The 6 Best Ways to Consolidate Debt
In 2017, the average American had $6,354 in credit card debt alone, to say nothing of medical bills, student loans, overdue utility payments, and outstanding personal loans. Whether people fall into debt because they live beyond their means or are facing dire personal circumstances, taking on multiple debt obligations can become unwieldy rapidly. But if you’re struggling to manage your debts each month, debt consolidation may offer a better path.
Debt consolidation is the process of bringing several debts together into a single monthly payment. Instead of making multiple payments to individual lenders each month, you make one payment to one lender. Oftentimes, debt consolidation enables you to secure a lower interest rate so you can potentially save money as well.
- Take out a personal loan
- Use a home equity loan or home equity line of credit
- Do a balance transfer on a zero- or low-interest credit card
- Enroll in a debt management program
- Borrow from your 401(k)
- Borrow from your life insurance policy
6 ways to consolidate debt
1. Take out a personal loan
How does it work? You apply for a personal loan in an amount equal to your current debts. Once you’re approved and receive the loan funds, you can pay off the other balances.
Who is it good for? Borrowers who have good credit.
Pros and cons: If you’re approved for a personal loan with a favorable interest rate, it can be a great option for paying off your other debts and simplifying to one lower monthly payment.
The drawback to an unsecured personal loan is that you may have a tough time getting the rate you want. Unsecured loans tend to carry higher interest rates because they’re not backed by collateral, so make sure the rate you receive is actually lower than what you’re already paying. A secured loan may get you a lower rate, but it will also require you to put up assets such as your home or car as collateral.
To compare lenders, use LendingTree’s personal loan tool. You’ll enter basic information about yourself and how much you need to apply for. You’ll then receive personalized loan offers. That could help you find and compare lenders to get a competitive rate for your credit score.
2. Use a home equity loan or home equity line of credit
How does it work? Home equity products allow you to borrow against your home’s equity. With a home equity loan, you’ll typically receive a fixed interest rate and you’ll receive a lump sum after the loan closes.
A home equity line of credit (HELOC) provides you with access to a certain amount of financing, but you don’t have to use it all at once. You can use a portion of the credit to pay down your debts, leaving the rest open for other expenses, so there’s more flexibility than with a home equity loan. However, these are usually variable rate loans, so you may pay more in interest over the life of the loan.
Who is it good for? Homeowners who have equity in their properties.
Pros and cons: Home equity products are advantageous for homeowners who have built up equity and feel comfortable using that to consolidate their debts. However, home equity loans and HELOCs are secured by your house, which means you could lose the property if you can’t repay the loan.
Borrowers who struggle to manage the balances on maxed-out credit cards will want to carefully consider whether they have the means and discipline to repay that debt in the form of a home equity loan or line of credit, according to Billie.
“Old Navy’s not going to come and take your stuff if you don’t pay your bill, but you can lose your home,” she said.
3. Do a balance transfer on a zero- or low-interest credit card
How does it work? If you qualify for a credit card that allows you to do balance transfers and includes a zero-interest or low-interest promotional period, you can transfer higher-interest accounts to that card to take advantage of the lower rate.
Who is it good for? Borrowers with strong enough credit to qualify for new credit card accounts.
Pros and cons: Offers vary, but some cards offer 12-21 months of promotional interest rates, during which you can make significant headway on paying down the principal of your debt.
“Ideally you’re able to pay off that debt within that promotional period,” said Katie Bossler, a Detroit-based financial counselor. “If not, it’s OK, but you want to know what happens afterward and what that new interest rate will be.”
Make sure you know what you’ll pay in interest after the introductory rate and evaluate whether you’ll really be able to meet the monthly payment requirements if you can’t pay off the debt before then. Bear in mind that most credit card companies charge balance transfer fees, often around 3% of the amount of each transfer, so factor that into the overall costs of choosing this option.
4. Enroll in a debt management program
How does it work? Borrowers who are struggling to make a dent in their debt because they’re only paying the interest each month can enroll in debt management programs. Nonprofit organizations often run these programs; a counselor will look at all your eligible debt and negotiate with your creditors to bring down your interest rates and reduce the amount you’re paying in monthly interest and fees. Not all creditors will sign on for a debt management agreement, but many are willing to work with consumers to get the debt repaid.
Once a plan is in place, you’ll make one monthly payment to the debt management company, which will distribute it to all of your participating lenders. Debt management plans typically include a maximum payoff timeline of five years.
Who is it good for? Borrowers who are unable to get ahead on unsecured debts.
Because you’ll be paying participating creditors less than the agreed-upon interest rate, your credit score may drop when you first enroll. However, you’ll be making payments on time and will pay down the principal faster, so your total debt will decrease. Both of these are major factors in your credit score, so a debt management program can ultimately improve your overall credit profile.
5. Borrow from your 401(k)
How does it work? If you have a 401(k) retirement account with your employer, you may be able to take a loan on that amount. How much you can borrow depends on your plan’s guidelines, but generally speaking, the cap is the lesser of 50% of your vested balance or $50,000. You’ll have to repay the loan within five years.
Who is it good for? Individuals who have accumulated savings in retirement savings or an investment plan.
Pros and cons: When you repay the loan, you’re paying the interest back to yourself, which is preferable to repaying an external lender. The interest on 401(k) loans is 1% plus the prime rate, which is lower than what you may find on products such as personal or home equity loans. Since you’re borrowing from your own account, you won’t need a credit check to be approved. While loans from outside lenders sometimes carry prepayment penalties, you can repay a 401(k) loan as quickly as you want without any negative consequences.
