Complete Guide to Debt Consolidation

Debt consolidation may help you pay your debt off faster, simplify your finances and improve your credit score. It can save you money if you approach it correctly. However, debt consolidation done wrong can leave you in a much worse financial position. This guide to successful debt consolidation can help you avoid the pitfalls and enjoy the rewards.

What Is Debt Consolidation?

The Consumer Financial Protection Bureau (CFPB) defines debt consolidation as a “type of loan that collects many of your debts into one loan with one loan payment.” 

But the CFPB goes on to stress that debt consolidation doesn’t eliminate or reduce any of your debts. It merely rearranges them into a more convenient form. If you owe $2,000 on one credit card and $3,000 on a line of credit and then consolidate them with a $5,000 debt consolidation loan, you still owe $5,000. 

How Can Debt Consolidation Help You?

Most people consolidate debt to achieve one or more of these benefits:

• To pay less interest

• To lower payments

• To simplify debt management

The best consolidation loans may achieve all three goals. Suppose the interest rates on your credit cards range from 17% to 27%. You pay them off with a 7% home equity loan. In that case, you can reduce your monthly expense, drop your interest rate, and combine several payments into one.

Optimize Your Loan Term

Getting a loan with a lower interest rate and a longer term can reduce your interest rate and lower your payment. However, too long a term could cost you more, even if the rate is lower. 

For instance, if you owe $5,000 on a credit card with a 17% interest rate, and your minimum payment is $100 per month, it will take 79 months to clear that debt and cost you $2,896 in interest. If you refinance it to a 15-year home equity loan at 10% interest, your payment drops to $53 a month. But it will cost you $4,671 in interest by the time you pay it off. 

So, you want to optimize the term of your new loan to suit your needs. You want it to be short enough to pay off within a reasonable period. But you don’t want it to be so short that you’ll struggle to make your monthly payments. One solution is to take a loan with a payment you can make easily but then pay it down as fast as you can.

What Kinds of Debt Can You Consolidate?

You can consolidate all sorts of unsecured debt. And an unsecured debt doesn’t have an asset attached (as collateral) that the lender can repossess if you fail to keep up payments. 

So unsecured debts include credit card balances, store card balances, personal loans, borrowing from family and friends, and so on. Credit card consolidation is widespread, partly because these tend to carry high rates.

In theory, you could consolidate some secured debts. You might zero the balance on your home equity line of credit (HELOC) or pay off your car loan. But these typically have low interest rates already. And it won’t be worth it unless your debt consolidation loan has a yet lower rate. 

Of course, student debt is unsecured. But consolidating that is a whole different topic. And you should read Should I Consolidate Student Loan Debt? before tackling that.

Prepayment Penalties

Nowadays, few loans come with prepayment penalties. But there are still a few around. And you should check your loan agreements for any debts you plan to consolidate. Store or credit cards don’t have such penalties.

Don’t automatically think you can’t consolidate an account because it has a prepayment penalty. Sometimes, these can be very small, though not always. So, call your lender and ask how much you’ll have to pay. Then decide whether it’s so much that it makes consolidation of that particular debt uneconomic.  

When Does Debt Consolidation Make Sense?

It’s usually a good idea to undergo debt consolidation before you begin to experience real problems. If you wait until you start skipping payments or making them late, you’ll likely have already damaged your credit score. 

And that means you’ll probably have to pay a higher interest rate on your debt consolidation loan. Leave it too long, and you might lose a lot of the savings you stood to make if you’d acted earlier. 

Make Sure You Benefit

There’s no point in consolidating your debts unless you’re going to achieve one or more of these three benefits:

• Reduce the interest you’re paying. A rate on your new loan that’s lower than the ones you’re currently paying should do the trick. 

• Lower your monthly payments – you probably want to have more disposable income left over at the end of each month. 

• Repay your debts faster – If your cash flow is good, you could consolidate to a loan with a short term (only worth doing if your interest rate is lower).

Most people can achieve at least two of those goals. 

Address Overspending Before Debt Consolidation

Many who need debt consolidation have had problems managing their spending. That’s not always your fault. You may be facing medical bills or have experienced a period of unemployment. And you had to let your credit cards or other borrowing take the strain.

