Are you having trouble paying your bills? Are creditors sending you mean, nasty letters? Are they calling you at all hours? Are your accounts being turned over to debt collectors?
Even if you answered yes to only one of the above questions, know this: You are not alone.
With the downturn of the economy in recent years, many Americans are deep in debt. In fact, the average credit card debt per household with credit card debt is $15,601. Not everyone will be able to work their way out of debt, but that’s where debt consolidation and other financial options come in.
Debt consolidation is a means of combining multiple loans. In addition to reducing the number of bills you have to pay each month, it can lower your monthly payments and reduce the long-term cost of your loans or debts.
To consolidate your debts, you’ll take out a new loan. Typically, it will be backed by some of your assets. Once you receive the new loan, you’ll use the funds to pay off your high-interest loans, such as credit card balances and other unsecured debts.
When done correctly, debt consolidation can:
- Help you get out of debt faster.
- Lower interest costs.
- Make paying off debts more manageable.
- Protect your credit rating.
However, this is not always the most advisable way to get rid of your debt. With debt consolidation, much of your unsecured debt becomes secured debt. That means if you don’t pay off the consolidated debt, you risk losing some or all of the assets you used to secure the debt.
How to Consolidate Debt
If you are among those carrying high credit card balances — and are paying exorbitant interest rates and/or crippling penalties or late fees — it may be worth it to you to consider debt consolidation. There are a number of workable alternatives, including the following:
Debt Consolidation Company
Like a credit counseling agency, a debt consolidation company can negotiate with lenders on your behalf in order to give you more time to pay your creditors, lower your monthly payment and even help reduce the amount you owe, but unlike a counseling agency, it will often charge major fees and commissions.
Some companies can serve as lenders who will offer you a debt consolidation loan, often secured by your home. When you opt for a debt consolidation loan from this type of company, you’re entering into an agreement for the lender to pay off your existing debts now.
You’ll then have one loan — meaning just one monthly payment — due to the lender, which you’ll pay back over a period of time. Your interest rate will be based on your credit and ability to pay back the loan.
Other Ways to Consolidate Debt
There are several ways to consolidate debt. The most hassle-free way is to find someone you trust to handle your debt for you. This third party can get you into a one-payment situation that meets your monthly budget and helps you climb out of debt sooner rather than later.
You can transfer balances from high-interest credit cards to one with a lower interest rate. You can get a personal loan to pay off your balances. You could get a home equity line of credit, a home equity loan or a second mortgage on your home, or refinance your existing mortgage.
Other options include borrowing against a whole life insurance policy and borrowing against you retirement savings.
Credit Card Debt Consolidation
One strategy for consolidating your credit card debt is to seek out another credit card offer with a low or even zero-percent interest rate on balance transfers. Banks offer these kinds of promotions all the time so they can sign up new credit card customers. Depending upon your credit worthiness, you may be able to roll your other high-interest credit cards into a new account and then pay them off in full.
Even though you will still be repaying the same amount of principal over the same time period, you will pay less in interest and your monthly payments will be slightly lower.
Here are four tips to remember if you do this:
- Make sure you know how long the low “teaser” rate will last. Try to pay off your balance before the promotional period ends. If you don’t think that you can do it, make sure that when the new annual percentage rate (APR) kicks in, it is still lower than what you are currently paying on your other cards.
- Check the fee on balance transfers. Some credit card companies will charge a 3 percent fee to a 5 percent fee on each balance transfer, which is added to your principal. Some charge a maximum fee of $75. See if you can negotiate with the company for a lower fee or none at all.
- Make your payments on time. Missing even one payment by a day can trigger a rate increase and late fees, wiping out any savings you may have realized.
- Don’t use the new card for any purchases or cash advances. The interest rates for these transactions may be much higher than the one for balance transfers.
Home Equity Loan and Home Equity Line of Credit
A home equity loan involves taking out a second mortgage on your home. You will have to pay this mortgage monthly in addition to the original mortgage on the house.
When you take out a home equity loan, you reduce your equity in the home, which means you own a smaller percentage of it. For example, if your house is worth $150,000 and you owe $100,000 on your mortgage, your equity is $50,000. Depending on the size of the home equity loan, you’ll lose all or part of that. You’ll regain your equity as you pay off the new loan, however.
For many homeowners, this usually is the best way to consolidate debt. Because the loan is backed by your assets, it typically results in lower interest rates than other debt consolidation options. If your credit history is good, you may qualify to receive an even lower interest rate.
This option also carries a bonus: interest paid on a home equity loan is typically tax-deductible, whereas interest on credit card debt is not.
