Debt consolidation is the process of combining multiple debts under a single loan or line of credit. Debt consolidation may help you get a lower interest rate, pay your debts off faster, and make your debts easier to manage. There are several methods of debt consolidation. Some methods are only available to people with good credit, and some involve serious risks.
Be careful, though. While consolidation can help you protect yourself and get out of major credit problems, you may risk losing valuable assets and you could damage your credit if you don’t manage your debt consolidation effectively. Debt consolidation can be a useful tool, but you’ll need to assess the risks, benefits, and requirements of each method carefully before making any commitments.
How Debt Consolidation Works
When you consolidate debt, you combine more than one debt under a single loan, ideally at a lower interest rate. Most forms of debt can be consolidated, including credit card debt, student loan debt, medical debt, payday loans, and personal loans.
Debt consolidation can be an effective strategy, especially if you have high-interest debt and your credit is good enough to qualify you for lower-interest loans or balance transfer credit cards. You will need to have a plan to pay off the consolidated debt and you will need to stick to that plan. If you can’t make the payments, your credit and your finances could be affected.
Consolidation can help you manage your debts, but it will not change the habits that create debt problems in the first place. Debt consolidation is most effective if you avoid or minimize new debt (including credit card spending) until your consolidated debt is paid off or reduced to a manageable level.
Debt Consolidation Strategies
There are several ways to consolidate debt. Each has its own requirements, advantages, and risks.
Getting a Debt Consolidation Loan
A debt consolidation loan is a new loan at a lower interest rate that you use to pay off your higher-interest debts. You can get a debt consolidation loan from a bank, a credit union, or an online lender.
This strategy is most effective if you are paying off high-interest accounts such as credit card debt and your credit is good enough to qualify you for a low-interest loan. If your credit is not in good shape, you may not be able to get a new loan at a good enough rate to make consolidation worthwhile. You will need to shop around for the best rate and terms you can get, and you’ll need to read the fine print on the loan agreement and be aware of any potential issues.
Using a Balance Transfer on Credit Cards
A balance transfer credit card allows you to transfer balances from other cards onto your new card. Most balance transfer cards offer a zero-interest or low-interest promotional period that lets you focus on paying off the debt, not just the interest.
There are several factors you should consider before using a balance transfer card to consolidate debt.
- Be sure that the balances you intend to transfer don’t exceed the credit limit of the balance transfer card.
- Most balance transfer cards charge a fee for each balance you transfer. Be sure the fees don’t cost more than you’ll save on interest.
- If you are using the new card for purchases as well, check the interest rate for purchases. They may not be included in the promotional rate. You may wish to avoid making new purchases on your balance transfer card until your old debts are paid off.
- If you’re not sure if you can pay off the balances before the promotion expires, check the interest rate that you’ll pay after that time. If it’s very high, consider that in your calculations. If you fail to pay off the balance during the promotional period, you could find yourself facing even higher rates than you had before.
- You may need good or excellent credit to get approved for a balance transfer card with competitive interest rates.
If you choose to consolidate debt with a balance transfer credit card, be sure to make every payment on time. Some cards will cancel the promotional period if you make a late payment or miss a payment.
Debt Management Plans
Debt management plans are offered by nonprofit credit counseling groups. If you are having serious problems managing credit card debt and your credit is not good enough to qualify for a debt consolidation loan or a balance transfer card, this may be an option to consider.
Most debt management plans cover unsecured debt, like credit card debt and personal loans. They usually do not include student loans or secured debts like mortgages or car loans.
If you qualify for a debt management program, your counselor will try to negotiate better terms with your creditors. You will make a single monthly payment to the counseling agency, which will pay your creditors. You may be required to close credit cards, which could affect your credit, and you may not be able to apply for new credit until your old debts are paid off.
Debt Settlement
Debt settlement is a process where you negotiate lower payments (or a lower overall payout) with your lenders or creditors, either on your own or with the help of a debt settlement company. A debt settlement company will usually charge you a percentage of the savings they negotiate.
A settlement company may require you to stop making payments while they negotiate. This could harm your credit if debts become delinquent or go to collection during the negotiation process. Debts that are paid at a negotiated discount rate may be noted as “settled” on your credit report, which can also harm your credit.
The IRS also requires you to report forgiven debt as income on your taxes unless you have certain exclusions or exemptions.
Debt settlement can reduce your debt and may be able to prevent bankruptcy, but it also poses serious risks to your credit. It’s usually something to consider when you are already having serious problems paying your debts, particularly if you have already missed payments or have some accounts in collection.
Tap Your Home Equity or Retirement Funds
You can use your equity in your home or your retirement account to consolidate debt, but these methods involve significant risks.
If you have equity in your house, you may be able to get a home equity line of credit, a home equity loan, or a cash-out refinance and use the proceeds to pay off your higher-interest debts. Because these loans are secured, the interest rates are low and it’s relatively easy to get approved. These loans involve risks: If you cannot pay the loan, you could lose your home.
