Do you need help getting out of debt? If you do, you’re not alone.
The latest report from the New York Federal Reserve tells us that U.S. households hold more than $12.29 trillion in debt. Mortgages aside, consumers owe nearly $4 trillion on auto loans, student loans, and credit cards. If you’re among the countless Americans looking to become debt-free, debt consolidation can be a big step in the right direction.
What is debt consolidation?
Before we discuss the ins and outs of debt consolidation, let’s define the term.
Debt consolidation is the process of combining your existing debts into one loan. Instead of making multiple payments each month to various creditors, you make just one payment at a lower overall interest rate, which reduces your monthly payment obligation and simplifies your bill-paying process.
Five options for debt consolidation
1. Loans from a qualified plan
Do you have a retirement fund or permanent life insurance plan with a cash value component? Either of these might offer you the opportunity to borrow money. Understand the risks, though. Failure to repay some loans can have adverse tax consequences and other financial penalties.
2. Unsecured consolidation loans
The advantage of an unsecured consolidation loan is that you can use it to pay off your debt without putting up collateral (such as a car). The downside is that it typically requires a good credit history and a good credit score, and interest rates on unsecured consolidation loans tend to be high.
3. Credit card balance transfers
If you have credit card debt, reducing or eliminating the interest you are paying on that debt is a good first step towards becoming debt-free. If you are paying high interest rates on your credit card debt, consider transferring that debt to a balance transfer credit card. Some balance transfer cards offer a 0% interest rate for 12-21 months, providing you a window of opportunity to pay down debt interest-free, which can save you hundreds or even thousands of dollars. Balance transfers aren’t free, however. The typical balance transfer card charges a fee that ranges from 3-5% of your balance transfer. And interest rates are typically high after the 12-21 month “introductory period” expires. If you’re serious about paying off high-interest credit card debt, here are five of the best balance transfer cards.
4. Home equity loans
Do you own a home with some equity? If so, you can apply for a home equity loan that can provide you with the cash to pay off all or most of your debt. The more equity you have in your home the more likely it is that you will qualify for a reasonable interest rate. The downside of this option is that if you fail to repay the loan, you could face foreclosure on your home.
5. Debt settlement
If consolidating your debts with a loan or credit card balance transfer will still leave you in a tight financial position, you might want to consider debt settlement. A debt settlement company can help negotiate your debt and set up an affordable monthly payment schedule. While there are some benefits to this approach, there are also risks, which are outlined in this helpful debt settlement article.
When is debt consolidation a good idea?
If you can realistically pay off your debts with a debt consolidation loan in 3-5 years, this is probably a good choice. If you’re not sure about your ability to pay, calculate your level of debt. If your unsecured debt is less than half of your gross income, debt consolidation is a manageable choice.
When is debt consolidation a bad idea?
Debt consolidation is almost always a good idea if you can both reduce your overall interest rate and make lower payments. However, some types of debt consolidation may be better than others, depending on your situation and spending habits. For example, if you have difficulty controlling your spending, it might not be a good idea to get a new credit card, regardless of your intentions. A debt consolidation loan may be a better option.
Debt consolidation is also not a good choice if your current debt is likely insurmountable. That is, if your unsecured debt is more than half of your gross income or if it will take more than five years to pay off your debt, consider other options.
Using loans vs. credit cards for debt consolidation
Credit card offers with low or 0% interest rates might be tempting, but they’re not always the best choice for those looking to consolidate debt. These rates usually last 12-21 months and then a much higher APR will kick in, leaving you in the same position, or worse, than you were before. Also, these cards can be difficult to qualify for, and there is often a balance transfer fee. Unless you plan on paying off your new credit card before the “introductory period” ends, a debt consolidation loan with clear terms is probably a better choice.
Lenders and loan options for people with credit scores less than 500
If your FICO score is below 500, your options for a debt consolidation loan are limited. If you own a home, you may wish to consider a home equity line of credit (HELOC). Depending on how current you are with your mortgage payments, you might qualify for one of these loans with a bank or credit union. Another option might be a secured personal loan such as a car title loan, which is backed by the title to your vehicle.
Lenders and loan options for people with credit scores between 500-600
If you have a FICO score between 500-600, you have more options. In addition to the choices listed above, you can either try to borrow from a lender that accepts people with bad credit or find a personal loan lender that allows a cosigner. The benefit of having a cosigner is that you will nearly always receive a more favorable interest rate on your loan.
Lenders and loan options for people with credit scores between 600-750+
If you maintain what is considered average to good credit, your choices for a debt consolidation loan improve considerably.
Understanding personal loan fees
Of course, taking out a personal loan for debt consolidation only makes sense if it saves you money. Some personal loans carry origination fees of anywhere from 1% to 6% that offset savings you might otherwise realize. Several online lenders that don’t charge loan origination fees include SoFi, Discover Personal Loans, and LightStream.
How to prepare for debt consolidation
- Make a list of all of your unsecured debts, their balances and APRs.
- Check your credit score so that you can determine your loan options.
With this information in hand you can calculate the savings you can realize by consolidating your debt.
For example, if you owe $10,000 on each of three credit cards with interest rates of 12.7%, 15.9% and 17% your monthly payments would total $1,458. But with a 680 credit score you could get a 24-month consolidated loan from, say, LightStream (one with a 9 percent interest rate, for example), which would reduce your payments from a total of $1,458 to a single payment of $1,371 per month.
Alternatives to debt consolidation
There are few alternatives to debt consolidation. If you are unable to pay your debts, you might try reaching out to creditors and ask them to lower your payments. Reaching out to a credit counselor to discuss your case can also often provide some suggestions and relief.
Debt consolidation may not be right for everyone, but it may help you save hundreds, thousands, or even tens of thousands of dollars. If you want to explore your options, let us help you determine whether or not debt consolidation is right for you.