How to Consolidate Debt

6 Ways to Consolidate Debt

Consolidating debt involves replacing multiple unsecured debts with a new one, generally with the goal of saving money, accelerating your debt payoff or simplifying your repayment plan. Here are some of the top options available.

1. Balance Transfer Credit Card

Balance transfer credit cards usually come with an introductory 0% annual percentage rate (APR) on balance transfers for a set period, typically between nine and 21 months. The idea is to transfer your debts to the new card and pay off that debt during the introductory period to avoid paying interest.

Depending on your situation, you may be able to save hundreds of dollars on interest charges. However, there are some things to consider:

• You may not be able to transfer all your debt. You typically can’t transfer more than the new card’s credit limit, and you won’t know what that is until after you get approved. So, depending on how much debt you have, you may need to use a balance transfer card in conjunction with another consolidation option to achieve your goal.
• You’ll likely pay a balance transfer fee. Balance transfer credit cards typically charge an upfront fee of 3% to 5% of the transferred amount. Before you apply, do the math to determine how the fee will impact your savings. This fee may be tacked onto the balance you transfer to the card, decreasing the amount you can transfer.
• Purchases may still incur interest. Unless the card also offers a 0% APR promotion on purchases, you may start accruing interest on new purchases immediately until you pay off your balance transfer.

If you don’t think you’ll be able to pay most of the balance before the promotional period ends, check to see whether your new card’s ongoing APR is lower than the rates you’re currently paying on your other cards. If it’s not, this option might not be the best way to deal with your debt.

2. Debt Consolidation Loan

Another option is to get a debt consolidation loan that offers a lower APR than you’re paying on your current debt. If your credit score is in good shape, this type of personal loan can help you reduce your total interest charges by hundreds or even thousands of dollars.

Debt consolidation loans can be particularly helpful with credit card debt because, unlike credit cards, personal loans have set repayment terms. If your card’s minimum payment has made you complacent about paying off your debt, a personal loan can help.

With that said, here are some things to consider before you apply:

• You’ll need good credit to make it worthwhile. You can get approved for a personal loan even if you have bad credit. But to qualify for an interest rate that’s low enough to make it effective, you’ll need good or excellent credit.
• Make sure you can afford the monthly payment. If you’ve been paying just the minimum on your credit card, you can expect a higher monthly payment with a personal loan. Run the numbers before you apply for a loan to determine if you can fit it in your budget.
• Watch out for origination fees. Some lenders charge upfront origination fees that can be as much as 10% of the loan amount. What’s more, this charge is deducted from your loan disbursement, so you’ll need to borrow more to ensure you get the amount you need. If you have great credit, though, you should be able to find lenders that don’t charge a fee.

Before you apply for a loan, however, shop around and compare debt consolidation loan rates to ensure you get the best offer available.

3. Tapping Into Home Equity

If you have equity in your house, you may be able to use a home equity loan or home equity line of credit (HELOC) to get the cash you need to pay off your other debts. This method is popular because home equity loans and lines of credit offer low interest rates, as they use your home as collateral for the loan.

And if you get a HELOC, you’ll still have access to that relatively inexpensive line of credit after you’ve paid off your credit card debt. That said, here are a few caveats to consider:

• You may run into limitations. Most lenders only allow you to borrow up to 85% of the value of your home, and that includes both your primary mortgage and your home equity loan or HELOC. Depending on how much equity you have, you may not be able to borrow as much as you need.
• You could lose your home. If you default on a loan that’s secured by your home, your lender could foreclose on your house—even if you’re still up to date on your primary mortgage loan.
• You may be on the hook for closing costs. Home equity loans typically charge closing costs ranging from 2% to 5% of the loan amount, and HELOCs sometimes charge annual fees, among others. Make sure you understand the costs before proceeding.

You can get a home equity loan or HELOC from your primary mortgage lender, but it’s a good idea to shop around and compare multiple options to get the best terms.

4. Borrowing from Retirement Accounts

If you have a 401(k) plan with your current employer, you may be able to borrow the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. There’s no credit check involved, and any interest you pay on the loan goes back into your retirement account. Payments on the loan will be deducted from your regular paychecks.

