What is Debt Consolidation?
Debt consolidation is the process of combining several debts into one new loan. The goal is to streamline payments, lower interest, and pay off debt more quickly.
5 ways to consolidate debt
Once you run the numbers, you’ll want to choose a method to consolidate your debt. There are pros and cons to each option and, as always, you’ll want to shop around for financial products to ensure you’re getting the best rate and terms.
Remember that debt consolidation is not be for everyone. You should only consolidate your debt if you qualify for a lower interest rate than you are currently paying. It is also important to note that only some types of debt can be consolidated.
1. Consider a personal loan
A personal loan is an unsecured loan that, unlike a credit card, features equal monthly payments. Loan amounts vary with credit score and history, but generally are limited to $100,000.
While banks and credit unions offer personal loans, subprime lenders are also very active in this market so it’s important to shop carefully and understand rates, terms and fees. Because a personal loan is unsecured, there are no assets at risk, making it a good option for a consolidation loan.
Be aware that a large, prime-rate loan requires good credit, and rates are typically higher for personal loans than for home equity loans. Check out Wallet Wisely’s list of top personal loans and compare lenders to find the best personal loan rate for you.
An important thing to note here is that if you open a personal loan to pay off credit cards, take care that if you close out all of those credit cards your % credit available is going to drop causing your credit score to drop. Personal loans are considered installment loans, a different type of debit than credit cards which are revolving lines of credit. They are treated differently by credit scoring companies and having a mix is beneficial to your credit score rather than having just revolving lines. Read more here.
Pros
Fixed monthly rate
Lower interest rate than revolving credit lines
Installment loans improved the credit mix part of credit scoring.
Cons
Good interest rates require 680+ credit scores (good to excellent rating).
2. Credit Card Consolidation Loan
Another alternative is to use a new card to consolidate balances into one payment with a lower rate. Your monthly minimum payment is likely to be much less than the sum total of the other cards you have. There are also many attractive offers out there for people to transfer balances and consolidate. These are almost always introductory offers for a limited period of time. To get the best rates here like the 0% introductory, you will need a credit score of 690+ (good to excellent rating).
Careful here to look at the fine print of the offer. There are some very high transfer fees out there. Calculate your new interest cost (Transfer fee % + Ongoing % rate) and the annual fee, if any. The best offers out there are 0% introductory rate for a period of 12-24 months with a fairly low balance transfer rate (3-5%). Provided you are aggressive in paying off the balances each month, you can make significant headway on eliminating your debt.
Another item to consider here is that if you close all of your other cards and maintain just the consolidated card, your % of available credit will go way down causing your credit score to decline rapidly. Look to keep some of these paid off cards open (put in a drawer or safe) but don’t use. This will help your credit score.
Pros
Lower monthly minimum payment
Reduced interest rate
Cons
Can be high balance transfer rates
Introductory rates are limited in time.
3. Home Equity Loan / HELOC
A home equity loan or line of credit (HELOC) is viable way to pay off your high-interest debt and pay down with one monthly payment. You do of course need equity in your house to do this. Rates on these can be considerably lower than unsecured credit card debt or other personal loans. The risk here is that you are putting your home at risk with this debt. Should you default on the loan, your home is the collateral the bank would pursue.
This could be a way for you to consolidate debt and pay off with one monthly payment. The trick here is to ensure you are paying down that debt and sticking to your payment schedule plus adding more each month when you have extra funds.
Pros:
Lower interest rate compared to other loans.
Longer loan periods will keep you minimum payment lower. (Try to add more when you have extra)
Cons:
Your house is always at risk should you default.
You do need equity in your home to qualify.
4. 401k Loan
While a 401k loan looks like an attractive option, you should be aware of the long-term consequences. You’ve built up a sizable 401k and are saving for your retirement. While a loan from this may solve your short-term debt issues, the long term ramification of taking a loan can be very negative.
Yes, you will pay yourself interest back on the balance and this amount will be lower than a loan you can obtain, but the overall impact on your long-term return will be substantial.
Consider this as a last resort. Should you lose your job within the timeframe of the loan, the full balance is deducted from your 401k.
Pros:
- Loan terms are on average around 5 years.
- Your interest rate is low.
- No impact on your credit report as this is your money you are borrowing.
Cons:
- Negative impact on your long-term retirement balance.
- Risk of having to pay back should you lose your job.
5. Explore a debt management plan
If you want debt consolidation options that don’t require taking out a loan, applying for a new card, or tapping into savings or retirement accounts, a debt management plan could be an option for you.
With a debt management plan, you’ll work with a nonprofit credit counseling agency to negotiate with creditors and draft a pay-off plan.
You close all credit card accounts and make one monthly payment to the agency, which pays the creditors. But you still receive all billing statements from your creditors, so it’s easy to track how fast your debt is being paid off.
With a debt management plan, you’ll get some of the best debt consolidation loan rates (but not lower balances) and an end to over-limit and late fees if you pay as agreed.
Some agencies may work for low or no cost, if you’re struggling. Stick with nonprofit agencies affiliated with the National Foundation for Credit Counseling or the Financial Counseling Association of America, and make sure your debt counselor is certified via the Council on Accreditation.
While you’re on a debt management plan, you won’t be able to reach for credit cards in a pinch because you’ll have to close all your accounts. This will lower your credit score. However, if you keep up with your payments and don’t get deeper into debt, a debt management plan could help improve your credit score long-term.
Pros
Fixed monthly payments
Lower interest rates
Cons
Negative impact on credit score
Reduced availability of credit
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