Creating a debt consolidation plan
If you’ve got a mountain of high-interest debt, you may benefit from taking out a debt consolidation loan. This involves taking out a single, lower-interest loan (often a home equity loan) and using it to pay off all your creditors. That way you can concentrate on one monthly payment and pay off what you owe much faster, at a lower interest rate.
Consolidating your debt can help you get closer to financial freedom. But it takes careful planning and the discipline to follow through. You can make it work by following these four steps:
Step 1: Determine Your Debt Load
Make a list of all of your current debts, excluding your mortgage, and determine what you’re paying on these accounts each month.
Let’s say you have a bank-issued credit card that charges 18% and a department store credit card with a rate of 20%. Two years ago, you also took out a $25,000 car loan with a five-year term at 8%. Here’s what your debt might look like:
|Department store credit card||$4,200|
Now add up the monthly payments you’re making on these accounts. For your credit cards this may vary, so use an average of your last six months or so. We’ll assume you’re paying 5% of the total balance on the bank-issued card and 10% on the department store card:
|Department store credit card||$420|
|Total monthly payments:||$1,400|
Now you’ve got a clear picture of your situation: when you consolidate your debts, you will need $30,000 to pay off your creditors, and you’ll want your monthly payments to be less than $1,400. You can also use LendingTree's Debt Consolidation calculator to help determine if having a single, lower-interest loan will help lower your payments.
Step 2: Shop for the Best Loan
There are several types of loans to consider when consolidating debt:
- Home equity loans and lines of credit offer the lowest interest rates, because they’re secured with your house. And because they’re a type of mortgage, the interest you pay may be tax-deductible. Following through with the above example, you might consider taking out a home equity loan for $30,000. At 7.5% interest over five years, the monthly payment would be just $600 -- less than half of what you’re currently paying.
- Cash-out refinancing is another option. It involves taking out a new mortgage on your home that’s larger than your current one. For example, if you have a $90,000 mortgage and your house is worth $180,000, you could take out a new mortgage for $120,000 and use the extra $30,000 to pay off your credit cards and car loan. Even if your monthly payment increases, it will still be less than your combined loan payments were before and the amount of interest you’ll pay will be greatly reduced.
- A personal loan can also be used to consolidate your debt if you don’t own a home, or you don’t want to use your home as collateral. The interest rates on these loans are higher than those of a home equity loan, but are usually lower than credit card rates. With a three-year loan at 10%, you could pay off $30,000 with less than $1,000 a month.
When you’re shopping for loans, don’t forget to factor in upfront fees and points as well as interest rates. The loan’s annual percentage rate (APR) is a good benchmark for comparison.
Step 3: Commit to a Timeline
After you’ve found the best loan, sit down and figure out a timeline for paying off your debt.
Home equity loans and personal loans have a fixed term, so you’ll know exactly how long it will take to retire your debt. If you’ve decided to consolidate with a home equity line of credit (HELOC), however, you’ll be required to make only a small minimum payment every month. But paying the minimum will not reduce your debt.
Instead, determine how much you can afford each month, and use the LendingTree Debt Consolidation Calculator to estimate how long the loan will take to pay off at that rate. For example, if you borrow $30,000 on a HELOC at 6.5% and feel you can afford $700 a month, you will pay back the loan in about four years. (Remember, though, that the interest rate on a HELOC is variable, so this calculation won’t be exact.) To help you stick to your timeline, consider setting up an automatic monthly withdrawal from your bank account.
Step 4: Control Your Spending
This may the most important step of all. Consolidating your debt only works if you resist the temptation to run up your credit cards again. Getting out of debt is not easy, and it won’t happen overnight. But the rewards of being debt-free are worth the effort.
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