How Should I Consolidate My Debt?
There are a number of ways to consolidate debt, & the best method depends on your financial situation. Learn pros & cons of common forms of consolidation.
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If you use a wallet full of credit cards, ring up debts on most of them and struggle every month to make even minimum payments, it might be time to consider consolidating what you owe into a single monthly payment.
Debt consolidation is sometimes the only way to escape financial quicksand without facing bankruptcy, but it requires serious commitment and often a major change in lifestyle.
If you decide that consolidating makes sense, you’ll need a strategy. The first step in any plan is figuring out how much you owe and what sort of debt it is. Is it all credit card debt or do you also owe money on a house, car or personal loan?
If it’s a mixture, break down your debt into secured and unsecured categories. That’s important because secured debt is attached to something you own. If you own a house, failure to make payments can lead to foreclosure. If you owe money on a car and don’t pay, the lender will repossess the vehicle.
Unsecured debt -- what you owe on credit cards, personal loans and student loans – doesn’t use collateral so there is nothing for the lender to take back. They might, however, sue and try to garnish your wages if you default. The downside of unsecured debt is the interest rate. A loan without collateral represents a bigger risk to lenders than one with collateral, so the interest rate is almost always higher.
There are five main ways to consolidate unsecured debt, and only one uses a collateralized loan.
- Arrange a debt management payment plan through a nonprofit credit counseling agency
- Transfer unpaid balances to a single credit card with a lower interest rate
- Take out a personal loan
- Use a home equity loan or a home equity line of credit (HELOC) to pay off your creditors, effectively transferring your balance to a lower interest loan, but one that uses your house as collateral.
- Borrow from a retirement savings plan like a 401(k) or a Roth IRA.
Your approach will hinge on your creditworthiness. Your FICO score, the number credit rating agencies assign to your finances, is important in determining if you can get a loan or a credit line large enough to consolidate your debts at an interest rate that makes sense.
Every strategy requires that you have the income to cover the monthly payment and all your other expenses. If you miss a payment, the deal could easily unravel. If you use a home equity loan or HELOC, you might even face foreclosure.
Nonprofit Credit Counseling Agency
Nonprofit credit counseling agencies are businesses that analyze your debt situation and advise you on the best course of action. If that involves consolidating your debt, the counseling agency will confer with your creditors and create a debt management plan. The credit counselor works with card companies to obtain lower interest rates and fees in exchange for a guaranteed monthly payment. The credit counseling agency collects the monthly payment from you and distributes it to the card companies at the agreed upon rate. There is little and sometimes no charge for their services.
Pros of Credit Counseling Agencies
- The reduction in interest rate all but assures a reduction in your monthly payment.
- This is not a loan. You can pay it off or choose to withdraw from the program, though you will lose concessions on interest rates and late payments if you withdraw.
- A debt management plan typically takes three to five years to complete, after which your credit card debts are settled. Paying off your individual debts like personal or student loans, can take longer and requires a self-managed plan.
- No more calls from debt collection agencies.
- Your credit counselor can provide useful suggestions for how to avoid falling into debt again after you complete the management plan.
Cons of Credit Counseling Agencies
- There is a monthly fee charged for managing your plan. That fee is included in your monthly payment.
- During the payment plan, it is almost always required to close all credit card accounts in the program. Occasionally, card companies allow you to keep one, but only for emergencies.
- If you miss a payment, the lenders can cancel the concessions on interest rate/late payment fees made when you started the program.
- Your credit score will drop a few points the first six months of the debt management plan, but as long as you consistently make on-time payments, it will recover and even improve over time.
Credit Card Balance Transfers
Transferring multiple credit card balances to a single card with a lower interest rate is really do-it-yourself consolidation. Credit card issuers offer balance transfers to build new business. They offer existing or new customers a no-interest-payment period on transferred balances. The hitch is the 0% interest lasts for an introductory period, usually 12-18 months. That means you need to pay off your balances before the grace period expires or face returning to high-interest debt.
Pros of Balance Transfers
- Gives you the chance to pay off your consolidated balances at no interest during the introductory period, saving on interest and allowing you to focus on paying off principal.
- Balance transfer cards come with a variety of options, including some that don’t charge transfer fees and others that offer longer 0% intro periods.
- If you were making multiple payments on multiple cards, consolidating through a balance transfer means paying on just one. That should simplify the bill-paying process.
- If you get a new credit card to consolidate debt, it might also offer travel or monetary perks.
Cons of Balance Transfers
- If you are using a balance transfer card to pay off multiple credit cards, you must be approved for a high-enough credit limit to handle all the debt.
- Balance transfer cards typically charge a fee of 3% to 5% on the amount of debt shifted. That adds to what you owe.
- Balance transfer cards usually are offered to existing or potential customers with high credit scores. If your credit score is suffering from late payments, this might not be an option for you.