However, this option can be incredibly risky, especially if you have good credit and can consolidate debt in other ways. Potential downsides include:

• Your employer plan may not offer loans. Not all 401(k) plan providers allow loans, which means that this option may not be available to you. Additionally, you must still be an employee of the company offering the plan, so using an old 401(k) account won’t work.
• You’ll miss out on future gains. Once you pull money out of your retirement account, it will no longer earn interest, diminishing the power of compound interest in the future. In the long run, you may end up losing out on far more in lost gains than you’d save on interest.
• You’ll run into problems if you leave your job or get laid off. If you leave your employer on your own or involuntarily, your repayment will be accelerated. Instead of the original five-year repayment plan, you’ll have until the due date for filing your federal income tax return for the taxable year in which you leave to pay back the loan in full. If you don’t, the unpaid amount will be treated as an early withdrawal and may be subject to income taxes and a 10% penalty.

5. Debt Management Plan

Debt management plans (DMPs) are programs offered by nonprofit credit counseling agencies. DMPs are designed to help consumers struggling with a large amount of unsecured debt, such as personal loans and credit cards. They don’t cover student loans or secured debts such as mortgages or auto loans.

Before signing up for a DMP, you’ll go over your financial situation with a credit counselor to see if this option is a good choice for you. If you decide it is, the counselor will contact your creditors to negotiate lower interest rates, monthly payments, fees or all of the above, and they will become the payer on your accounts.

Once they reach an agreement with your creditors, you’ll start making payments to the credit counseling agency, which will use the money to pay your creditors.

Some things to know before speaking with a credit counselor include:

• You may have to close your credit cards. You may be required to close your credit cards as part of the agreement. If this happens, it could cause your credit utilization rate to spike, damaging your credit until you pay down the balances.
• Your credit options will be limited. If you apply for new credit while you’re on a DMP, your creditors will likely withdraw from the program. DMPs can last for three to five years, which can be a long time to commit to no new credit.
• There are fees involved. You’ll typically need to pay a one-time setup fee—typically $30 to $50—along with a monthly fee, which can range from $20 to $75. Review your budget to determine your ability to pay before you start the process.

If you’re curious about a debt management plan or simply want some advice, nonprofit credit counseling agencies typically offer free consultations.

6. Debt Settlement

Debt settlement involves negotiating with your creditors to pay less than what you owe. You can try to negotiate a settlement on your own or hire a debt settlement company or law firm to do it for you, which can help if you feel like you’re in over your head.

If you work with a debt settlement company, it will usually require you to stop paying your bills while it negotiates your new settled amount. Settlement can help you save thousands of dollars, but there are some significant downsides to consider:

• It can damage your credit. Missing payments while you negotiate or put together a lump-sum payment can result in significant negative damage to your credit score. And once you’ve reached a settlement, the creditor will add a note to your credit reports, causing more damage.
• It can be costly. Working with a debt settlement company or law firm can potentially help you get a better settlement, but it can cost you between 15% and 25% of the settled amount.
• You may end up with a tax bill. The forgiven debt may be reported as income to the IRS, which means you may have to pay taxes on it.

As a result, it’s best to consider debt settlement only as a last resort. It may make sense if you already have accounts that are severely delinquent or in collections, but if you’re generally caught up, consider other consolidation options.

How Debt Consolidation Affects Your Credit

In the long run, sticking to your debt payment plan can help your credit scores. However, as you begin to consolidate debt, you might see your scores drop. How long it will take your scores to recover will depend on the consolidation method you’ve chosen.

Here are some ways debt consolidation can affect your credit:

• New credit applications: When you apply for a debt consolidation loan or balance transfer credit card, the lender will check your credit, resulting in a hard inquiry on your credit report. Hard inquiries lower your score by a few points; however, your score should recover fairly quickly.
• New credit accounts: Adding new accounts to your credit file also reduces the average age of your credit, or how long you’ve maintained open accounts. This can impact your credit score temporarily. Also, if you decide to close credit card accounts as you pay them off, that can also negatively impact your length of credit history in the long term.
• Change in credit utilization: Your credit utilization rate, or the percentage of available credit you’re using, also affects your credit score. The lower your ratio, the better it is for your credit. If moving credit card debt to a balance transfer credit card increases your utilization rate on the new card, it could damage your credit score until you pay down the balance. Also, closing credit cards on a DMP can hurt your credit temporarily.
• Settled debts: Of the methods we’ve discussed, debt settlement presents the biggest risk to your credit score because you’re paying less than the full balance on your accounts. The settled debt will be marked as “paid settled” and will remain on your credit report for seven years from the first missed payment. The more debts you settle, the bigger hit your credit score could take. In addition, late payments and even collections, which often occur when you use this method, will bring your score down.

