If you use a wallet full of credit cards, ring up debts on most of them, struggle every month to make even minimum payments – and have grown tired of the financial fatigue that causes – debt consolidation is one way to turn things around.
Debt consolidation is an escape route from financial quicksand. It organizes your debt in a manageable and affordable fashion, but requires serious commitment and often a major change in lifestyle.
The best way to consolidate debt is to choose a program that offers you an affordable monthly payment, while reducing your debt over time. The good news is that there are six options available for consolidating debt. The one you choose will depend on your current financial situation, but at least one of them should help you reduce or eliminate debt.
The first step is figuring out how much you owe and what sort of debt it is: secured or unsecured?
Secured debt means there is something of value, known as collateral, backing up the loan. In most cases, the collateral is a home, but it could be a car or property. Failure to make payments on secured debt can result in foreclosure (on a home or property) or repossession (on an automobile).
Unsecured debt – usually credit cards, but also personal loans or student loans – has no collateral behind it. There is nothing for the lender to take back, but if you default, they might try to get a court judgment against you and garnish your wages.
The downside of unsecured debt is a higher interest rate. A loan without collateral represents a bigger risk to lenders, so the interest rate is almost always higher.
6 Ways to Consolidate Unsecured Debt
- 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.
- Borrow from a peer-to-peer online lender.
- 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.
The choice you make for consolidation largely depends on your creditworthiness. Your FICO credit score is the major factor 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 for solving problems. 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 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 to 8%, sometimes lower, 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 3-5 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.
- Stops all 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.
- 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 that in most cases, there is a 3%-5% transfer fee and the 0% interest expires after 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
- You can 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 offer longer 0% intro periods.
- This simplifies the payment process, especially if you were making multiple payments on multiple cards.
- If you get a new credit card to consolidate debt, it might also offer travel or monetary perks.
Cons of Balance Transfers
- Balance transfer cards usually are offered to existing or potential customers with high credit scores, 670 or higher. If your credit score is suffering from late payments, this might not be an option for you.
- 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.
- 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 introductory period, the remaining balance will revert to the high interest levels that credit cards normally charge.
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. Personal loans give those with less than sterling credit scores a chance to convert high interest revolving debt into a fixed monthly payment at somewhat lower interest rates.
Pros of Personal Loans
- Personal loan interest is fixed. You’ll know exactly what you have to pay each month and have a payoff date. By contrast, credit card interest rates can vary based on your payment history.
- 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 should 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 Personal 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.
Peer-to-peer lending is another option for personal loans, sometimes a very good option. Peer-to-peer lending connects individuals loaning money directly to other individuals, with no middleman (i.e. banks or credit unions) involved. Borrowers go to the lending website, fill out an application and are assigned a risk category based on their financial profile. Investors then offer loan terms and interest rates that the borrower can accept or reject. If the offer is accepted, the money is transferred through the website. The entire process is handled online.
Pros of Peer-to-Peer Lending
- Because it’s individuals involved – not institutions – the qualifying standards vary and may swing in your favor if you have a low credit score.
- There is fierce competition between lenders so the interest rate you receive could be lower than you expected.
- You will repay the loan at a fixed monthly rate, usually over a 3-5 year period.
- Most lenders report your payments to credit bureaus so this could help improve your credit score.
- The entire procedure is conducted online, so you never have to leave your home to complete the process.
Cons of Peer-to-Peer Lending
- There could be a variety of fees applied to the loan that drive up the cost. Origination fees, for example could be as low as 1% or as high as 8%.
- Borrowers are assigned grades – high, low or medium risk – and have no input on how their grade is determined.
- Multiple investors may want to bid on the loan, making the process stretch for over a week as opposed to a one-day decision from your bank.
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 charge.
- Fixed monthly payments. HELOCs often charge interest-only on balances during the draw period, which usually is 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 on time.
- To qualify, you need to prove your creditworthiness. This includes proving you have enough income to pay back the money you borrow and 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, whichever 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.
How to Choose Best Debt Consolidation Option for You
Debt consolidation companies offer so much variety on the menu of choices for debt relief that you may find yourself overwhelmed just deciding which one is best. It might be easier to eliminate choices by answering these questions:
- Do I want to risk losing my house to pay off credit card debt? If not, you can eliminate home equity and HELOC loans.
- Do I want to risk my retirement savings to pay off credit card debt? If not, eliminate the 401k loan.
- Do I want to take out a loan to cover credit card bills I already struggled to cover? If not, eliminate the personal loans and peer-to-peer loans.
What you’re left with a debt management program through a credit counseling agency or a balance transfer card from a company that you don’t already owe money to on your current credit cards.
The balance transfer card, which typically gives you 12-18 months to pay off your balance at 0% interest, is the most efficient method … IF YOU QUALIFY! And that’s the real issue here. You need at least a good credit score to qualify and if you’re already missing credit card payments, you’re not going to have a good credit score.
Which leaves debt management via credit counseling. Debt management has some of the positive characteristics of other choices – low interest rate, affordable monthly payment, debt eliminated in 3-5 years – but it only works if you stay with the program. The penalty for missing payments is you could lose the concessions that made the program so attractive.
Bottom line? Choose the one that provides peace of mind, that leaves you feeling comfortable that you can afford the payments and is eliminating your debt.
Then change your spending habits so you don’t have to make this choice again!
About The Author
Bill “No Pay” Fay has lived a meager financial existence his entire life. He started writing/bragging about it seven years ago, helping birth Debt.org into existence as the site’s original “Frugal Man.” Prior to that, he spent more than 30 years covering college and professional sports, which are the fantasy worlds of finance. His work has been published by the Associated Press, New York Times, Washington Post, Chicago Tribune, Sports Illustrated and Sporting News, among others. His interest in sports has waned some, but his interest in never reaching for his wallet is as passionate as ever. Bill can be reached at firstname.lastname@example.org.
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