Loans > How Does Debt Consolidation Work?

How Does Debt Consolidation Work?

This guide will show you the different options for debt consolidation, how they work, and ultimately — how you can have less debt.

Reviewed by
Updated January 10, 2022

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Need to get out of debt? If the answer is yes, then you’re in the same boat as 189 million Americans. 

This number is huge but not unbelievable. Debt is often like a hydra—one second you cut it in half, and the next second it doubles again. On top of that, keeping track of all credit-related monthly payments can be a complicated mess, even for the most math-savvy of us. 😰

Alas, if only there was a way to turn 10 debts into a single one with better terms… Spoiler alert—there is a way, and it’s called debt consolidation. 

Consolidation essentially means you can “merge” multiple debts into one obligation with spread-out payments, lower interest rates, and a single monthly bill you need to worry about. Hence the name.

Having to worry about one hydra sure beats getting swarmed by a dozen, which is why debt consolidation loans are so popular in today’s low interest-rate environment. Even if you don’t feel like taking out a new loan, there are other ways to consolidate your debt.

There’s a way that’s completely free, as well as a method that can lower your debt by 50% or more.

In this guide, we will explain the 3 types of debt consolidation super-quickly, and give you all the know-how you need to cut your debt down to size. Let’s see how debt consolidation can make multiple lines of credit easily manageable.

What you’ll learn
  • How Debt Consolidation Works
  • Debt Management Plan
  • Debt Consolidation Loans
  • Debt Settlement
  • The Smartest Way to Consolidate Debt
  • Risks of Debt Consolidation
  • When to Consolidate Debt
  • When not to Consolidate Debt

How Debt Consolidation Works 🛠️

Well, it is a way to consolidate debt, meaning —to replace multiple annoying debts into one big debt with better terms. The practice of combining multiple debts into one is quite common and usually gives many benefits to the debtor.

However, it can do more harm than good if you get a bad deal, which is why we’ll go through all the best options for debt consolidation in a moment. You can consolidate your debt in 3 ways—either through a debt consolidation loan, DMP, or debt settlement.

This image shows how debt consolidation can be used to merge multiple debts into one.
You can consolidate multiple debts into one, with better terms.

These 3 methods are quite different, so you must understand all of them before making any major financial moves. Let’s see what each of these does very quickly, and then we can get into what’s the ideal solution for you.

Debt Management Plan (DMP) ✅

Let’s start with the most lightweight debt consolidation method. If you’re having trouble making all your debt payments, you can turn to a debt management agency. These agencies can negotiate with your creditors and restructure your debt in a way that’s easier for you to pay.

After they have negotiated better terms, you can pay the agency once a month, and they will promptly send the money to each of your creditors. The idea is, instead of thinking about making a dozen different payments every month, you only need to worry about one. This will eliminate a lot of confusion and make your payment process as simple as humanly possible.

A good thing about debt management agencies is that they operate as nonprofits—and that means you don’t have to pay them for their service.

There are exceptions to this rule and a credit management service can sometimes incur a small fee, but these can be waived based on your income. 

👉One of the best aspects of a DMP is that it won’t hurt your credit score.

Negotiating better terms with your lenders without missing a payment means they won’t put anything negative in your credit report, so it’s best to turn to a credit management agency before missing a payment. 

During this consolidation process, all involved credit accounts will be disabled—you won’t be able to spend borrowed money. This is a plus because it removes the temptation of using credit and really helps getting rid of debt as fast as possible.

Debt Management Plan Overview 📋


  • Spreads out payments, making them more manageable
  • Financial counseling
  • Cheap or free
  • Doesn’t damage your credit score


  • Won’t lower the amount you have to pay
  • There’s no guarantee your agency will negotiate great terms with lenders
  • Will remove all involved credit account from your credit report—even good ones

Who Provides Debt Management Plans? 🏢

Credit management agencies or credit consulting agencies, whichever term you like more. As these are counseling agencies, they will also educate and advise you about credit-related matters, so you know how to avoid getting in an uncomfortable state of debt in the future. 

