If you’re feeling buried by what you owe, debt consolidation could provide you with both immediate relief and a quicker path to debt-free.
Debt consolidation is the process of taking out a new loan and using that money to pay off your existing debt. It can help in a number of ways:
- A lower interest rate could save you money and allow you to pay your debt off sooner
- A longer repayment period could reduce your monthly payment
- A single loan and single payment could be easier to manage than multiple loans
But debt consolidation isn’t without its potential pitfalls. First and foremost: Consolidating your debt doesn’t address the behavior that got you into trouble in the first place. If you’re in debt because of overspending, consolidating may actually exacerbate your problems by opening up new lines of credit that you can use to spend even more.
And every debt consolidation option has its own set of pros and cons that can make it a good fit or a bad one, depending on your circumstances.
This post explains all of those pros and cons. It should help you decide if debt consolidation is the right move for you, and, if so, which option is best.
Six Consolidation Options to Choose From
1. Credit card balance transfers
A credit card balance transfer is often the cheapest debt consolidation option, especially if you have excellent credit.
With this kind of transfer, you open a new credit card and transfer the balance on your existing card(s) to it. There is occasionally a small fee for the transfer, but if you have excellent credit, you can often complete the transfer for free and take advantage of 0 percent interest offers for anywhere from 12-21 months. None of the other debt consolidation options can match that interest rate.
There are some downsides, though:
- You need a credit score of 700 or above to qualify for the best interest rate promotional periods.
- Many cards charge fees of 3 to 5 percent on the amount that you transfer, which can eat into your savings.
- Unless you cancel your old cards, you’re opening up additional borrowing capacity that can lead to even more credit card debt. Let’s put that another way: Now that you’ve paid off your old cards, you might be tempted to start using them again. (Don’t!)
- If you don’t pay the loan back completely during the promotional period, your interest rate can subsequently soar. Some balance transfer cards also charge deferred interest, which can further increase the cost if you don’t pay your debt off in time.
- This just isn’t for people with high levels of debt. Credit limits are relatively low compared with those tied to other debt consolidation options.
Given all of that, a credit card balance transfer is best for someone with excellent credit, relatively small amounts of debt and strong budgeting habits that will prevent them from adding to their burden by getting even further into debt.
2. Home equity/HELOCs
Home equity loans and home equity lines of credit (HELOCs) allow you to tap into the equity you’ve built in your home for any number of reasons, including to pay off some or all of your other debt.
The biggest benefit of this approach is that interest rates are still near all-time lows, giving you the opportunity to significantly reduce the cost of your debt. You may even be able to deduct your interest payments for tax purposes.
But again, there are perils. Here are some of the downsides to using a HELOC/home equity loan for debt consolidation:
- Upfront processing fees. You need to watch out for upfront costs, which can eat into or even completely negate the impact of lowering your interest rate. You can run the numbers yourself here.
- Long loan terms. You also need to be careful about extending your loan term. You might be able to reduce your monthly payment that way, but if you extend it too far, you could end up paying more interest overall. Home equity loans typically have terms of five to 15 years, while home equity lines of credit typically have 10-to-20-year repayment periods.
- You could lose your home. Finally, you need to understand that these loans are secured by your home. Fail to make timely payments, and you put that home in jeopardy. This is why, though the interest rates are lower than with most other debt consolidation options, there’s also added risk.
Home equity loans and HELOCs are generally best for people who have built up significant equity in their home, can get a loan with minimal upfront costs, and either don’t have excellent credit or need to consolidate more debt than is possible with a simple balance transfer.
3. Personal loans
Personal loans are unsecured loans, typically with terms of two to seven years. Interest rates typically range from 5 to 36 percent, depending on your credit score and the amount you borrow.
The advantage of a personal loan over a credit card balance transfer is that it’s easier to qualify. While you typically need a credit score of 700 for a balance transfer, you can get a personal loan with a credit score as low as 580. You can also qualify for larger loan amounts than the typical balance transfer.
And the big advantage over a home equity loan or line of credit is that the loan is not secured by your house. This means you can’t lose your home if you have trouble paying back the debt. You can also apply for and obtain a personal loan very quickly, often at a lower cost than a home equity loan or line of credit.
The biggest disadvantage is that your interest rate will likely be higher than either of those options. And if your credit score is low, you may not find a better interest rate than what you already have.
Generally, a personal loan is best for someone with a credit score between 600 and 700 who either doesn’t have home equity or doesn’t want to borrow against his or her home.
4. Banks and credit unions
In addition to shopping for a personal loan online, you can contact your local banks or credit unions to see what types of loan options offer.
This is more time-consuming than applying online, and it can be harder to compare a variety of loan options. But it may lead to a better interest rate, especially if you already have a good relationship with a local bank.
