Debt Consolidation: How to Escape the Debt Trap

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If you’re struggling to make multiple minimum monthly payments or are turning to payday lenders to cover gaps until payday, debt consolidation may be the solution. But it’s important to understand how it works, the different types of debt consolidation loans and how it will affect your credit score.

What Does Debt Consolidation Mean?

Debt consolidation is when a borrower uses a new loan to repay other loans, rolling everything into one larger loan, ideally with a lower interest rate. It combines a borrower’s existing personal loans, credit card bills, payday loans and any other fixed monthly payments into one loan with a single payment.

Basically, you use a loan with a lower interest rate to refinance high-interest debt.

Almost any unsecured loan can be consolidated, but it’s important to understand that secured debts like home and auto loans cannot be consolidated.

Two types of loans can be used to consolidate debts.

  • Debt consolidation loans are generally low-interest installment loans. The initial lump sum pays off the old credit accounts, and then the borrower can pay back the new loan over the agreed-upon term.
  • Credit card debt consolidation: Borrowers can move all their outstanding balances to the new credit card, which usually has an introductory period with a fixed rate of 0%, usually for the first 12 to 16 months. But after that period, interest will resume on the remaining credit card balance, potentially at a higher annual percentage rate than with a consolidation loan. And the credit card issuer will charge a balance transfer fee ranging from 3% to 5%.

Pro tip: If you already have a credit card and you have a bad credit score, using a credit card to consolidate may not be a bad idea. Credit card interest rates tend to be fixed at 30% APR or lower. Some of the installment loans that target bad credit borrowers max out at an APR of 36%.

READ MORE: Credit card refinancing vs. debt consolidation

It’s not always easy to qualify for debt consolidation loans or balance transfer credit cards. Most lenders require at least “fair” credit for eligibility. If they can, people should always try for consolidation before falling behind on payments and damaging their credit scores.

That said, it’s not impossible to consolidate even with bad credit. Shop around before giving up on the strategy. Online lenders and credit unions are usually the best places to start. 

Pro tip: Watch out for hidden fees, like origination fees, prepayment penalties and late fees if you fall behind on your debt payments.

READ MORE: How to get a loan with bad credit

How Debt Consolidation Works

Debt consolidation is relatively simple. Add up your unsecured debts and figure out how much you’re paying toward minimum monthly payments each month. Write down the interest rate you’re paying for each debt.

Unsecured debts include:

  • Credit card bills
  • Personal loans
  • Payday loans
  • Medical bills
  • Private student loans

After you’ve calculated the total amount of debt you have and how much you’re spending each month on debt payments, you will apply for a new loan. Ideally, that new loan will have a lower interest rate, but a rate that’s comparable to what you’re currently paying will also work.

Here’s an example of how to break everything down: 

DebtTotal balanceMinimum monthly paymentInterest rate
Credit card #1$8,000$24024%
Credit card #2$4,000$106.6720%
Credit card #3$4,000$106.6720%
Personal loan$3,000$10028%
Medical bill$2,000$4012%

Pro tip: Use a debt consolidation calculator to determine how much you can save each month.

In this example, the borrower has a total of $21,000 in debt and spends $593.34 a month on minimum monthly payments.

This means that the goal is to find a debt consolidation loan that’s large enough to pay off all five debts with one monthly payment that’s lower than the current monthly payment total of $593.

In this case, the loan offered is for $22,000 at 14% interest repaid over six years. That means a monthly payment of $453.34, freeing up $140 each month. The total amount repaid would be $32,639.49, and the total interest would be $10,639.49. You would be debt-free in 72 months. If you want to keep paying the $593 per month you currently pay, you could be debt-free in about 50 months, and you’d pay just over $7,000 in interest.

Meanwhile, if you continue to make the minimum payments each month, it would take 300+ months and more than $15,000 in interest just to pay off credit card #1.

Pro tip: Before consolidating, check with your lenders to confirm that you won’t have to pay a prepayment penalty for paying a loan off early.

READ MORE: How to consolidate credit card debt

How Long Does Debt Consolidation Take?

This will depend on the amount of debt you have and the terms of the debt consolidation loan. It can take as little as one year and as long as ten years to pay off the new loan. 

You Won’t Have to Close Your Credit Cards

Debt consolidation allows you to pay off your debts while keeping your credit card accounts open. Because you’re technically paying them off in full with your consolidation loan, credit card companies are getting paid, and that’s all that matters to them. Other debt relief methods, including nonprofit credit counseling, Debt Management Plans and debt settlement, may require your credit card accounts to be closed.

Pro tip: If you choose to keep your credit card accounts open, be very careful that you don’t run up new debt. Your debt consolidation loan won’t be much help if you max out your credit cards again.