A couple of popular names are ACCC and NFCC. These are agencies you can reach online for free counseling, as well as a full-package DMP.

Remember, these are nonprofits that exist to help Americans get out of debt and stay out of debt.

Even if you’re not considering getting a DMP, it can be beneficial to call the agencies just to get a few practical tips about credit management if nothing else.

Debt Consolidation Loans 💰

This means: Get a big personal loan, use it to pay off multiple smaller loans instantly, and then just focus on paying off the one big loan. Basically, you replace a bunch of loans with just one—practically consolidating them into one (hence the name).

Sort of like this…

This image shows the multiple types of debt that can be consolidated into a single financial obligation via debt consolidation.
How consolidation can simplify the structure of your debt.

So, this simplifies things, but what else? Well, if you get a good deal on your consolidation loan, the interest you have to pay will be smaller than the combined interest of your other, smaller loans.

This means, if you get a favorable debt consolidation loan, you pay less money in interest. Plain and simple.

Another fortunate circumstance is that getting a new loan means getting new payment terms. For example, if you have to pay off your credit cards in one year, and replace that with a 3-year credit card consolidation loan—you just bought yourself 2 extra years to take care of business.

Consequently, this means much smaller payments every month. 🎉

Debt Consolidation Loans Summary 📋


  • “Combines” all your debt into one loan, simplifying things
  • If you find a good deal, you will save on interest rates
  • Can  significantly stretch out your payments


  • Best deals require a great credit score
  • No counseling or assistance—you’re on your own
  • May incur origination and prepayment fees

Does a Debt Consolidation Loan Look Bad? 😔

A debt consolidation loan won’t look bad on your credit report or anywhere else. Therefore, your credit score will remain intact so long as you treat your consolidation loan with the care it deserves.

Make all payments on time, and you will be on an upward trajectory, paying off debt and improving your credit all at once.

💡 FYI: There are even a number of options available if you’re looking for debt consolidation loans with bad credit.

What Is the Best Debt Consolidation Loan? 🎯

Due to its many benefits, a debt consolidation loan might seem like the way to go—but that might not always be the case. To get a good consolidation loan, you need a good credit score. 

If your score is good, you won’t have a problem finding a good deal at a bank, debt relief company, or via a home equity loan. If your credit isn’t great, a DMP might suit you better, but hold that thought.

🔍 Keep in mind: Before deciding if you want to manage your debt this way, check out the leading debt consolidation loans to take a look at their requirements.

Debt Settlement 🏛️

The two aforementioned methods can be of great help if you can see yourself in a lot of credit-related trouble in the future. One the other hand, debt settlement (a.k.a. debt relief) is a tool for those who are already in dire straits and need to reduce their debt even if it means taking a risk.

Here’s how debt settlement works: 👇

If you turn to a debt settlement company they will negotiate with your lenders in your name and try to postpone your payments and reduce the amount you need to pay. While the negotiations are on, you will not be paying anything to the lenders. Rather, the debt settlement company will accept your debt payments and hold them in a trust account for when they’ve negotiated better loan terms for you—that’s when you pay off the debt.

So, what’s the best-case scenario?

A debt settlement company can manage to lower your total debt by 10% or even up to 70% in some cases—that is the total amount with the interest and everything. 

If this happens you’ll pay a lot less and get rid of the debt but it will damage your credit score. Your lender will report this, and the debt settlement will most likely sit on your credit report for another 7 years.

This image shows the process of debt settlement broken down in 6 steps.
The process of debt settlement in 6 steps.

On top of that, the debt settlement company will charge you a lofty fee—they are not nonprofits like debt management agencies and won’t hesitate to collect their piece of the pie. By the way, none of this is easy on the nerves, as you can probably guess.

