Debt consolidation allows borrowers to roll multiple old debts into a single new one. Ideally, that new debt has a lower interest rate that makes payments more manageable or lets borrowers pay off the total more quickly.
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Many people try debt consolidation, but not all emerge better off.
Some borrowers wind up in worse shape, either because they run up their credit cards again or because their debt remains overwhelming despite the better repayment terms. Others succeed because debt consolidation is part of a bigger plan to gain control over their finances.
So the first step in debt consolidation is simply to consider whether it will actually work for you.
There are many ways to consolidate your credit card and other debt, such as with a 0% APR credit card, a home equity loan or a personal loan. The option that best suits you will depend on your credit, available cash and other aspects of your financial situation, as well as your personality.
In this article
Should you consolidate your debt?
Ask yourself a few questions to see if debt consolidation is really what you need:
Am I serious about paying off my debt? Consolidation works best as part of a larger plan to become debt-free; it shouldn’t just be a way to buy some breathing room.
If you are consolidating debt just to get a lower interest rate without really knowing how you’re going to pay the debt off, then you are simply moving the problem around instead of facing it. You’ll have to change the behavior that got you into debt in the first place.
Is my debt load manageable? Take a close look at your income and expenses and ask:
- Can I realistically pay off my unsecured debts (credit cards, personal loans and medical bills) within five years?
- Is my total unsecured debt less than half my gross income?
If you answered “Yes” to either of these questions, skip down to read about your debt consolidation options.
When your debt is insurmountable
If you owe more than half your gross income or if you can’t expect to pay off the debt within five years, then you should seek a debt management plan through a credit counselor or consider filing for bankruptcy.
Credit counselors can help with financial basics like creating a budget and managing cash flow, but they can also create a debt management plan for you.
“People usually wait too long to reach out to a credit counselor, because it’s human nature to try to do it on your own,” says Gail Pridgeon, senior credit counselor at Baltimore-based Guidewell Financial Solutions.
A debt management plan typically sets you up to pay off your debt within five years. You pay the counseling agency, which pays your bills and gets your interest rate reduced or fees waived. You’ll usually have to give up your credit cards. Damage to your credit score is generally minimal.
Counseling agencies are different from debt settlement companies. Those companies ask you to divert your payments into an account from which they make lump-sum settlements with creditors who haven’t seen a dime in months. Damage to your credit is severe, and personal finance experts and regulators warn against this strategy in the strongest terms.
You should also see a bankruptcy attorney. Bankruptcy? Yes.
“If your debt problem is bad enough that you require a debt management plan, then you should also consider making an appointment with a bankruptcy attorney,” says NerdWallet personal finance columnist Liz Weston. “You don’t want to keep struggling with debt that ultimately may not be payable.”
Filing for bankruptcy lets you erase your debt and keep some of your possessions, but it typically stays on your credit report for 10 years and affects your ability to get loans or new forms of credit. (However, its impact fades over time if you handle new credit responsibly.)
Initial consultations for both bankruptcy attorneys and credit counselors are usually free.
Get ready to tackle your debts
If you think you can successfully manage your debt, then ask yourself a few more questions.
- Can I pay off the debt in six months to a year? If so, it may not be worth the time and effort to consolidate. You might end up paying a few extra bucks of interest, but probably not much more.
- Can I get a lower interest rate on my current debt just by asking? You can always try calling up your credit card issuers and requesting lower interest rates. If you’re a longtime customer and have paid your bills on time, you stand a chance.
- Am I ready to change the spending patterns that built up the debt in first place?
You’ll need to think about which options are open to you, given your credit history and assets. A long credit history and good credit scores are necessary to qualify for 0% balance transfer credit cards and the best rates on personal loans. You still may be able to find a personal loan even if your credit history isn’t long or good, but you’ll likely pay higher interest.
You also can borrow against the equity in your home, a retirement account or a life insurance policy.
Your debt consolidation options
This type of credit card charges no interest for a promotional period, often 12 to 18 months, and allows you to transfer all your other credit card balances over to it, usually for a small fee. This method works best if you have a plan to pay off your debt within the 0% promotional period.
Pros: Allows you to manage only one credit card payment at no interest, instead of multiple payments at high interest. Some cards even accept balances from certain types of non-credit-card debt.
Cons: Generally requires a good credit score to qualify.
If debt can’t be repaid during the promotional period, you’ll need to find another balance-transfer offer or face higher rates.