One strategy you might try: Get quotes online using a service like LendingTree’s, then take those quotes to the bank or credit union and give it a chance to do better.
This strategy is best for anyone who already has a good and lengthy banking relationship, particularly with a credit union. But if you’re going the personal-loan route, it’s worth looking into in any case.
You can find credit unions in your area here.
5. Borrowing from family or friends
If you’re lucky enough to have family members or friends who have ample assets and are happy to help, this could be the easiest and cheapest debt consolidation option.
With no credit check, no upfront fees and relatively lenient interest rate policies, this might seem like the best of all worlds.
Even so, there are some things to watch out for.
First: A loan fundamentally changes your relationship with the person from whom you borrow. No matter what terms you’re on now or how much you love and trust this person, borrowing money introduces the potential for the relationship to sour in a hurry.
Consequently, if you do want to go this route, you need to do it the right way.
Eric Rosenberg, the chief executive of Money Mola, an app that lets friends and family track loans and calculate interest, suggests creating a contract that outlines each party’s responsibilities, how much money will be borrowed, the timeline for repayment, the payment frequency and the interest rate. He also suggests using a spreadsheet to keep track of the payments made and the balance due.
And Neal Frankle, a certified financial planner and the founder of Credit Pilgrim, suggests adhering to the current guidelines for Applicable Federal Rate (AFR), which as of this writing require a minimum interest of 1.27 to 2.5 percent, depending on the length of the loan. Otherwise, you may have to explain yourself to the IRS and the person lending you the money could be charged imputed interest and have to pay additional taxes.
If you have a family member or a friend who is both willing and able to lend you money, and if your credit isn’t strong enough to qualify favorably for one of the other options above, this could be a quick and inexpensive way to consolidate your debt.
6. Retirement accounts
Employer retirement plans like 401(k)s and 403(b)s often have provisions that allow you to borrow from the accumulated sums, with repayment of the loan going right back into your account.
And while you can’t borrow from an IRA, you can withdraw up to the amount you’ve contributed to a Roth IRA at any time without penalties or taxes, and you can withdraw money from a traditional IRA early if you’re willing to pay both taxes and a 10 percent penalty (with a few exceptions).
The biggest advantage of taking the money out of a retirement account is that there is no credit check. You can get the money quickly, no matter what your credit history looks like. And with a 401(k) or 403(b), you are also paying interest back to yourself rather than giving it to a lender.
Still, while there are situations in which borrowing from an employer plan can make sense, most financial experts agree that this should be considered a last-resort debt consolidation option.
One reason is simply this: Your current debt is already hindering your ability to save for the future, while taking money out of these accounts will only exacerbate the problem. Another is that tapping a retirement account now may increase the odds that it will happen again.
“I’d stay away from a 401(k) loan like the plague,” says Ryan McPherson. McPherson, based in Atlanta, Ga., is a certified financial planner and fee-only financial planner and the founder of Intelligent Worth. “With no underwriting process, and because you’re not securing it with your house, you’re more likely to do it again in the future.”
If you are in dire straits and cannot use any of the other strategies above, then borrowing or withdrawing from a retirement account may be the only consolidation option you have. Otherwise, you are likely to be better off going another route.
Things to consider before picking a debt consolidation strategy
With all these debt consolidation options at your disposal, how do you choose the right one for your situation? To be sure, it’s a key decision: The right option will make it easier for you to pay your obligations, and less likely that you’ll fall back into debt.
Here are the biggest variables you should consider before making the choice:
- Have you fixed the cause of the debt? Until you’ve addressed the root cause of your debt, how can any consolidation option help you get and stay out of debt?
- How much debt do you have? Smaller debts can be handled through any of these options. Larger debts might rule out balance transfers or borrowing from relatives or friends.
- What are your interest rates? You need to be able to compare your current interest rates with the interest rates you’re offered by the options above, if you want to know whether you’re getting a good deal.
- What is your credit score? Your score determines eligibility for various debt consolidation options, as well as the quality of the offers you’ll receive. You can check your credit score here.
- When do you want to be debt-free? Shorter repayment periods will cost less but require a higher monthly payment. Longer repayment periods will cost more but with a lower monthly payment. With this in mind, you need to decide both what you want and what you can afford.
- Do you have home equity? This determines whether a home equity loan or line of credit is an option. If it is, you should decide if you’re comfortable putting your home on the line.
- Do you have savings? Could you use some of your savings, outside of retirement accounts, to pay off some or all of your debt? That may allow you to avoid debt consolidation altogether and save yourself some money.
So … what’s the best consolidation strategy?
Unfortunately, there is no single answer to this tough question. The right answer for you depends the specifics of the situation.
Your job is to know what you currently owe and understand the pros and cons of each option we’ve outlined above. In this fashion, you can make an informed choice, one that’ll get you out of debt now and keep you out of it forever.
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