How does debt consolidation work?
When you have multiple debts to different creditors and loans to pay at varying interest rates, debt consolidation is a debt relief option that allows you to combine them into one loan at a lower interest rate.
Let’s say you have $25,000 in debt spread across five different credit cards, two outstanding medical bills and a student loan. That means you have eight different payment schedules and possibly eight different interest rates.
It can be overwhelming to manage all of that. But you could take out a debt consolidation loan for $25,000 and use it to pay off all 0f your other bills, leaving you with just one loan.
Consolidating your debt helps keep you more organized and focused as you work to pay it off. You'll wind up with not only a more favorable interest rate but also a single and typically lower monthly payment.
Plus, debt consolidation loans often have longer repayment schedules, so you're able to buy yourself some time to rebuild your finances.
Types of debt consolidation loans
There are a few ways to consolidate your debt into one single loan.
A balance transfer credit card offers you the opportunity to move your debt onto a card that, for a period of time, offers a low or 0% interest rate.
Credit card balance transfers are a great way to simplify your debt and slash your interest costs. But watch out, because you may be required to pay a fee of up to 5% on whatever balances you move over. You'll want to see if you can score a card that doesn't have a balance transfer fee.
A home equity loan, line of credit, or HELOC, allows you to borrow against the equity in your home to pay off your other debts.
Rates on HELOCs are considerably lower than the average rates on credit cards, but there's a fair amount of risk with this type of borrowing. Namely, you could lose your house.
A fixed-rate personal loan provides a way to roll your debt into one big loan from a bank, credit union or online lender, and at a steady interest rate. You can feel confident your rate won't change.
The interest on personal loans generally ranges from around 6% up to 36% APR (annual percentage rate). Your rate will be determined by factors including your credit score and the lender you choose.
Personal loans are either secured — meaning you have to put up some sort of collateral, like your car or house — or unsecured. Secured loans tend to come with better interest rates, but they're riskier: You can put your car, home or other collateral in jeopardy.
Taking out a loan against your 401(k) plan or other retirement account might be considered a fourth option, but that's generally a very bad idea.
These loans must be paid back within five years, and if you default you can find yourself owing income tax and a steep 10% early withdrawal penalty. Not to mention that you'll have less money to retire on.
Is debt consolidation a good idea?
There are a number of downsides and risks of debt consolidation, including:
- Your credit can take a hit. Applying for a loan or credit card to pull together your debt will result in a "hard inquiry" into your credit, which may knock a few points off your credit score.
- You'll lower the average age of your credit accounts. When you close out credit cards and other loans and replace them with one new loan, you effectively shorten your credit history, which also can be bad for your credit score.
- You can put your stuff at risk. Borrowing against your home, car or other assets can backfire easily if you aren’t diligent about sticking to your repayment schedule.
- You may not reform your bad spending habits. As the Consumer Financial Protection Bureau puts it, "If you get a consolidation loan and keep making more purchases with credit, you probably won’t succeed in paying down your debt."
But there are plenty of good reasons to consider debt consolidation, including:
- It makes your debt more manageable. When you combine several balances into one loan, you have fewer bills and payment schedules to juggle.
- You'll save on interest. Your new loan will usually come with a lower interest rate, meaning you'll have lower borrowing costs and will free up some money you can use to more aggressively pay off your debt.
- You can boost your credit score. Your score will benefit it you make your consolidation loan payments on time, and if you leave your older, paid-off accounts open. That will lower your "credit utilization," or the amount of your available credit that you're using.
Debt consolidation can be a good plan, particularly if your credit is decent enough to land a new loan and if your debt isn't overwhelming your income.
A good rule of thumb is that your monthly debt payments shouldn't exceed 40% of your monthly income before taxes.
The best way to consolidate debt is to make and stick to a plan to never get deep into debt again. But you've really got to mean it.
Take advantage of our partnership with Fiona, and look into debt consolidation loan rates today!