“Sure, you can move debt around from one balance transfer offer to the next, but each time you do this you generally face a 3% fee, which quickly adds up,” says NerdWallet credit card expert Sean McQuay. “Eventually, the daisy chain of balance transfer offers will end and your debt will be due.”
Also, moving multiple debts onto a single card may push your credit utilization ratio high enough to damage your credit score.
If you are a homeowner, you can take out a line of credit on the equity in your home. Interest rates are typically variable and low. You can use that money to pay off your debts.
A HELOC typically requires interest-only payments during the first 10 years. That means you’ll need to pay more than the minimum payment due to make a dent in your overall debt.
“When you borrow from a HELOC, you may be spreading the debt out over a longer period, which means you end up paying more in interest,” Weston warns.
Pros: Lower interest rate than an unsecured loan.
Cons: This is a secured loan, which means that your house is on the line if you don’t keep up with payments.
A personal loan taken from your local bank or credit union or an online lender may give you a lower interest rate on your debt, or help you pay off your debt in a shorter period of time.
Depending on your credit profile, you may get a lower interest rate at an online lender than at a bank. You can shop around at different online lenders without affecting your credit score — most will give you a rate without a “hard inquiry” on your credit, unlike banks and credit unions — and pick the one that gives you the lowest rate. The lowest rates go to those with the best credit; rates top out at 36%.
Credit unions are a good option for those with dinged credit, because they generally work with borrowers to help them pay off debt and offer lower interest rates than a bank. There are also some online lenders who focus on debt consolidation, and others that cater to those with bad credit by looking at nontraditional factors such as profession and education.
Most online lenders do not have a prepayment fee, so you could pay your loan off early without penalty.
Pros: Fixed installment payments may be easier to work into your budget.
A personal loan may help your credit score by moving credit-card debt over to the installment loan column. The way credit scores are figured, borrowers who use all or most of the available credit on their cards get hit with a significant penalty.
Cons: A debt consolidation loan is still debt. You cannot borrow your way to financial freedom; lower payments may help, but only if you use the money as intended and follow through as part of a larger plan.
If you have an employer-sponsored retirement account, it’s generally not a great idea to take a loan from it, since the goal of the account is to set aside money for when you retire. If you really need to pay off debt, however, this may be an option for you.
Pros: You are borrowing money from yourself, instead of someone else. The debt disappears from your credit reports as well, because 401(k) loans aren’t reported to the credit bureaus.
Cons: If you can’t repay the loan, you’ll owe a hefty penalty plus taxes on the unpaid balance — you may end up losing one-quarter to one-half of your loan balance to taxes and penalties, Weston says.
Most retirement plans typically require you to pay the loan back within five years. In the event that you lose your job, you have just 60 days to repay the loan. You may be left struggling with more debt and no immediate income to pay it off.
Longer term, you’re borrowing money that should be left alone to grow, leaving you less prepared for retirement.
As with a 401(k) loan, it’s not the best idea to borrow from a life insurance policy to pay off debt. Again, you may have to pay some interest for taking out a loan against your policy, and if you borrow more than the policy amount, you could lose your life insurance. Consider the tradeoffs carefully before you try this option.
Pros: You don’t have a deadline to pay back the loan, and you can also choose not to pay it back.
Cons: You can borrow only against the cash value of your policy, which can be low during the policy’s initial years. Any unpaid interest is added to the loan balance, so you essentially owe interest on the interest. If you don’t pay it back, the amount you borrowed will be deducted from the proceeds paid out to your heirs. If the loan grows large enough, it could cause your policy to collapse — meaning nothing would be paid to your heirs, and there could even be a tax bill on the difference between the loan balance and the policy’s face value.
CASH ADVANCE/PAYDAY/NO-CREDIT-CHECK INSTALLMENT LOANS
A payday loan, also known as a cash advance loan, will give you money fast without a credit check, but such loans are a bad idea. They come with interest rates as high as 1,000%, which doesn’t make sense if you are trying to pay off debt, and lenders also require the loan to be paid back on the borrower’s next payday.
Some loans that are available for longer terms are marketed as no-credit-check installment loans. But they’re as bad as payday loans, because they also come with high interest rates, often more than 200%.
Cons: If you have so much debt that these rates seems a viable option for paying it off, you probably belong in bankruptcy court.
Amrita Jayakumar is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org. Twitter: @ajbombay
This post was updated. It was originally published Feb. 2, 2016.
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