What is a debt consolidation loan?

Close to half of credit card users carry a balance from month to month, according to data from The Century Foundation and Protect Borrowers. 

Juggling multiple balances can easily balloon into out-of-control debt. One solution is to use a personal loan to consolidate your debts into one streamlined payment at a fixed, lower APR.

A debt consolidation loan can simplify your bills, save on interest and shrink your monthly payments. Many lenders will even pay your creditors for you directly.

Here's what to know about debt consolidation loans, including how they work, the benefits and drawbacks, and how to find the right lender.

A debt consolidation loan is a fixed-rate installment loan used to pay off higher-interest bills. Since annual percentage rates on personal loans are typically lower than credit cards, debt consolidation is often used to tackle card debt.

These loans are available from traditional banks, credit unions and finance companies. SoFi offers loans of up to $100,000 with no origination or late fees, and will pay your creditors directly. Rocket Loans' maximum APR is lower than many competitors and same-day funding is available for eligible borrowers.

Debt consolidation streamlines multiple unsecured debts into a single monthly payment.

Debt consolidation loans

In most cases, you'll apply for a debt consolidation loan the same way you would for any traditional personal loan, with the proceeds being used to pay off balances, rather than on car repairs, a new refrigerator or some other expense.

Many lenders will send the funds directly to your creditors. Some, including Happen Bank and Achieve, offer a rate discount for using direct payment.

For the strategy to make sense, the consolidation loan should have a lower interest rate than your existing debts. So make sure you include any origination fee or other loan costs when calculating the cost of borrowing.

While a debt consolidation loan can simplify your financess and lower your monthly payments, it won't erase your debt or address the issues that led to your debt in the first place. After paying off your balances, avoid taking on new debt that could put you back in financial straits.

Balance transfer credit cards

Another popular form of debt consolidation is transferring existing credit card balances to a new credit card with a 0% introductory APR.

Balance transfer cards offer zero-interest for up to 21 months. You still have to make the minimum monthly payment during the promotional period, but the 0% APR allows you to make headway with the principal.

If you're considering a debt consolidation loan, the key is to compare the total cost of borrowing, not just interest rate or monthly payment.

• APR: Compare the annual percentage rate that a lender is offering with other offers and the rates on your existing debts.
• Fees: Many lenders charge up-front origination fees of 1% to 10%., which will impact the overall cost of borrowing. You should be able to avoid a prepayment penalty for paying off the loan early.
• Eligibility requirements: Try to find out what a lender's credit score and income-to-debt requirements are to see if you're a good candidate. If you're not sure, see if you can prequalify to get an estimated rate and term without damaging your credit score.
• Repayment terms: Shorter terms generally mean higher monthly payments but less spend paying interest in the long term. A longer term may work better with your budget
• Direct payment: Having your lender pay your creditors directly will save time and may earn you a rate discount.
• Funding speed: Some lenders are able to deposit your loan the same day or next business day.
• Collateral and joint loans: If you have poor or limited credit, you may want to find lenders that offer secured loans or co-borrowers.

If you apply for a debt consolidation loan or a balance-transfer credit card, the issuer will perform a hard inquiry on your credit, which will temporarily lower your credit score.

If you're approved, your credit utilization rate will likely increase and the average age of your credit accounts will drop, both of which can also ding your score.

The most important factor, however, is how well you are about paying off your debt. Payment history is worth 35% of your credit score, and on-time loan or credit card payments will improve your number. But late or missed payments can easily hurt your credit.

Debt consolidation can help pull you out of a financial hole, but there are drawbacks.

Pros

• Simplified payments: You're replacing several bills and due dates with a single, predictable monthly payment.
• Lower rates: For debt consolidation to be truly effective, you should qualify for a lower APR than your existing debts. A loan will give you a fixed APR, while a balance transfer card will offer a zero-interest period for several months.
• Clear end date: Unlike credit cards, a debt consolidation loan has a fixed timeline to pay off your balance.
• Improved credit score: Making regular on-time payments toward your loan or card can improve your credit score over time.

Cons

• Fees: Debt consolidation loans may have origination fees, while balance transfer cards commonly come with transfer fees. Both raise the cost of borrowing.
• Eligibility requirements: You typically need good credit to qualify for a transfer card or a consolidation loan with a competitive rate.
• Risk of taking on more debt: Debt consolidation doesn't address the principal balance or your spending habits. If you're not careful, you could end up even further in debt.

Debt consolidation is just one way to tackle debt. The strategy that's best for you depends on your credit, income, home equity and other factors. 

Balance transfer credit cards: If you have good credit you may be able to get approved for a 0% intro APR credit card. You can then move some or all of your current credit card balances to the new card and enjoy a promotional period, usually between 12 and 21 months, with no interest. A standard APR goes into effect after that — and there's typically a balance transfer fee of between 2% and 5% — so a balance transfer isn't a good option if you don't have a strategy to pay off the balance before the intro period expires.

Home equity loan or HELOC: Homeowners with enough equity, good credit and stable cash flow may want to apply for a home equity loan or home equity line of credit (HELOCs) to pay down their balances.

APRs on both are lower than credit card rates, but you're swapping unsecured debt for secured debt that uses your house as collateral. If you can't keep up with the payments, your home could be at risk of foreclosure. In addition, HELOCs often have variable interest rates, meaning your monthly payments could increase over time.

Credit counseling: If you're still able to make your minimum monthly payments, credit counseling can provide guidance and structure to tackle your bills. A certified counselor will review your income and expenses and create a debt management plan. They may also be able to negotiate with your creditors to lower your interest rate or have certain fees waived.

Debt settlement: A debt settlement company may be able to negotiate with your creditors to reduce your principal balances. You typically need to have at least $7,500 in unsecured debt and the process isn't cheap: Debt settlement companies usually charge between 15% and 25% of your enrolled debt, and your credit score will take a major hit. But if they're successful, you may be able to have as much as 50% of your card balances cleared.

Bankruptcy: If you're facing unmanageable debt and have exhausted other options or are at risk of losing your home, car or other major assets, bankruptcy can provide a legal framework to settle some or all of your debts. Chapter 7 bankruptcy enables borrowers with limited income to have unsecured debts, such as credit card bills and personal loans, formally discharged. They may, however, have to sell nonessential assets to repay creditors. Chapter 13 bankruptcy establishes a court-approved repayment plan that may allow borrowers to keep their home and other assets, provided they stay current on payments.

At CNBC Select, our mission is to provide our readers with high-quality service journalism and comprehensive consumer advice so they can make informed financial decisions. Every loan story is based on rigorous reporting by our team of expert writers and editors with extensive knowledge of loan products. While CNBC Select earns a commission from affiliate partners on many offers and links, we create all our content without input from our commercial team or any outside third parties, and we pride ourselves on our journalistic standards and ethics.

Catch up on CNBC Select's in-depth coverage of credit cards, banking and money, and follow us on TikTok, Facebook, Instagram and Twitter to stay up to date.