Debt Settlement Overview 📋


  • May reduce the amount you need to pay dramatically
  • Can help you avoid bankruptcy
  • Is the most sensible option if you’re overwhelmed by debt


  • The lender might not accept the debt settlement and might sue you
  • Your credit score will get damaged
  • Debt settlement companies can be expensive

What Can Go Wrong with Debt Settlement? ⚠️

The solution we just mentioned might not seem perfect because of the harm it will do to your credit rating, but keep in mind—this was the best-case scenario. The worst-case scenario might look something like this:

The debt settlement company negotiates with your bank for a few months so you don’t make your regular debt payments. Then, the bank rejects all the debt settlement proposals and decides to sue you.

Meanwhile, your credit has gone down the drain because of the missed payments. To put the cherry on the cake, your settlement company might still require you to pay them for their valiant effort.

But even that might be the second-to-worst possible outcome. Like many other sectors of the finance industry, the debt settlement world is full of scams. There are companies out there promising to remove half of your debt in a few weeks for a “small upfront fee”.

Recently, the opportunities for fraudsters have expanded due to the COVID-19 pandemic. For example, some companies are going around college campuses, claiming they can remove student loan debt

To sum things up, take a debt settlement deal only if you truly need it, and be very aware of scams or else they will make a giant mess out of your finances.

What is the Smartest Way to Consolidate Debt? 🧠

Your strategy will depend on your situation. If you have a great credit score and can apply for the top low-interest personal loans—then a debt consolidation loan might be the way to go. This means you would have to organize and manage the whole ordeal yourself, but you’ll be able to delay payments and save money on interest rates.

If you want the most user-friendly and the least extreme method, getting a DMP is a good idea. Your debt management agency will guide you through your debt consolidation, simplifying the process significantly. In the end, you will likely get better terms for your loan, your credit score will remain intact, and you won’t have to pay the agency.

Debt settlement should by no means be your first option but will seem sensible if you have no way of paying off your debt or are nearing bankruptcy. A successful debt settlement can lower your debt significantly, but will inevitably damage your credit (not as much as bankruptcy would, though). 

However, things can take a dreadful U-turn with debt settlement if your bank decides to sue instead of accepting your proposal. Do not take debt settlement lightly, and be very suspicious about any company promising to remove a big piece of your debt—only talk to well-known, established debt settlement services.

What are the Risks of Debt Consolidation? 🚨

Each of the 3 methods comes with its own set of risks and disadvantages. The safest way to consolidate debt is probably to get a DMP. Since your debt negotiations will be managed by professionals, you’ll be in good hands and receive advice on what to do next. All involved credit accounts will be frozen for spending, so you’ll have a minimal chance of doing anything to damage your credit.

A consolidation loan is different—you are on your own here. A good consolidation loan has great potential, but only if you’re very responsible with it and make sure every payment goes through on time. A missed payment for a big consolidation loan will look bad on your credit report, so make sure you make a realistic plan and stick to it.

Debt settlement is even more different as risks are quite high. We already discussed what can happen if things don’t go your way and you get sued, or if you run into a cleverly disguised scam.

Getting your debt lowered massively sure sounds alluring, but think of the long-term—a damaged credit score and the risk you’re taking might not be worth getting your debt slashed.

A married couple receiving debt consolidation advice from an expert.
Debt settlement might not be worth the risk, as it can negatively affect your credit score.

How Does Debt Consolidation Affect My Credit Score? 🏦

If successful, a DMP or a debt consolidation loan won’t do anything to your credit score. If anything, going through the consolidation process properly will improve your credit score. However, debt settlement will always damage your score. 

That damage might be preferable to bankruptcy, but be aware of the risks when considering this option. Usually, all bad items stay on your credit report for up to 7 years if they aren’t removed before that. These bad items can drag your credit score down, but can also be fixed.

Fixing a damaged score is not hard if you know how to read and understand a credit report. However, if you don’t want to deal with the bureaucracy of fixing your own credit reports, there are agencies for that too. 

These agencies will often give you a run-down of your credit report and tell you if there’s anything that needs to be fixed before you pay them anything. If you think your credit report could use a cleanup, see how the best credit repair companies can help.

How You Can Manage Your Debt (Six Steps) 💪

Whether you decide to consolidate your debt or not, you’ll still need to manage your debt payments and make sure you know what’s going on with your finances. Here are some tips on how to make this process a lot less vexing and much more efficient.