Loans based on home equity may take some time to negotiate and may involve appraisal fees and closing costs. Consider all costs before using a loan based on home equity to consolidate debt.
If you have a 401(k), you can borrow up to 50% or $50,000 from it. There’s no credit check and the interest is low. You will not earn interest on the amount until it’s paid back. If you fail to pay the amount in full, you will pay a withdrawal penalty and the amount you withdrew will have to be reported as income.
Debt Consolidation Can Affect Your Credit
Applying for a consolidation loan or balance transfer card will leave hard inquiries on your credit report. If you’re shopping for a debt consolidation loan, be sure to keep your inquiries within a two-week period. Credit reporting companies will recognize that you are shopping for a loan and will place only one hard inquiry on your credit report.
These new accounts may also reduce the average length of your credit history. Consider keeping your old accounts open, even if you don’t intend to use them. A longer credit history can be a positive influence on your credit.
Moving several balances onto a balance transfer card could affect your credit utilization. Keeping the old accounts open will mitigate that impact, but even a single account with a large balance could have an impact on your credit.
Signing up for a debt management plan does not affect your credit, but plans may require you to take steps like closing cards, which could affect your credit.
Debt settlement can have a serious impact on your credit. Debt paid at a negotiated discount is noted as settled on your credit report and that note will remain there for seven years. If you incur late payments or accounts are sent to collections during the negotiation process, your credit could also be affected.
When Is Debt Consolidation the Right Choice?
These are some signs that debt consolidation is the right choice for you.
- You have a good credit score. A good credit score will qualify you for balance transfer cards with good terms and will enable you to negotiate good terms on a debt consolidation loan.
- You have high-interest debt. Credit card debt, which carries very high interest, is a good choice for consolidation because you’re likely to be able to negotiate another loan at a substantially lower rate.
- You have a repayment plan. Debt consolidation works best when you have a clear plan for meeting your new payments and you have the will and the ability to follow that plan. Remember that debt consolidation won’t work if you keep taking on new debt.
- You’re overwhelmed with payments. If you have so many payments that you’re having trouble keeping track of them, you could easily miss payments and damage your credit. Consolidating those payments into a single monthly bill may help you keep your finances orderly.
- You have federal student loans and you consolidate with a federal loan. Federal student loans come with several forms of forgiveness and delayed payment. The government also offers federal consolidation loans with approved lenders that maintain those perks while consolidating the loans accrued over your years in school.
When Is Debt Consolidation the Wrong Choice?
There are also some indications that debt consolidation may not work for you.
- Your debt is small. If you can pay off your debt in a relatively short time and consolidation would only save you a small amount, you might be better off focusing on paying your existing debt.
- You have federal student loans and you consolidate with a private loan. Federal student loans carry many benefits, including forgiveness and delayed payment options. Consolidating with a private loan often means giving up those features, and typically with less than favorable terms compared to federal loans.
- You can’t or won’t change your spending habits. Debt consolidation doesn’t reduce your debts. It just repackages them. If you carry on with the same spending habits that got you into debt in the first place, you probably won’t see much benefit and the effort and cost of consolidation may be wasted.
- You’re overwhelmed by debt and have no hope of paying it off even if it’s consolidated.
Some Alternatives to Debt Consolidation
Debt consolidation can be a useful debt management tool, but it’s not the only debt management tool. If consolidation doesn’t seem right for you, look at some other options.
- Better financial management can solve many debt issues. Budgeting your money carefully and freeing up money to pay debt may not sound dramatic, but it can be very effective.
- The debt avalanche method focuses on high-interest debt. Examine your accounts and select the one with the highest interest rate. Make only minimum payments on your other accounts and focus on paying off that one debt. When it’s done, move on to the debt with the next-highest rate.
- The snowball method targets your smallest debt first. Again, make only minimum payments on your other accounts and focus all your available cash on paying off that smallest account. When you’re done, move on to the next smallest one. Paying off an account completely can help motivate you to keep going and go after the next target.
- If medical bills, job loss, a natural disaster or similar problems have contributed to your debt problem, you may qualify for a credit card hardship program. Some credit card issuers will temporarily reduce interest and fees for people who have fallen into debt because of circumstances they could not control. Call your card issuer and ask if they have such a program.
- If your debt is so large that you have no realistic chance of paying it back, you may need to consider bankruptcy. The consequences are severe and It’s not a decision to take lightly, but bankruptcy offers a second chance and many people eventually emerge in better financial shape.
Bottom Line
Debt consolidation is a useful tool but it’s not a universal tool. You will have to determine whether it’s the right tool for you and what form of consolidation is most likely to achieve your goals. Honestly assessing your debts, your resources and personality, and the available options can help you choose the strategy that will be most effective for you.
Whatever strategy you select, start by reviewing your credit reports and assessing your debts. Keep checking them to track your progress and make sure it’s reported accurately. Effective financial planning begins with understanding your own spending and borrowing patterns. Understanding your credit report will build that understanding and help you to make confident, informed decisions on issues like debt consolidation.