READ MORE: Does debt consolidation close credit cards?

Dangers of Debt Consolidation

The biggest danger of debt consolidation is racking up more debt. If you roll your credit card balances into a new loan and then continue to run up balances on your newly paid off credit cards, you could end up deeper in debt. 

Other risks include: 

  • You may not qualify
  • You may only qualify for a new loan with a higher interest rate than your current debts
  • You could end up paying more in interest over the life of the loan
  • It could knock down your credit score
  • Increased costs
  • Loan fees
  • The new loan terms may not be ideal

Advantages and Disadvantages of Debt Consolidation

Faster repaymentYou may pay more over time to get out of debt
Simplified personal financesMissing payments will have serious consequences
Fixed repaymentsYou may only qualify for higher interest rates
Lower interest ratesDoesn’t fix underlying spending issues
Improve your credit scoreYou will repay the full amount of your debts

READ MORE: Debt consolidation pros and cons

Is Debt Consolidation a Good Idea?

If you’re struggling to make multiple monthly payments on various unsecured debts and your credit score is good, debt consolidation can be an ideal way to ease your financial crunch, build in some budget flexibility and save some money on interest.

The key is determining whether you will qualify for a loan large enough to pay off all of your other debts, and whether your new loan’s interest rate will be low enough to save you money.

Where Can I Get a Debt Consolidation Loan?

Virtually any traditional bank, credit union or online lender will offer some type of loan that can be used for debt consolidation. They may also be called installment loans or personal loans. Your odds of approval may be higher if you apply through a bank or credit union with which you have an established banking relationship, but the interest rates from some online lenders may be lower, particularly if you have good to excellent credit. 

Use the preapproval process to check with various lenders, then make your final decision based on the lender that offers you the best terms for your financial needs.

READ MORE: Best debt consolidation loans

What to Look For in a Debt Consolidation Loan

  • Low fixed interest rate
  • Loan amount that’s high enough to pay off your other debts
  • No prepayment penalties
  • No or low origination fee
  • Other hidden fees

Pro tip: If you’re a homeowner with enough equity, consider using a home equity loan for debt consolidation. Because these are secured by your home, they typically have a much lower loan rates than a traditional debt consolidation loan, and your credit score won’t be as much as a factor.

READ MORE: How to get a loan with bad credit

Different types of debt can be consolidated but may require different considerations and approaches.

Debt Consolidation Loan Interest Rates

Interest rates will vary widely depending on your credit score, but the rates typically range from annual percentage rates from 6% to 36%. Shop around to find the lowest rates and best repayment terms. The lower the interest rate, the more money you’ll save over the life of the loan.

How Debt Consolidation Affects Your Credit Score

There are two primary credit score models (FICO and VantageScore) and five different ranges:

FICO score rangeVantageScore range
Excellent credit800 and up781 and up
Very good credit740 to 799 661 to 780 
Good credit670 to 739601 to 660 
Fair credit580 to 669500 to 600 
Poor credit300 to 579300 to 499

Debt consolidation will initially hurt your credit score. It could knock it down anywhere from a few points to an entire level. This is because the lender will run what’s known as a “hard pull” on your credit report, plus you’ll see a short-term score reduction any time you take on new credit. However, allowing loans to default will damage your credit score even more. How severe the damage will be depends on the credit score you start with. Ironically, the higher your score, the more significant the initial hit will likely be. 

The damage will be temporary. Once you’ve paid off your other loans and made a few on-time payments toward your consolidation loan, your credit score should bounce back relatively quickly as the new loan lowers your credit utilization ratio and helps you make on-time payments.

READ MORE: Does debt consolidation hurt your credit

How Long Does Debt Consolidation Stay on Your Credit Report?

Debt consolidation technically doesn’t appear on your credit reports. However, your debt consolidation loan will. Most new accounts will show up for ten years after account closure. The new loan is unlikely to have a significant long-term impact on your credit score. However, your credit score could fall if you close your other accounts after paying them off. That’s because it will affect the percentage of your available credit that’s in use, and could lower your average age of accounts (More new accounts can be a red flag to lenders). Keep at least a couple of your oldest accounts open.

Not consolidating your debts is likely to have a bigger impact on your credit score. That’s because each time you miss a due date and pay your accounts late, it will be noted on your credit reports for seven years. 

How to Get Approved for a Debt Consolidation Loan

You shouldn’t have much difficulty getting approved for a debt consolidation loan if you have a credit score of 670 (considered good credit) or higher.

