Being in debt is difficult enough—but when you're staring down multiple due dates on multiple bills, that amps up the stress factor. Debt consolidation may make sense as a way to streamline payments and, in certain cases, lower interest rates.
What Is Debt Consolidation?
Debt consolidation is the process of combining multiple debts into one, with the goal of lowering your interest rate, paying the debt off faster, or streamlining your debt payments. If you have five high-interest credit cards, for example, you could choose to open a 0% intro-APR credit card and transfer all five balances over to that card. You would then both save money on interest and only have one bill to pay each month instead of five.
Here, we're taking a look at the pros and cons of consolidating your debt, along with discussing the different types of debt consolidation – including student loan consolidation, credit card consolidation, using a personal loan to consolidate debt and, finally, using the equity in your home to consolidate debt.
Pros and Cons of Debt Consolidation
Andrew Poulos, a tax and accounting expert based in Atlanta, says that in general, debt consolidation is a good idea when you can reduce multiple payments to just one or two per month, and when you can cut their interest rates, which saves money over the life of the loan.
But it's critical to understand the terms of the consolidation: If you're trading in a lower interest rate for a higher one, or if the repayment period is much longer, beware. Even though it's lower interest, you could end up paying more on a longer term.
"Consolidation is also not a good idea when you don't plan to change your habits, and after the debt consolidation you charge up the existing credit cards again and now have more debt than you started off with," Poulos says. He also advises against refinancing your house to repay a debt—you don't want to risk losing your home if you can't pay and you're too highly leveraged.
Poulos says the major considerations to consolidation include:
- The new interest rate
- Repayment terms
- Fees, whether it's a balance transfer fee or a loan origination fee
- A requirement to close existing credit lines or credit cards
In short, will the total interest and fees that you will pay with the consolidation loan over the new term compared to the interest that you will pay with the current debt repayment term make it worthwhile?
Student Loan Debt
It's nearly impossible to get out of student loan debt—you can't ignore it or write it off. One thing you can do, however, is apply for a student loan refinance.
When you have multiple loans, this option is a way to streamline them, and you may be able to improve your interest rate. But do the math: if you're adding months or years to the loan, you can also be spending more on interest over time. Other options you could consider if you're having trouble making the payments are deferments or forbearance, which can give temporary relief without resulting in a default.
Another thing to note: If you're consolidating student loans, you may also lose some of the specific attributes from the original agreement, such as the ability to defer, or to loan forgiveness.
The first place to start is with the accounts you already have, Poulos says. "Ask them if they can offer a zero interest balance transfer at a low transfer fee of 2-3%. Doing a balance transfer with a small fee at a zero interest rate for 12-18 months can be an easy way to save a lot of interest on credit card debt while keeping your credit cards open with available credit to maintain a good credit score."
You can also compare credit cards to see which ones best meet your needs for consolidation—try for 0% for the longest period of time available.
Another option Poulos suggests for those with excessive unsecured debts is to attempt a debt settlement with the credit card companies. "This allows you to pay a small percentage of what you owe while the credit card companies report the debt as fully paid on your credit report," he says. While your credit score takes a hit, you're saving money monthly. "The question to ask is would you prefer to have your credit score impacted negatively for 24-36 months and potentially save thousands of dollars in interest, or would you rather pay thousands of dollars in high interest debt while preserving your good credit, but continuing to live in debt, stressed, and be cash poor," he adds.
Do be aware that if you settle, the lender is required to issue a 1099-C for cancellation of debt, which is reported to the IRS and it becomes taxable income on your tax return – however, there is a tax law that allows an exclusion from being taxable if you are considered insolvent at the time you do the debt settlement. "This is the option that will not only save you money on high interest debts, but also save you money on taxes while perhaps rebuilding your credit rating over the short period of time. You should consult with a licensed and qualified tax professional who can assist with the insolvency tax laws so you can get the tax benefits." Poulos says.
Banks and credit unions can offer personal loans at low interest rates. You can also compare personal loan offers from banks for as low as $1,000 up to $35,000, with repayment terms from one to seven years at a fixed interest rate. These are "unsecured," meaning that you don't have to put up collateral (such as your home or car), and are based on your credit. The bonus here is that when you pay on time, you can improve your credit score.
If you're certain you can manage the payments, you can look into home equity as a way to consolidate debt. HELOCs – home equity lines of credit – generally are based on interest rates much lower than credit cards offer, Poulos says, with the added bonus that the interest on a HELOC is tax deductible if you itemize, while credit card interest is not. "You should be aware that unlike the credit card debts that are unsecured, the HELOC is secured with your home, and if you can't make the payment the lender can foreclose on your home. This can be a risky way of consolidating your debts if you don't plan on changing your habits and lifestyle," he says.
Create Good Habits
Hopefully, your next debt consolidation will be your last. "Having excessive debt inhibits your ability to save for rainy days and for retirement, and impacts your credit score negatively, effectively costs you more over the long term because lenders and credit card companies will charge you higher interest rates," Poulos says. "The key to success is knowing how to manage your credit and being financially independent is maintaining a low debt level, and living within your means."