You can also consolidate your debts by applying for and receiving a home equity line of credit, or HELOC. Depending upon your credit rating, and your amount of home equity, you can be approved to borrow up to a certain amount of money — your credit limit — and you can tap into the credit to consolidate and pay off your other debts.
With a HELOC, you’ll access the money as needed rather than take out a large loan all at once. A credit card, debit card or checking account will be linked to this line of credit to give you access to the funds, and you’ll only pay interest on the amount of money you actually spend.
The catch is that your home is now at risk. If you default on a home equity loan or line of credit, the bank could take your home.
Refinancing a Mortgage, Getting a Second Mortgage
If you own a home and have been paying your mortgage regularly, you may qualify for a refinancing of your first mortgage. This is an oft-mentioned way to put many debts into one.
The advantage is that you may find a refinance loan with a lower rate of interest and one that will also allow you to borrow some cash at the same low rate. This will allow you to consolidate your other debts and pay them off.
Taking out a second mortgage will also give you cash to pay your other debts. But there is a big disadvantage to this option: You put your home at risk. If for any reason you can’t pay off the mortgage — or mortgages — you can lose your house.
A personal loan is an option for people who don’t own homes or don’t want to use their homes as collateral. Interest rates for this type of loan are higher than those for a home equity loan, but they often are lower than credit card rates. Most banks will limit these kinds of loans to $5,000.
If you can take out an unsecured personal loan, you won’t have to put up any belongings as collateral. Or, to receive lower interest rates, you can choose to apply for a secured personal loan. In such instances, debtors typically use their cars as collateral.
Life Insurance Loans
Borrowing against a whole life insurance policy is a longtime practice, though not always the best one. It can end up costing you money that you will want or need later.
If you do have a whole life insurance policy, you can consolidate your debts by borrowing against the cash value of the policy. The advantages of this option are that you don’t have to negotiate for another loan, and you won’t have to repay the money on a set schedule, or at all, if you don’t want to.
Borrowing from Retirement
If you are enrolled in either a 401(k) or 403(b) retirement plan, you may be able to borrow funds from the account to consolidate and pay off your other debts. You will have five years to repay the money, and you’re charged interest on the balance.
The advantage of this option is that you’re actually borrowing your own money.
The major disadvantage here is the potential penalties, which can affect the long-term production of the plan and also hurt you on your taxes. If your retirement plan is offered through work and for some reason you change jobs or lose your job, you could be in a position of having to repay yourself — or risk losing a large chunk of money.
Debt Management Program (DMP)
Credit and debt counseling agencies are organizations funded primarily by major creditors, including banks, credit card companies and department stores that have a vested interest in having debts paid.
To use a debt counseling agency, you must have some source of disposable income. A reputable credit counselor will evaluate your finances and suggest improvements in the way you are handling your budget, by setting financial goals and providing you with financial education.
If appropriate, a credit counselor may have you enroll in a debt management plan (DMP). In the program, the counselor will contact your creditors to let them know that you have sought assistance and need more time to pay. Based on your income and debts, the counselor, along with the creditors, will decide how much you need to pay each month to the counseling agency, which in turn pays your creditors.
A successful DMP requires that you make regular, timely payments, and in return your creditors may agree to lower your interest rate, cancel late charges and/or or waive certain fees. It may take three to five years to complete a DMP, and you may have to agree not to apply for, or use, any additional credit while you are in the plan.
Student Loan Consolidation
Another area where consolidation may offer some relief to a debtor is that of student loans. The average college senior who graduated in 2010 had more than $25,000 in student loan debt. About two-thirds of college graduates owe on student loans, up from less than 50 percent in the early 1990s.
While each type of student loan has specific repayment options, and consolidating student loans doesn’t save on interest payments — the consolidated loan simply averages the interest rate on all the loans to come up with the rate on the new one — it may allow for a greater variety of payoff options, helping a student avoid default.
A consolidated student loan can: stretch the payment period for as long as 25 years, which lowers the monthly payments; offer a graduated payment plan with bigger payments in later years, when presumably the debtor is making more money; and/or be income sensitive, adjusting the monthly payment annually depending upon income.
Debt consolidation may not be the right choice for everyone, but when used correctly and responsibly, it can save you money and aggravation.
It is important to remember that consolidating debt is sometimes thought of as treating the symptom and not the disease. While allowing you to repay one loan, rather than many, your debts still remain and sometimes the actual repayment of them will cost you more than if you paid them off individually.
It also is important to note that debt consolidation itself should not affect your credit score by more than a few points. But consistently paying your monthly bills or consistently missing payment deadlines can greatly increase or decrease your score, respectively.
Whatever option you choose, it is essential that you stick with a payment schedule after you’ve consolidated your debts. That way your credit score will slowly improve and you’ll find yourself in less and less debt.