But, often, you’re in this position because you overspent trying to maintain an unsustainable lifestyle. Again, that might not be your fault. Some people are better money managers than others. You might as well blame yourself for not being an Olympic sprinter as for being inept with your finances. It’s who you are. No judgment here. 

However, you really can’t leave things the way they are. If you consolidate your debt and then keep spending beyond your means, you’re heading for a world of pain. Because you’ll have to repay your debt consolidation loan and all the new borrowing you accumulate afterward.

The federal regulator we quoted earlier, the CFPB, has a good article about this. Do read it. But, briefly, it suggests you:

• Take a good look at your spending – If you understand where your money’s going, you can find ways to cut back in the least painful areas. Track over a month where every cent you spend goes.

• Make a budget – Set a limit on costs that vary each month. And keep track of how you’re doing. You may be able to increase your budget for something you genuinely value by reducing the amount you spend on something less important to you.

• Reach out to your creditors. The CFPB says, “Some creditors might be willing to accept lower minimum monthly payments, waive certain fees, reduce your interest rate, or change your monthly due date to match up better to when you get paid, to help you pay back your debt.”

Consider credit counseling and/or a debt management plan (DMP) if your spending is beyond self-help. With a DMP, you’re usually required to close your credit cards and then make a single monthly payment into the plan. That payment is distributed to your creditors. Because your cards are closed, you can’t run your balances back up. And credit counselors can show you how to budget.

Does Debt Consolidation Hurt Your Credit Score?

Yes, your credit score will probably fall when you consolidate your debts. But it’s likely to be a minor hit that lasts a brief time. And, soon after, you might well see your score boosted – perhaps by a lot.

Lenders pull your credit report when you apply for a debt consolidation loan. And every inquiry causes your score to drop a few points. (That’s why you should prequalify first and only authorize a credit report when you’re ready to apply for a loan.)

But once you zero out your credit cards and other unsecured accounts, your score could rise dramatically. That’s because your credit utilization will normally fall, and credit utilization is 30% of your score. This isn’t your total debt. It’s the proportion of your credit limits that your card balances make up. People with the best credit keep balances below 30% of their credit limits. 

Here is an example of how debt consolidation can improve your utilization and credit rating.

Suppose you have credit cards with a total spending limit of $10,000, and your balances total $8,000. That’s 80% utilization, which is relatively high. By paying them off with an $8,000 personal loan or home equity loan, your utilization drops to 0%. That’s because installment loans don’t count in the utilization calculation. Note that you still owe $8,000, but your utilization is much-improved.

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How Do You Consolidate Debt?

There are many ways to consolidate your debts. Here’s a list of common ones. 

• Credit card balance transfers

• Personal loans for debt consolidation

• Cash-out mortgage refinances and second mortgages (home equity loans) – Only for some homeowners

• 401(k) loans

• Debt management plans from credit counseling firms

Here’s what you need to know about each.

Credit card balance transfers

You’ve probably received mailings about these. You transfer balances from existing cards onto a new one that offers an introductory interest-free period. This period ranges from six months to 21 months as of this writing.

A 0% annual percentage rate (APR) is unbeatable. So, examine this option first. But watch out for these potential drawbacks:

• Don’t bother applying unless you have a decent credit score. These are for creditworthy borrowers.

• Compare balance transfer fees, which typically run between 1% and 5% of your transfer amount.

• Remember, the reason for taking a balance transfer card is to take what you’d otherwise pay in interest and put it toward paying off your debt faster. 

• Avoid carrying credit card balances in the future. If you’re carrying balances routinely, you’re spending too much.

These are primarily for people with pretty healthy finances who need a breather from high credit card rates to accelerate their debt repayment.

Personal loans for debt consolidation

This is the first choice for many, especially those who aren’t homeowners. You apply to your bank or an online lender for a personal loan, and you use the proceeds of that to pay down your existing debts. 