How to Get Approved If You Have Fair or Average Credit

If your credit score is between 580 and 669, you still have a few debt consolidation options, but any new lender will likely charge you higher interest rates. There are several lenders who specialize in loans for borrowers with fair credit. There are also peer-to-peer lending platforms that match potential borrowers with investors willing to loan money to people with blemishes on their credit reports.

READ MORE: Best debt consolidation loans for fair credit

How to Get Approved If You Have Bad Credit 

If your score is 579 or lower, it’s considered poor credit and you’ll have a more difficult time qualifying for a new loan. But there are lenders who cater to bad-credit borrowers. Here are some steps to take to boost your odds of approval:

  • Learn your credit score: Request free copies of your credit reports from and ensure there are no errors weighing down your credit score.
  • Gather your documents: Compile paperwork that will show your ability to repay. This includes pay stubs and tax returns. 
  • Research lenders: Review potential lenders and learn their credit score requirements. Make a short list of the ones with the most potential.
  • Check with credit unions: Credit unions are nonprofit and member-owned, so their loan requirements may be less stringent.
  • Apply with a co-signer: Try enlisting the help of a family member with good credit who is willing to cosign on a loan. But remember that if you miss any payments or default, they will be responsible for making the payments. 
  • Prequalify: The prequalification process only involves a soft credit inquiry, so you can check the loan terms, review loan offers and learn whether you’re eligible without affecting your credit score. 
  • Choose a lender and complete the application: At this point, the lender will run the hard credit inquiry that will knock down your credit score but the damage will be temporary. 

If your application is approved, the money will typically be deposited into your bank account as quickly as the next business day, but always within a few days. You will then use this money to pay off your other debts.

Use Caution

Predatory lenders are everywhere, and bad credit can make you a target. Avoid lenders that offer no-credit-check loans, payday loans and title loans. Some lenders trick borrowers into thinking they’re paying a 36% APR, when in reality, they’re paying interest rates of 300% or more. 

What to Do If Your Loan Application is Denied

If your loan application is denied, that doesn’t rule out consolidation.

There are several reasons your loan application could be denied, ranging from high credit utilization to a low credit score. No one knows for certain which algorithm a lender is using. But before you submit another application, it’s important to understand what might have gone wrong.

Take these steps to figure out why your application was denied and take some steps to fix the underlying issue.

  • Learn why your application was denied
  • Review your credit report
  • Apply with a new lender

READ MORE: Reasons your loan application may have been denied

Why Can’t I Get a Debt Consolidation Loan? 

In most cases, if your application is repeatedly denied, it will be because:

  • Your credit score is too low
  • Your debt-to-income ratio is above 36%
  • The percentage of your available credit that you’ve used is too high (this is also called a credit utilization ratio)
  • You have a pattern of late or missed payments
  • You have debt in collections or accounts that have been charged off

More Options if Your Loan Application is Denied

Debt resolution: This is also called debt settlement. You will hire a team of professionals to help you with the process. Some debt resolution companies offer debt consolidation as an option and can even search multiple loan options to find the one that will work best for you. If you simply will not qualify for a new loan, they will review your other options for debt relief.

READ MORE: How debt settlement works

Credit counseling: If your debt is primarily on credit cards, a nonprofit credit counseling agency may be able to help you determine your next steps. They offer a product called a Debt Management Plan that will help you get back on track.

READ MORE: Credit counseling

Bankruptcy: This sounds dire, but sometimes you just need a fresh start. There are two options: Chapter 7 and Chapter 13. Chapter 7 is easier to complete but has strict income requirements. Chapter 13 is basically an extended repayment plan. In either case, you will be assigned a bankruptcy trustee to help you through the process.

READ MORE: Bankruptcy

Build credit: If you can afford to wait a few months, take some steps to improve your credit history.

READ MORE: How to build credit

How to Rebuild Credit After Debt Consolidation

Creditworthiness is important. It will determine the interest rates you’ll pay to borrow money, can impact whether you’re allowed to rent an apartment and can even be a factor in job searches. It’s important to try to keep your credit score as high as possible. 

  • Set up autopay to ensure that all loan payments are made by the due date
  • Don’t close old accounts (this can help keep your credit utilization low)
  • Watch your debt-to-income ratio – most lenders want to see a DTI of 36% or lower
  • Boost your income with a side hustle
  • Make extra payments to your debts

The Bottom Line

If you’re struggling to make your minimum payments each month and are racking up late fees, a debt consolidation loan may be the solution you need to get your financial situation back on track. But it won’t work for everyone. Qualifying for a new loan could be tricky for borrowers with bad credit. 

If you’re stuck, don’t despair. You still have a few remaining options, including debt settlement programs and Debt Management Plans.

Debt Consolidation by State

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