How Credit Card Debt Consolidation Works
Credit card debt consolidation is one way to manage ballooning monthly payments on multiple high-interest credit cards. When you consolidate debt, you take out another, lower-interest loan, such as a home equity loan or a personal loan, and pay off all of your credit card balances. That leaves you with only one monthly loan payment, which typically is lower than the combined payments on the old credit cards.
When is a debt consolidation loan a good idea?
This strategy will not work if you continue to spend and build up debt, as you’ll just find yourself swimming in even more debt that before. Successfully paying off credit card debt with a lower-interest loan requires understanding how you got into debt in the first place — and then changing your habits. This may mean cutting back on shopping and eating out and resolving to spend less until the debt is paid off. If you are truly committed to paying off your debt and are willing to change your lifestyle, a credit card debt consolidation loan could be a workable solution to clawing your way out of debt.
What fees should I look out for?
All debt consolidation tools are not equal, and some come with fees and other costs that potential borrowers should know about. Home equity loans, for example, require closing costs that can total several thousand dollars. If you transfer your balance to a lower-interest credit card, you’ll likely see a transfer fee on your first statement, which can be 2 to 5 percent of the amount you transfer and add that much more debt to your pile. Few debt consolidation tools are free, so be sure to thoroughly research fees and costs.
What if my credit is poor?
While consolidating debt can be a good way to pay down debt — and gradually raise a poor credit score — it may be difficult to get a debt consolidation loan if you have poor credit. Traditional lenders such as banks typically will not approve loans for applicants with low credit ratings.
If your credit score is lower than 640, it may be worthwhile to spend some time building up your score before you apply for a loan. You can qualify for personal loans with a lower score, but you could face significantly higher interest rates. You can rebuild your credit by regularly making all of your monthly payments on time in full for consecutive months, and lowering your credit card utilization, which will demonstrate that you can reliably pay off debt.
This may mean you have to forgo extra spending or even take on an extra job temporarily to ensure you have enough income to stay on time with your payments. It will pay off, however, as when your score increases enough, you may have a better chance of getting approved for a debt consolidation loan.
Best options for consolidating debt
Your options for debt consolidation loans generally depend on your credit score and total debt, which will determine which loans you are eligible for and what interest rate you will receive. Poor credit and a high debt-to-income ratio will limit your choices, but if you are committed to reducing debt, there are options for consolidating debt even if you have bad credit. Before taking on any loan or debt consolidation tool, make sure that your new debt payment fits within your budget and that you have a steady source of income to make payments.
Here are all the different tools you can use to consolidate debt.
Best for: Those with debts less than $10,000 or who are certain they can pay down the debt within the promotional period.
How it works: Balance transfers can be an excellent way to take advantage of a competitive credit card market where credit card companies are offering great deals to sign up new customers. Some cards offer an introductory period, typically 12 to 18 months, with 0% APR. You apply for the card, and if you’re approved, you have a window of time to transfer existing credit card balances onto the new card. Balance transfers make sense if you can pay them off completely before your 0% APR intro period ends.
Pros: Balance transfers are a good option for people with good to excellent credit. They also provide a break from interest payments, which gives borrowers a chance to pay off their entire balance or make a significant dent in it.
Cons: Many 0% intro APR credit cards will charge a one-time balance transfer fee that can be between 2 and 5 percent, which will show up on your statement. Also, once the interest-free introductory period is over, interest rates will kick in that could be higher than those on your previous card.
Find a card: LendingTree compares cards for you, including details about their annual fees, bonus programs, introductory offers, and credit requirements for approval.
Best for: People who have good credit but may not have the collateral to qualify for a home equity loan.
How it works: Personal loans for debt consolidation typically are unsecured debt, which means they come with a higher interest rate than a home equity loan, which is backed by the borrower’s house. Personal loans can be made for up to $100,000 and are paid off at a monthly, fixed rate for terms of one to seven years. The application process is quick and easy, and borrowers may get approved for the loan within one business day.
Pros: Personal loan payments are easy to budget because in most cases they are fixed, and loan fees typically are lower than those for home equity loans. The loans’ short terms mean borrowers who pay them off may get out of debt more quickly.
Cons: Borrowers with lower credit or higher debt-to-income ratios may not qualify for an interest rate that’s lower than the rate on their credit cards. Payments may be higher because the loan’s terms are short.