Whichever debt consolidation method you choose, the most important step you can take is to maintain a positive payment history by making all your payments on time. This can help your scores recover from short- and medium-term negative effects and even improve in the long run.

Is Debt Consolidation the Right Choice for Me?

Whether debt consolidation is a good option for you depends on your financial circumstances and the type of debt you wish to consolidate. Carefully consider your situation to determine if this path makes sense for you.

When to Consider Debt Consolidation

Debt consolidation may be worth considering if any of the following are true for your situation:

• You have good credit. Having a high credit score can make it possible for you to qualify for 0% balance transfer cards and low-interest loans. On the other hand, if your score could use some work, you might not get the terms that would make debt consolidation effective.
• You have high-interest debt. Debt consolidation is a good option if you have high-interest debt because it can allow you to save money by reducing the interest you’re paying.
• You’re overwhelmed with payments. If it’s becoming hard to keep track of your debt payments, debt consolidation can solve that by helping you merge multiple payments into one, making it easier for you to pay on time.
• You have a repayment plan. Consolidating debt without a repayment strategy in place could reduce the effectiveness of the consolidation. Before taking the first step to consolidate debt, decide on the payment strategy and make sure you’ll be able to stick to it. This may include reviewing your budget and changing some of your spending habits.

When to Think Twice About Debt Consolidation

Debt consolidation may not be the best approach in these situations:

• Your credit is poor. Some debt consolidation options may still be worth considering, but a debt consolidation loan or a balance transfer credit card may be out of the question.
• You don’t have a lot of debt. Debt consolidation doesn’t make much sense if you can pay off your debt in less than a year. It might not be worth your effort if you’d only save a small amount by consolidating.
• You’re not planning on changing your spending habits. If you aren’t ready to commit to changing some of the habits that got you into trouble in the first place, debt consolidation may not provide you with the long-term advantages you’re looking for.

Alternatives to Debt Consolidation

Debt consolidation can be an effective tool when managing debt, but it’s not a magic bullet. There are other solutions you can try that don’t involve taking out new credit or potentially damaging your credit score.

Create a Budget

Sometimes all it takes to get out of debt is making a budget and following it. To create a budget, start by reviewing your income and expenses over the last few months. Categorize each expense to get a better idea of where your money is going.

Once you can see the full picture, look for areas to cut back and allocate that cash flow toward additional debt payments. You’ll also be able to set realistic goals for monthly spending, debt payoff and savings. Be sure to track your expenses to evaluate your progress over time.

Consider the Debt Avalanche Method

Another approach to eliminating debt is the debt avalanche method, which focuses on paying off the debt with the highest interest rates first as you work to pay off all your accounts.

For this approach, list all your debts from the highest interest rate to the lowest and pay the minimum balances on all of them. Then, use whatever your budget allows to pay more toward the debt with the highest interest rate. When you’re done paying it off, add that payment to the minimum payment on your debt with the second-highest interest rate on your list until it’s paid off, and so on. This approach can help you maximize your interest savings.

Consider the Debt Snowball Method

The debt snowball method is similar to the debt avalanche approach, but instead of focusing on your debts with the highest interest rates, you order your debts by balance, starting with the lowest.

After paying the minimum balance on all your debts, use any extra money to put more toward the debt with the lowest balance. Once that’s paid, move on to the debt with the next lowest balance, and so on. This way, you can reduce the number of debts faster, which can motivate you to keep going since you’ll see progress quickly.

The Bottom Line

If you’re considering debt consolidation, it’s best to carefully evaluate your financial situation and research your options to determine if it’s the right solution for you. Before you begin, take a look at your credit score to see where you stand and make sure to monitor it to track your progress and any changes as you work to pay off your debt.