if you get extra cash and want pay off the loan faster, you can do so without penalties.
Why can’t I consolidate student loans and credit card debt together?
Student loans are typically unique, even when it comes to loans issued by private lenders. Private lenders tend to offer lower rates on student loans than other unsecured loans. It’s basically their way of acknowledging that many student loan borrowers have low credit scores or no credit at all. Since most students wouldn’t qualify for low rates, they relax lending standards and offer better rates up front.
But that makes merging student loans and credit card debt problematic. Credit cards have relatively high interest rates. So, using a personal loan to consolidate credit card debt almost always offers significant rate reduction with a good credit score. But a low rate on a credit card debt consolidation loan may often be higher than the original rates on your student loans.
There’s also a problem with discharge during bankruptcy. Student loans – private and federal – cannot be easily discharged during bankruptcy. Credit card debt is very commonly discharged. So, if you combine the debts, it creates a problem with potential bankruptcy discharge.
For all these reasons, most lenders won’t let you consolidate the two together. And even if you find a lender who would, it’s really not advisable.
Why do I want to limit the term from 36 monthly payments to 60 monthly payments?
There are two basic reasons that you want to keep the term limited on a consolidation loan:
- A longer term means more months to apply interest charges, which increases total costs.
- It’s difficult to avoid using credit and taking on new debt for longer than five years.
When you consolidate, you want to focus on debt repayment before you start taking on new debt. This is especially true for credit card debt consolidation. If you run up new balances too quickly, then consolidation makes your debt situation worse instead of better. You basically just increase your debt instead of paying it off more efficiently.
Giving up credit cards for a few years can be tough, but it’s doable. Giving up credit cards for more than five years can be downright unfeasible. It’s like a yo-yo diet – you get tired of eating bland, boring health food, so you eventually fall off the program. It’s the same thing here.
Debt consolidation loans are the best solution when your:
|Current debt is…||Credit score is…||Interest rates are…||Monthly payments are…||Main goal is…|
|Credit card debt consolidation loans||Usually less than $50,000 and most of the debts are current||Good or excellent||High (as in over 20%)||Using more than 10% of your income||To pay off your debt faster and save money|
|Private student debt consolidation loans||Usually less than $50,000; be careful converting federal debt to private||Higher than when you initially took out your student loans||High compared to what you’d qualify for on the consolidation loan||Higher than what you’d qualify for on the consolidation loan||Lower the interest rates applied to your debt|
|Federal Direct consolidation loans||Federal student loans with at least one Direct loan||n/a (credit does not apply to lending decisions)||n/a (federal consolidation will not lower your rates)||n/a (to lower payments, you must enroll in hardship-based repayment after you consolidate)||Simplify repayment and make as many loans as possible eligible for federal relief programs|
Article last modified on February 11, 2019. Published by Debt.com, LLC .