However, withdrawing from a retirement account is risky. As long as a portion of that money is withdrawn, that amount will not accrue compound interest, so you will have fewer funds saved for retirement than if you had never touched the account. You may pay origination fees, and you’ll also be taxed on the interest you paid on the loan. If you can’t repay the loan, you’ll likely have to pay a 10% tax penalty on the amount borrowed, since the IRS will classify that as a withdrawal that can be taxed as income.
It’s important to read the terms of your plan carefully, especially if you think you may leave your job before you’ve repaid it. Switching to a new company could change the repayment terms, and you need to be prepared for that possibility.
6. Borrow from your life insurance policy
How does it work? You can borrow against your life insurance policy, using the loan to pay off your selected debts.
Who is it good for? Individuals who have a life insurance policy large enough to cover their debts.
Pros and cons: As with other loans, borrowing against your life insurance policy provides a means of streamlining and simplifying your debt, and potentially paying less money in interest. Depending on your policy’s terms, you may not be required to repay the loan. But if you don’t repay, the policy will not be paid out to your designated beneficiaries in the event of your death.
Borrowing from your life insurance policy reduces the amount of financial support you’ll leave behind for your loved ones. You may be confident that you can repay the loan quickly, but there are no guarantees that you’ll be able to do that before you pass. If you have other financial buffers in place for them, you may be willing to take the chance. But like a 401(k) loan, this is a very risky option, and you will likely be better served by exploring other debt consolidation strategies.
Debt consolidation: FAQs
Why should I consolidate my debt?
Not only are you avoiding the headache of making payments to multiple lenders, you’re reducing the chance that you’ll overlook one of your bills. Missed payments incur late fees and negatively impact your credit score, so you should be vigilant about paying on time. And debt consolidation options may enable you to secure a lower interest rate, which translates to money saved.
Ellen Billie, programs director at the Fair Credit Foundation in Salt Lake City, noted that credit card interest rates are often in the 20%-29% range, though some get down to 10%.
“If you’ve gotten yourself into credit card trouble and you’ve got 10 different accounts with 29% interest rates that you’re making only the minimum payment on, and really everything is going toward interest, it can be really beneficial to get a consolidation loan with a lower interest rate,” she said.
How much can I save my consolidating debt?
That depends how much you owe and how low your new interest rate is. You can use LendingTree’s debt calculator to estimate how much you’d save by taking out a new, lower-interest loan you can use to pay off your existing debts.
Shortening your repayment period will impact the savings as well. “If you have a maxed-out credit card and you’re making the minimum payments, generally, you’re going to pay it off in 20 years, 15 years – a very long time,” Billie said. But taking out a personal loan with a three-to-six-year repayment window can significantly reduce your total interest payments, especially if you can secure a better interest rate.
Which types of debt are eligible for consolidation?
Generally speaking, unsecured debts such as credit cards, personal loans, payday loans, medical bills and utility bills are candidates for consolidation. Some plans may allow you to pay off tax debts as well, although student loans are typically ineligible for debt management programs.
How much does it cost to consolidate debt?
Costs vary based on different consolidation strategies. Personal loans, home equity loans and lines of credit often include closing fees, and the latter two options may require appraisals as well. Debt management programs charge fees once you’ve enrolled, but they offer free counseling sessions beforehand to determine whether that’s the right move for you. Borrowing from a retirement account may incur tax penalties and other fees.
Is debt consolidation worth it? 2 questions to consider
Asking the following questions will help you determine whether debt consolidation is right for your situation:
1. Does the math work out?
Bossler said that depending on a borrower’s credit score and history, they may not get a loan large enough to pay off all their debts, so they have to “pick and choose” which they’ll target with the new loan. You’ll still be paying other debts with interest while tackling the new loan, so make sure you’re not paying as much or more with this strategy.
Billie said that when people become too focused on the simplification aspect, they miss the fact that the interest rates on large consolidation loans may cost them more than they’re already paying, so you need to run the numbers carefully.
“It may be financially beneficial for them to pay each individual debt down rather than taking out that consolidation,” she said.
Borrowers should also be scrupulous when evaluating offers from lenders who advertise extremely low interest rates, Bossler said. Individual borrowers will receive different interest rates, so she advised digging into the offer before jumping at what sounds like a promising ad. She noted that many new lenders have much shorter repayment terms as well, so make sure you know when you need to pay the loan off. Finally, factor in any origination fees, as these may end up making the loan less beneficial than you expected.
2. Do you have a plan for staying out of debt?
Unless you address the root causes of your debt, there’s a good chance you’ll find yourself in the same situation after your consolidation.
“If people are paying off 10 credit cards with a consolidation loan, then all of a sudden they have 10 credit cards with zero balances and it feels like they’ve got all this extra money,” Billie said. “It can be very easy to slip back into credit card debt, and now you’ve got this consolidation loan in addition to the credit card debt.”
Bossler shared Billie’s perspective. “It’s very common, unfortunately, for consumers to go back and charge on those old accounts,” she said. “If you’re going this route, you really want to think about the steps you want to take to prevent yourself from using the old cards again.”
The bottom line
Debt consolidation can be a way out of overwhelming monthly payments, but it doesn’t erase your debt or the patterns that led you there. Consider it a tool toward improving your long-term financial well-being, but not a solution in and of itself.