1. Know What You Owe 📋

First thing’s first—make a list of all your creditors, how much you still owe them, how much you pay them monthly, and when the payments are due. This will give you an idea of how much money you need to set aside every month, and when you can expect to pay everything off.

2. Make a Calendar and Do What It Says 📅

Schedule your month so you can make all payments on time. Missing a payment by one day can happen very easily, but will hurt your credit and won’t do any favors to your mood either. Keeping payments on time is the most important factor for your credit score, so make sure this is your priority.

3. Pay off the Expensive Stuff First 💰

Credit cards with higher interest rates should be paid off before everything else for obvious reasons. If you have extra money, pool it towards your most expensive loan and pay the minimum fee for everything else. This way, you’ll get rid of your obligations one by one starting with the most annoying one.

4. Give Your Good Accounts Priority 👍

Missed payments can incur collection fees and charge-offs—even if you get these, don’t sacrifice your good accounts for the sake of paying other overdue debt. Try to keep as many accounts as possible in good standing, or else you’ll have collectors crawling out of the woodwork to rudely remind you of things you already know.

5. Build an Emergency Fund 📩

If you still have some financial legroom after making all your monthly payments, you should consider preparing some money for emergencies. Remember, if you’re trying to bring your debt to an even 0, you don’t want to get into more debt in case of a medical emergency or some other sudden expense.

6. Be Honest With Yourself—Get Help If You Need It 🚑

Getting out of debt requires discipline, consistency, and budgeting. Even if you do everything by the book, your debt might simply be overwhelming—in that case, you might want to look at debt consolidation. 

One the other hand, if keeping track of everything is giving you a hard time, there are a few digital solutions you will find useful. There is free software you can use to track your payments and monitor your credit score, as well as companies that can keep track of this for you, as well as protect you from identity theft.

👓 Take a look at our pick of the premier credit monitoring services for some paid solutions, as well as a few free ones.

When is a Debt Consolidation Loan a Good Idea? 😊

Here’s a scenario when a debt consolidation loan can be a godsend. Let’s say you’re paying off 5 credit cards with interest rates in the 16% – 25% range. If you come across a consolidation loan with a 5% interest rate, it’s a no-brainer—get the loan, consolidate your debt, and you’ll have a much easier time taking care of your finances.

As a rule of thumb, you should make sure your gross income is at least two times larger than your debt, excluding mortgage. If you have a steady income and a good credit score to boot, you’re in an excellent position to look for a consolidation loan. Add a bit of frugality to the mix, and you’ll likely be able to get rid of your debt in a year or less.

When is a Debt Consolidation Loan a Bad Idea? 🥺

If your credit score isn’t great, but your stream of income is steady, getting a DMP is the better option. If you’re simply overwhelmed by debt, then debt settlement might be the wisest option.

In both cases, a consolidation loan isn’t ideal. If you’re not sure whether your credit is solid enough for a favorable consolidation loan, check out the top loans for good credit to see what offers you can get with a middle-tier credit score.

Estimated APR

6.99% - 24.99%

8.99 - 23.43%

Loan term

3 - 6 years

2 - 7 years

Loan amount

$3,500 - $40,000

$5,000 - $100,000

Best for

Best for  borrowers with good to excellent credit

Students and debt consolidation/home improvement borrowing

Estimated APR

8.99 - 23.43%

Varies (but known to be low)

Loan term

2 - 7 years


Loan amount

$5,000 - $100,000

$5,000 - $100,000

Best for

Students and debt consolidation/home improvement borrowing

Borrowers with good to excellent credit


Estimated APR

6.99% - 24.99%

8.99 - 23.43%

Varies (but known to be low)

Loan term

3 - 6 years

2 - 7 years


Loan amount

$3,500 - $40,000

$5,000 - $100,000

$5,000 - $100,000

Best for

Best for  borrowers with good to excellent credit

Students and debt consolidation/home improvement borrowing

Borrowers with good to excellent credit

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.