- Card companies don’t allow 0% interest on balances transfers between cards they issue themselves.
- If you fail to pay off what you owe during the offer period, the remaining balance will revert the normally high interest levels that credit cards charge. Using a balance transfer to pay off debt requires a commitment to paying off the debt before interest payments resume.
Personal loans used to consolidate credit card debt are another way of turning multiple balances into a single monthly payment. These loans, which don’t require collateral, are available through banks, credit unions and a variety of online lenders. They give those with less than sterling credit scores a chance to convert revolving debt into a fixed monthly payment at somewhat lower interest rates.
Pros of Loans
- Credit card interest rates are variable and can increase if your credit score declines. Personal loan interest is fixed. You’ll know exactly what you have to pay each month and have a payoff date.
- Like credit card debt, personal loan debt is unsecured, so a creditor can’t seize property if you fail to make timely payments.
- If you have good credit, you might be able to find a much lower interest rate than you’re paying on your credit cards.
- You can prequalify for a loan without committing to it, allowing you to shop for better deals from other lenders before deciding. Prequalifying doesn’t impact your credit rating.
- In most cases you can pay off the loan before the payoff date without fees or penalties.
Cons of Loans
- Personal loans are most useful for those who have high credit scores before applying. Those with lower scores, typically less than 600, can expect to pay high interest rates, which can negate the value of consolidating debt with a personal loan. If your credit rating is very low, you might not qualify for a loan at all.
- Lenders often charge origination fees for personal loans, which can use up money that should go to pay down debt.
- If you use a personal loan to pay off your credit cards, you need to refrain from adding fresh debt to the cards. If you continue to use your credit lines to finance purchases, your debt situation will worsen, which could lead to default.
Home Equity Loans and Lines of Credit
Using a home equity loan or a HELOC to consolidate credit card debt can substantially lower your monthly interest payments, but it’s a risky strategy. Home loans use your dwelling as collateral. If you can’t afford to repay the loan, the lender can foreclose on your property, possibly costing you your home and whatever equity you have in it.
Home equity loans and HELOCs allow you to borrow against your monetary stake in your home, however lenders will only allow you to borrow a portion of your equity. What you borrow can either be a lump sum (home equity loan) or a credit line (HELOC) that you can use as you wish for a fixed number of years. To consolidate, you can use the equity loan proceeds to pay off credit cards.
Pros of Borrowing Against Your Home
- Much lower monthly interest rate than what credit card issuers typically charge.
- Fixed monthly payments. HELOCs often charge interest-only on balances during the draw period, which is often about 10 years. There is no prepayment penalty in most cases.
- If you have paid off a large portion of your primary mortgage or own a home that has substantially appreciated in value, you could qualify for an equity loan or HELOC that is more than enough to pay off your credit card balances.
Cons of Borrowing Against Your Home
- You could face foreclosure if you fail to make payments of time.
- In order to qualify, you need to prove your creditworthiness. This includes proving you have enough income to pay back the money you borrow and having an acceptable credit score.
- Your credit score will help determine how much you can borrow, and the interest rate the lender will offer.
- Equity loans and HELOCs use underwriting like first mortgages, meaning you will need to pay an application fee, have an appraisal done on your property and cover other application costs. Occasionally lenders will waive these fees. You should ask about them before you apply.
If you have a 401(k) retirement plan through you job or past employment, you might be able to borrow from your balance to pay off your credit card debts. Not all employer plans allow this. If yours does, you can borrow $50,000 or half your vested account balance, which ever is less. You have five years to repay the money. Most plans charge interest on the advance, which is usually the prime rate plus 1%.
You could also withdraw, but not borrow, money from an IRA or Roth IRA to pay off balances, but there are significant disadvantages. If you are younger than 59 ½, you will pay a penalty on IRA withdrawals. You can withdraw from the portion of you Roth IRA that you deposited into the account. In both cases, you face impairing your retirement savings.
Pros of Borrowing from Retirement
- You can pay off high-interest credit card debt with a 401(k) loan. Your future contributions to the account, which are payroll deductions, will pay down the loan.
- The interest on the loan is paid to you. That means you won’t lose the money; it will revert to your account.
- You don’t pay loan origination fees since you are borrowing your own money.
Cons of Borrowing from Retirement
- The amount you borrow from the plan won’t benefit from investment gains.
- If you leave your job, you will have a limited time to pay back the money or face an early withdrawal penalty if you left your job before you turned 55. The 2017 federal Tax Cuts and Jobs Act loosened the repayment schedule. Prior to the change, you had 60 days after leaving your job to pay back the loan. The new tax law gives you until your next tax return filing deadline to do that.
- You may not want to move to a better job with a different employer if you are worried about paying a penalty or returning the amount borrowed to the account.
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