How Do Debt Consolidation Loans Work?

Debt consolidation loans work by giving you access to a lump sum of money you use to pay off your unsecured debts, like credit cards, in one fell swoop. You’re then left with only one payment on your new debt consolidation loan.

Debt consolidation loans are a smart way to pay off debt if you can qualify for a lower annual percentage rate compared to the average rate across your existing debts. This lower rate means you’ll save money on interest, and you’ll likely get out of debt faster.

Debt consolidation loans also have fixed rates and terms, so you’ll pay the same amount every month, which makes the payment easier to budget for than revolving debts like credit cards. Plus, you’ll know exactly what day you’ll be debt-free, which can be especially motivating.

You can find debt consolidation loans at banks, credit unions and online lenders.

Banks typically offer the lowest interest rates on debt consolidation loans, but you may need good or excellent credit (a score of 690 or higher) to qualify. If you already have a relationship with a bank, it’s worth asking what their loan options and qualification criteria are before considering other lenders.

Credit unions also offer lower-rate loans and may be more lenient to borrowers with fair or bad credit (a score of 689 or lower). You’ll need to join the credit union before applying for a loan, but the membership process is typically quick and affordable. You can usually fill out the application online, and you may need to make an initial deposit of $5 to $25.

Online loans are available to borrowers across the credit spectrum, and they’re often the most convenient option. Some online lenders can make immediate approval decisions and fund loans the same or next day. Many also let you pre-qualify, which means you can check your potential loan terms without hurting your credit score. Since online loans can have a higher cost of borrowing, it’s best to pre-qualify with multiple lenders to compare rates.

You qualify for a debt consolidation loan based on the information in your application. Lenders typically look at three core factors: credit score, credit history and debt-to-income ratio.

Some lenders may publish minimum credit score or minimum credit history requirements to apply. Most like to see a good credit score and two to three years of credit history that shows responsible repayment behavior.

You’ll also need to list your income. This gives lenders an idea of your debt-to-income ratio, which divides your total monthly debt payments by your gross monthly income, and helps lenders assess your ability to repay a debt consolidation loan.

A debt consolidation loan should help build your credit score, as long as you use the loan to successfully pay off your debts and you pay back the new loan on time.

You’ll also undergo a hard credit check when you apply, which knocks a few points off your score, but this is temporary. Any missed payments on the loan can hurt your score.

The first step to getting a debt consolidation loan is knowing how much debt you have. Make a list of unsecured debts you’d like to consolidate, since this is the loan amount you’ll need to apply for.

You can also calculate the average annual percentage rate across your current debts using a debt consolidation calculator. You’ll want to get a debt consolidation loan with a lower rate in order to save money on interest and pay off the debt faster.

Not all lenders offer pre-qualification, so take advantage of those that do. This typically involves filling out a short application with basic personal information, including your Social Security number. The lender will run a soft credit check, which won’t hurt your credit score, and then display potential loan offers.

If your lender doesn’t offer pre-qualification, it doesn’t hurt to call and see what information they can tell you over the phone about applicant requirements, including minimum credit score.

Once you’ve pre-qualified or decided on a lender, it’s time to fill out your loan application.

A loan application asks for personal information — think name, birthdate, address and contact details — as well as information about the loan you want, including loan purpose, desired loan amount and repayment term. You may need to show proof of identity, address, employment and income. Once you submit your application, you’ll undergo a hard credit check.

Most applications are available online, but a smaller bank or credit union may ask you to visit a branch.

You can typically expect to hear back from the lender within a few days.

Once approved, funding time is typically within a week, though some lenders may offer same- or next-day funding. Lenders can deposit the loan funds in your bank account, but some may offer to send the money directly to your creditors on your behalf, saving you that step.

This is a convenient way to pay off your debts, but make sure to check your accounts to confirm your balances are $0. If the lender doesn’t offer direct payment, use the loan funds to pay off your debts yourself.

Once your debts are paid off, you’re left with only your new loan payment. Your first payment is typically due one month after funding and will be due every month until the loan is paid off. Make sure you add this payment to your budget. Missing a loan payment can result in costly late fees and hurt your credit score.

Debt consolidation loans aren’t the right choice for everyone, and they can be risky, particularly if you’re someone who struggles to stay out of debt. For example, if you use a debt consolidation loan to pay off your credit cards, but then start using your credit cards again, you’ll have even more debt than you started with. This can hurt your credit score and leave you struggling to repay your loan.

Terms on debt consolidation loans can also be long — sometimes up to seven years, depending on the lender. If you have good or excellent credit, you may want to consider other types of consolidation, like balance transfer cards, which come with 0% promotional periods. This can help you pay off debt faster, since there’s no interest.