The interest rate you’re offered will mainly depend on two things:

1. Your credit report and score

2. Your choice of lender

That second one is important. Some lenders offer the same borrower a much better interest rate than others, so do your research. In addition, many personal loans come with fees. Compare loan fees and interest rates before applying. The annual percentage rate, which lenders have to disclose by law, incorporates both the interest rate and the costs to obtain a loan so you can compare offers more easily.

But don’t apply to multiple lenders, or you risk damaging your credit score. FICO has a list of loans that you can apply for many times with a minimal effect on your score: “mortgage, auto and student loans.” And personal loans aren’t among those. However, most personal loan providers allow consumers to prequalify without pulling their credit. Do this with a few before choosing your lender and applying.

Cash-out refinances and home equity loans

These are only available to homeowners whose homes are worth more than their mortgage balances. Few lenders will let you borrow against more than 85% of your home’s value, either with a cash-out refinancing or with your existing mortgage plus a new home equity loan.

But, if you’re eligible and have plenty of equity, home equity financing comes with some of the lowest interest rates available. And monthly payments are smaller because loan terms are longer than those of most personal loans.

However, there are still some downsides:

1. Loan set-up costs can be high, especially with a cash-out refinance

2. It’s expensive in the long run to borrow for a long time, even if your interest rate is low

3. These loans are secured on your home. If things go badly, you could face foreclosure

If you qualify, either of these is likely to require the lowest monthly payment you can find. But that might cost you over the long term.

401(k) loans

If your employer allows you to borrow against your 401(k), it might make sense to do so. 

• You’re essentially borrowing from yourself, so bad credit isn’t usually an issue.

• You can get up to 50% of your account balance or $50,000, whichever is less.

• Repayment comes out of your paycheck, so you’ll never be late.

However, there are significant disadvantages, which is why many financial advisors don’t recommend this course of action:

• As long as you have a loan against your account, you can’t contribute to it. If your company matches contributions, you lose that benefit.

• Suppose you leave the company, voluntarily or involuntarily. In that case, you have to pay off the loan, or it becomes a distribution for tax purposes. If you’re not eligible to withdraw from your account, you’ll face a 10% penalty, and the unpaid loan balance also becomes taxable.

This form of debt consolidation can be attractive, but it is potentially dangerous and costly.

Debt management plans from credit counseling firms

Like other forms of debt consolidation, debt management plans don’t make your debts disappear. But they may ease your burden by reducing your monthly payments.

You’ll work with a certified credit counselor who will look into your financial situation in depth. You’ll then get a customized plan, and your counselor may be able to negotiate lower interest rates (“concession rates”) with your creditors. 

You make one payment covering your enrolled debts each month into the plan, and it’s distributed among your creditors. The payment includes a fee that goes to the counseling firm. DMPs can work if you can afford the payment, and it gets you out from under your enrolled debts in a reasonable amount of time.

However, the Federal Trade Commission says, “The traditional Debt Management Plan (DMP) supported by creditors is not sufficient to help many consumers…these inflexible full principal programs will work for only about 25 percent of consumers who seek credit counseling assistance because they require a payment beyond a consumer’s ability to manage over the life of a program.”

If you enter a DMP, make sure you can afford it.  

Debt Consolidation Mistakes

Debt consolidation can help pay off debt faster if you do it correctly. However, some mistakes can put you in a much worse financial position. Don’t undertake debt consolidation lightly, and avoid these common errors.

1. Choosing the wrong method – the right program or loan should provide a real benefit and help you achieve your goal better than other methods.

2. Choosing a plan you can’t afford – falling behind with your debt consolidation loan could be financially disastrous. So be realistic about the monthly payments you can comfortably afford.

3. Thinking that consolidation “wipes out” your debt – it certainly doesn’t. You’ve simply rearranged your financial deck chairs. Your task is to make sure those deckchairs aren’t on the deck of your own personal SS Titanic.

4. Incurring balances while you still owe on your debt consolidation loan – it’s tough, but don’t build up more debt while you’re paying down your consolidation loan. Learn to live frugally, at least until you’re clear of unsecured debt.

Arguably, the biggest mistake is waiting too long to act – If you’re in financial trouble, there’s a good chance your credit score is falling. And that’s going to badly affect the interest rate you’ll pay when you finally get around to consolidating. So act now!