Taking out a debt consolidation loan is a good strategy for consumers trying to eliminate high interest credit card debt, but there is a hitch to this plan if you start with bad credit.
Bad credit usually means you have a low credit score and that is a risky combination for lenders.
People in the “bad credit” or “low credit score” category are called subprime borrowers and pay a high price for that. They may be denied a debt consolidation loan, and if they are approved for a loan, it’s going to include interest rates so high that it’s not much help. In fact, it could lead to even bigger problems if they can’t make the monthly payments.
But if you have bad credit, before you give up hope and file bankruptcy, consider these eight loan alternatives. One of them might salvage your credit and satisfy your creditors.
Just know that you don’t need a loan to consolidate your credit card debt.
1: Make and Follow a Budget
Careless spending is what leads to most bad credit ratings. Making a budget – and sticking to it – is the fastest way to solve that problem. There are plenty of budget apps that you can download to make this a simple and convenient process. Mint, You Need a Budget (YNAB), Goodbudget, Simple and PocketGuard are just a few of the apps that can track every dime coming in and every dime going out. They’ll even alert you when you’re overspending. And the information is always available right there in the palm of your hand.
2: Refinance Your Credit Card
Credit card refinancing, also known as a balance transfer card, is one alternative that would help you avoid subprime borrowing, but once again, there is a hitch: You gotta qualify! Your credit score – yes, there’s that term again – needs to be 670 or higher to get a balance transfer card. If you qualify, you pay 0% interest on your credit card balance for an introductory period (usually 12-18 months). That is exactly the break you need to pay down your debt. It’s rare that the same company whose car you’re using now will issue you a balance transfer card. That opens the door for competitors trying to entice you to switch to their card. If you’re in the neighborhood of that 670 credit score, shop around and find one.
3: Home Equity
Homeowners are often tempted to borrow against the equity in their property, but this is a risky strategy for those trying to pay off consumer debt. The interest rate on a home equity loan or line of credit (HELOC), can be lower than on a personal loan, but the potential downside is huge. The debt on your credit card is unsecured, meaning there is no collateral that a lender can seize and sell to settle what you owe. But if you borrow against the equity in your home and miss payments, your property can be taken in foreclosure. If you’re still determined to use your home equity, there are several options.
Home Equity Line of Credit
Commonly known by the acronym HELOC, home equity lines of credit essentially allow you to use the equity in your home like a credit card. After evaluating your creditworthiness and the amount of equity you have in your home, a lender will offer you a credit line secured by your house. Often you have a fixed amount of time – 10 years is typical – during which you can take draws on your credit line and only pay interest. After that, for up to 20 years, the credit line is closed and you pay back both principal and interest. Failing to adhere to the payment terms can result in foreclosure.
Home Equity Loan
Like a HELOC, you borrow against the equity in your home, but receive the money in a lump sum. If your home is worth $300,000 and your equity is $100,000, the lender could approve a home equity loan for a portion of the equity (usually 70%-80%). Again, your home is collateral and can be taken if you don’t make timely payments.
Cash Out Refinance
This option allows you to refinance your mortgage and take some of the equity in cash. For instance, if you owe $80,000 on a home worth $300,000, you have $240,000 in equity. You might consider refinancing the loan, especially if interest rates are lower than what you’re paying on your current mortgage, allowing you to take a portion of the $240,000 in cash and add it to the refinanced loan. You might take a new mortgage for $200,000, pay off the $80,000 you still owe, freeing $120,000 in cash that you can use as you wish.
4: Credit Counseling Programs
Discussing your situation with a nonprofit credit counseling agency is a very good idea before deciding to consolidate your credit card debt. A certified credit counselor will help you evaluate your indebtedness and recommend the best way to deal with it. The counselor will review what you owe, discuss how you might budget better and prioritize debts. Then the counselor might suggest a debt management plan, debt consolidation, debt settlement or, if no other solution seems possible, bankruptcy.
5: Debt Settlement
If you haven’t paid your credit card debt in a while, creditors might accept a lump-sum payment for less than what you owe and call it a day. That is what debt settlement amounts to: paying less than what you owe to settle a debt.
Debt settlement might work well if you can’t arrange a consolidation plan, but there are downsides. It’s a hard ding on your credit report for seven years, causing a drop in your credit score of 75-100 points. The alternative – not making at least minimum monthly payments – will also have a seriously negative impact on your credit score. A certified credit counselor should help you weigh the alternatives.
Think of bankruptcy as the point in a poker game when it becomes obvious that you don’t have the cards to win under any circumstances and you fold. Filing for bankruptcy puts your finances in the hands of a bankruptcy trustee, who can either eliminate your debts after you’ve liquidated your remaining eligible assets or create a reorganization plan that allows you repay part of what you owe.
Liquidation bankruptcy, known as Chapter 7, gives the bankruptcy trustee authority to sell your assets to cover as much debt as possible. The creditors must accept the proceeds as final payment. Some assets are protected under state exemptions. These could include your home, car, furniture, clothing and retirement accounts.
Chapter 13 is the other avenue for individuals entering bankruptcy. It allows the debtor to create a 3-5 year repayment plan that might not cover all that is owed but is, in the court’s assessment, sufficient to wipe away debt. Chapter 13 might be your only option if your income exceeds certain limits. It allows you to keep certain assets, including your home, if you own one.
Both chapters severely damage your credit rating and will limit your ability to get credit in the future. A bankruptcy judge will review your filing and decide if your situation merits a bankruptcy filing.
7: Consolidating Debt with a Debt Management Plan
Nonprofit credit counselors can help you create a debt management plan that will allow you to repay various creditors with a single, lower monthly payment at a reduced interest rate. Perhaps just as important: credit score isn’t a factor in qualifying for the program.
The counselors contact your creditors and get an agreement to pay off the debt in 3-5 years. You send a monthly payment to the credit counseling agency, which then distributes it to the card companies in an agreed upon amount. The nonprofit counseling agency also works with the creditors to reduce the interest rate to 8% or possibly lower.
Always deal with a nonprofit management company, especially those accredited by the National Federation for Credit Counseling (NFCC). Avoid companies that guarantee approval and ask for money before contacting your creditors. If you have questions about reputable firms, consider contacting your local state attorney office or the U.S. Bankruptcy Court for a list of referrals.
8: Family and Friends
Some borrowers who can’t make payments ask friends or relatives for a loan. This can be a great solution because you likely will get agreeable interest rates and repayment period. However, it also can cause great damage to a relationship if you fail to make on-time payments.
If borrowing from a family member or friend, treat it like a business deal, meaning write up a contract that details the repayment terms and consequences if payments are late or not made at all.
If you can’t get a loan that way, you can try peer-to-peer lending platforms that connect borrowers with potential lenders. Credit score usually is a factor in setting the interest rate, but online lenders can be more be more forgiving than banks. If your creditworthiness is degraded, this might be one of the few options to borrow money to repay debt.
About The Author
Max Fay has been writing about personal finance for Debt.org for the past five years. His expertise is in student loans, credit cards and mortgages. Max inherited a genetic predisposition to being tight with his money and free with financial advice. He was published in every major newspaper in Florida while working his way through Florida State University. He can be reached at [email protected].
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- Lewis, H. (2018, March 19) Cash-Out Refinance: When Is It a Good Option? Retrieved from: https://www.bankrate.com/finance/financial-literacy/when-is-cash-out-refinancing-a-good-option--1.aspx