How does debt consolidation work?
Let’s say you have $25,000 in debt spread across two different credit cards, two outstanding medical bills and a student loan.
It can be pretty overwhelming to manage all of that. Not only do you need to keep track of five different payment cycles, you may have five different interest rates and five different minimum payments to handle. Just look at it:
|Total owed||Interest rate||Minimum payment|
|Credit card #1||$10,000||22%||$300|
|Credit card #2||$5,000||21%||$150|
|Medical bill #1||$2,000||0%||$60|
|Medical bill #2||$3,000||2.5%||$90|
Meanwhile, the interest on credit cards compounds monthly — that’s interest both on the amount you borrowed and on the interest you’ve already accrued. If you’re stuck making only minimum payments on your credit cards, your debt problem will get worse and worse with time.
At that point, you need to find a solution.
When you consolidate, you take out a new low-interest loan and use it to pay off all of your high-interest debt. That can give you some breathing room and also keep you more organized as you work to pay it off.
You’ll have just one bill each month and, if you choose a fixed plan, you’ll know exactly when your debt will be paid off.
You’ll also have the chance to set new terms. If you want to get out of debt sooner and save on interest, you can choose a shorter repayment plan. Or you can choose a longer plan, giving you smaller monthly payments and some extra time to rebuild your finances.
How to consolidate debt
There are a few ways to consolidate your debt into one single loan.
A personal loan from a bank, credit union or online lender is the simplest option. And because the interest rate is usually fixed, you can feel confident that your payments won’t change.
The interest on personal loans generally ranges from around 6% up to 36% APR. 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 unsecured. Secured loans come with better interest rates, but they're riskier: You forfeit your collateral if you stop paying.
A home equity loan or home equity line of credit is a secured loan that 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 because you’re putting some serious collateral on the line. Namely, you could lose your house if you stop making your monthly payments.
A balance transfer credit card offers you the opportunity to move your debts onto a card that, for a period of time, offers a low or 0% interest rate.
Balance transfers are a savvy way to slash your costs. But watch out, because you may be required to pay a fee of up to 5% on whatever balance you move over. You'll want to see if you can score a card that doesn't have a balance transfer fee.
And don’t forget, that introductory low rate is only temporary. You’ll want to spend that period paying off the balance in full if you can. Otherwise, you might end up paying more in interest than you were before.
Taking out a loan against your 401(k) plan or other retirement account might be considered a fourth option, but that's generally a 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 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. While you’ll want to look at some quotes, these loans usually come with lower rates, meaning you'll stop losing so much in interest and free up money you can use to aggressively pay off your debt. Plus, the problem will stop growing because of your credit cards’ compounding interest.
You can get a fixed rate. Knowing that your interest rate won’t increase will give you some peace of mind and help you organize your payments. The only exception is a credit card balance transfer, where your low or 0% interest rate is just temporary.
You can set a plan. Because personal loans carry a fixed term, you're forced to commit to a plan to fully pay off your debt, typically in two to five years.
You can boost your credit score. Your score will benefit if you make your consolidation loan payments on time and you leave your older, paid-off accounts open. That lowers your "credit utilization," or the amount of your available credit that you're using, which is one of the main factors in calculating your score.
No solution is perfect. Consolidation doesn’t just make your debt disappear, and there are definitely risks and downsides to consider:
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 history, which may knock a few points off your credit score. Luckily, this is temporary, and there are many strategies to help fix your credit score fast.
You may lower the average age of your credit accounts. If you close your credit cards and other loans when you replace them, you may 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 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."
Debt consolidation is only the first step. Use this opportunity to change your financial habits, too. Start budgeting your expenses and use the money you’re saving to build a rainy day fund or start investing for the future.
What are the first steps?
Consolidation can be a smart way to free yourself from debt, so long as you’re committed to a new plan and go about it the right way.
When choosing new terms, make sure your monthly debt payments don’t exceed 40% of your monthly income before taxes. Otherwise, you’ll struggle to meet your needs. Go for a longer repayment plan if you must, but know that you’ll lose more in interest that way.
And remember that your credit score has to be decent enough to land a good deal on your new loan. Check it online and take steps to improve it if you can. A solid score will help you land a better interest rate, and that’s half the point of consolidation.
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