What Is Debt Consolidation and How Does It Work?

Debt consolidation is a repayment strategy that involves combining multiple debt balances into a single loan or line of credit. The goal is to make the “new debt” more manageable by having one lender, one monthly payment and one — ideally lower — interest rate.

The most popular methods to accomplish this include debt consolidation loans, balance transfer credit cards and home equity loans or lines of credit. Borrowers often seek debt consolidation when they want to simplify their bill payments, pay off debt faster, get a lower monthly payment or stop paying a high interest rate.

Here’s how it works, more details on your loan options and when you should consider this strategy.

How does debt consolidation work?

To consolidate debt, you usually request a new loan or credit line. The amount of credit offered must be high enough to pay off your other debt balances. People typically use this process to consolidate unsecured debt, like credit card debt, a personal loan or a payday loan.

Approval for debt consolidation requires applying and meeting the lender’s specific criteria. A low debt-to-income ratio and a good credit score will increase your options and lead to better interest rates. There are debt consolidation loans for those with bad credit, but they come with higher costs and may need collateral or a cosigner.

Here’s a hypothetical example of how it’d look: Let’s say you have three credit cards, with interest rates ranging from 21% to 28%, and a combined balance of $9,000. You’d compare your loan options (more on that below) and decide which makes most sense for your situation. In this case, you choose to pursue a personal loan, shop around, and are approved for a 12% interest rate and a three-year loan term. After the personal loan funds are deposited into your bank account, you’d use them to pay off all three credit cards.

The lender will expect you to make your new monthly payment as agreed. Otherwise, you can experience fees, credit damage and potentially collateral loss (if your loan was secured by collateral).

The advantages of debt consolidation

Having a single payment instead of various debt bills to manage each month makes it easier to remember to pay the bill on time and avoid late fees. If you get a lower interest rate, a debt consolidation loan can save money and ultimately pay off your debt faster.

Consolidating debt can also extend your repayment period and lower your monthly payments. This usually means you’re paying more over time, but depending on your cash flow, it could be a necessary step in managing your debt. Building a history of paying on time can also help your credit score.

The disadvantages of debt consolidation

There are upfront costs with debt consolidation because the lender on your new debt will charge a fee for either originating the credit or transferring balances. Balance transfer credit cards charge anywhere between 3% to 5% of the debt to be transferred, and debt consolidation loans and loans based on home equity also have varying origination fees. Depending on your credit profile and the loan terms you’re looking for, you may not be able to find an interest rate lower than what you’re paying now.

Steps to take before consolidating your debt

Before you consolidate your debt, you need to get a handle on your situation so you can choose the right loan and terms.

Take inventory of the debts that need consolidating

First, make a list of the debts you want to consolidate along with their remaining balance. Unsecured debts, like credit cards, are simpler to bundle up than secured loans, like auto loans. (And it may be harder to get a lower rate than you’re already paying on secured loans unless you offer up collateral.)

Check your credit score

A good credit score and credit history are ideal for pursuing debt consolidation. Knowing your credit score will allow you to determine whether it’s the right time to consolidate, or if you should work on improving your credit first. You can request a free credit report from all three major credit bureaus (Experian, TransUnion, and Equifax).

Know the interest rate you’re shooting for

At a minimum, you’ll want an interest rate that’s better than the weighted average rate of the debts you’re paying. To calculate what your weighted average interest rate is, multiple each loan amount by its interest rate. Then add up the total interest and add up all your debt balances. Then, divide the total interest by the total debt and multiply that number by 100 to get that percentage.

Here’s an example:

In this case, you’d divide $3,144 by $18,400 and then multiply the result to get 17.09% for a weighted interest rate.

Keep in mind that consolidation doesn’t have to be all or nothing. In this case, for example, if you’re not able to get a new loan with a rate close to or lower than the 11% you’re paying on the personal loan, you could choose to consolidate the credit card debts and leave the personal loan out. You’ll still have multiple monthly debt bills, but you’ll have fewer and you’ll still be able to take advantage of lower interest rates.

Determine how much you’re willing (or able) to pay every month

Run the numbers and come up with a monthly payment that’s reasonable based on your current financial situation. Don’t forget to factor in any upfront costs required. Finally, make sure this amount is a number you can deal with; debt consolidation can be a smart strategy to manage debt, but only if you actually are able to pay off the consolidation loan.

Debt consolidation options

Personal loans used for debt consolidation, home equity options and balance transfer credit cards can all work for merging debt. The payment amount, repayment length, interest rates, fees and application processes vary for each method.

Take out a debt consolidation loan or personal loan

A debt consolidation loan gives the borrower a lump sum to pay off debts such as credit cards, medical bills and personal loans. It’s a personal installment loan available through many online and traditional lenders. In most cases, the loan doesn’t need collateral. You will also have a fixed monthly payment for easy budgeting.

Lenders usually let you borrow anywhere from $1,000 to $50,000 and give you between one to seven years to pay the loan back. The lender may charge a one-time origination fee equal to a percentage of the debt consolidation loan amount.

Your financial profile will determine the loan terms you’re eligible for. As with all financial products, it’s important to shop around. The best debt consolidation loans will offer competitive rates, minimal fees and a streamlined application processes.

Use a balance transfer credit card

A balance transfer involves moving other credit card balances to a single credit card and typically involves getting a balance transfer card that provides a low or 0% APR introductory period. That way, you can avoid paying interest for several months and have payments fully applied to the principal owed.

Once you request and are approved for the balance transfer, the credit card company will pay off the listed debts. This process can take up to six weeks. Once the transfer finishes, your card balance gets updated with the transferred amount.

Note that most of these cards charge a balance transfer fee, typically between 3% and 5% of the transferred amount. After the promotional period, the regular interest rate will apply and it’s usually higher than debt consolidation loan options. If you pursue this option, you have to be strict about paying off the balance before the promotional period ends, and afterwards, you have to stick with your budget to avoid racking up new credit card debt.

Tap into your home's equity

Owning a home can give you more debt consolidation options in the form of a home equity loan or home equity line of credit. You’ll need at least 15% equity in your home. This option typically has the lengthiest and most involved application process, but because you’re offering collateral, these can help you snag a lower interest rate.

A home equity loan provides all the money in a lump sum and typically comes with a fixed interest rate. The loan term can be up to 30 years, and the monthly payment stays the same throughout. HELOCs, on the other hand, provide a line of credit to access as needed during a draw period. Some lenders offer fixed-rate HELOCs, but usually the interest on these products is variable, and you would only make interest-only payments until the full repayment period begins.

Both come with the risk of using your home as collateral — in other words, if you default on your loan, you could lose your home. They both also usually involve closing costs that can range from 1% to 5% of the borrowed amount.

Is consolidating your debt the right move?

Consolidating your debt likely won’t solve your problem if you’ve built up a lot of debt because you’re spending more than you’re earning. Instead, it will just kick the debt down the road, until you take steps to change your spending or earning.

That said, if you’re no longer accruing new debt and you have a high debt balance with expensive interest, consolidating debt can help you save significantly on interest. This will require getting approved though, so if you have a poor credit score, you may need to first look into ways to improve your credit score.

If, on the other hand, you have smaller debt balances or manageable interest rates, the upfront cost of consolidation may not be worth it. Instead, other strategies to pay down debt, like the debt snowball or debt avalanche methods, may work better for you.

Alternative debt consolidation options

If your cash flow isn’t enough to cover your monthly debt bills, then neither debt consolidation nor a do-it-yourself payment plan are likely a good fit. But there are other debt solutions worth looking into, including signing up for a debt management plan or settling current debts with creditors.

Debt management plan

A debt management plan through a credit counseling agency can help you streamline multiple debt payments into one. It can also help you save on interest and fees since the credit counselor will often negotiate with your creditors.

Since it doesn’t require taking out a new credit line or loan, this option can be a good choice for those who may not meet the credit or income requirements for traditional loans or credit. Sticking to the plan and paying on time can ultimately eliminate your debt, but you’ll need to follow the agency’s rules to avoid being removed from the program.

These plans come with a one-time setup fee and a monthly fee while the plan is active.

Debt relief or debt settlement

If your debt bills are eating up most of your income, a small reduction in your monthly payment probably will not be enough to make a difference. In that case, you may want to consider debt relief.

Debt relief, also called debt settlement, involves working alone or with a debt relief company to persuade creditors to accept less than the full balance owed. Whether you take the do-it-yourself approach or sign up with a company, it’s important to know that settled accounts are seen as a negative item on your credit report, and they’ll hurt your credit score, though you can rebuild it after handling your debts.

This option works best if your account has already been delinquent for at least a few months. Working with a debt relief company can make the process easier since the company negotiates on your behalf, but you will have to pay a fee of between 15% and 25% of your enrolled debt, based on whatever the company is ultimately able to settle.

More from Money:

How to Use Your Home Equity to Pay Off Debt

A 4-Step Guide to Negotiating Credit Card Debt

Debt Snowball vs. Debt Avalanche: Which Payoff Strategy Is Right for You?