Fees and fine print: Some lenders charge origination fees and other costs for borrowing, but some don’t. Be sure to shop around for different lenders to get the best rate and lowest fees.
Find a loan: LendingTree’s personal loan offer tool can compare rates and generate offers for personal loans for debt consolidation.
Home equity loan/HELOC
Best for: Homeowners who have built up a significant amount of equity in their homes and plan to stay in their homes for the near future.
How it works: Home equity loans and home equity lines of credit (HELOCs) allow homeowners to borrow money against the value of the equity in their home to pay off high-interest debt. A home equity loan provides a one-time lump sum of money that is repaid in fixed installments over a set period, while a HELOC operates like a revolving line of credit. Homeowners withdraw money from a HELOC when they need it, and they only repay the money they’ve borrowed at the current interest rate.
Pros: Because home equity loans and HELOCs are secured by the borrower’s home equity, these loans typically have interest rates that can be much lower than credit card interest rates. Payments can be stretched out over many years, lowering the amount the borrower pays each month.
Cons: The biggest downside of home equity loans and HELOCs is that if the borrower cannot make payments, the lender can seize the house and send it into foreclosure. If you are concerned that you could lose your income and not afford the payments in the future, home equity loans and HELOCs are not a good option
Borrowers also should make sure that a home equity loan or HELOC actually will save them money. While payments may be significantly lower, if they are made over a long period of time, you could end up paying more in interest than you would on a higher-interest loan with shorter terms. This situation can be avoided by making extra principal payments on your home equity loan or HELOC.
Fees and fine print: Home-equity-backed loans come with some of the same closing costs and fees associated with mortgages, such as an appraisal cost, title search, and application fee. These costs typically range between 2 and 5 percent of the loan.
Find a loan: Use LendingTree’s home equity calculator to figure out how much equity you have in your home and decide whether a home-equity-backed loan is right for you.
Best for: People with significantly more savings in their 401(k) plan than they want to borrow and who feel secure in their current job.
How it works: A 401(k) loan is essentially a way to borrow from yourself. You withdraw a lump sum of money out of your 401(k) savings account with your current employer and repay yourself, with interest. Interest rates usually are set at the current U.S. prime rate plus 1 percent, and the loan typically must be repaid in five years.
The Internal Revenue Service has rules about which 401(k)s qualify for loans and how much can be withdrawn.
Here are the general rules about withdrawing loans from qualified 401(k)s if you have not taken out a 401(k) loan in the past twelve months:
- If loans are allowed, you can withdraw up to $50,000 or 50 percent of the vested balance in your 401(k), whichever is less.
- There is one exception to the first rule. If your vested balance is less than $10,000, you can borrow up to $10,000 but not exceed your 401(k) balance. However, not all plans include this exception.
Pros: Credit checks are not required for 401(k) loans, so the loan should be easy to get. The application can be done through your company’s human resources department. If you default, it will not be reported to a credit agency nor hurt your credit because you have not borrowed money from a lender. And you are paying yourself back with interest.
Cons: If you are let go from your job or you leave voluntarily, the entire balance of your 401(k) loan will become due.
If you default on the loan, the remaining balance will be considered a disbursement from the 401(k) plan and will be hit with an early distribution tax. This type of loan also can deplete your retirement savings and reduce opportunities to invest returns on the money you withdraw.
Spouses often must sign off on the loan, and you may be required to pay a fee when you take out the loan. The loan is not reported to a credit agency, so repaying a 401(K) loan will not increase your credit score.
To learn more: Check with your company’s human resources department for more information about whether your 401(K) qualifies for a loan and how to apply for one.
An alternative to debt consolidation: debt management plans
How it works: A debt management plan (DMP) can benefit anyone deep in debt. People who qualify for DMPs work with a counselor who helps them plan and follow through with monthly payments. Payments are made to a credit counseling agency, which then sends the money to creditors.
Lenders may be willing to waive or reduce fees and finance charges and back off on collection calls for enrollees in DMPs. The programs typically allot three to five years for enrollees to pay off debts, and counseling programs are available to help enrollees better manage their finances.
Pros: For people overwhelmed with debt, having a third party step in and help organize and manage their finances can be life-changing. If participants stick with the program, they can pay off debts quickly and rebuild their credit. Creditors also are more likely to reduce interest rates and waive fees for borrowers who are working with an official DMP.
Credit counselors associated with the DMP also can you help you cut back on spending and establish and stay on a budget.
Cons: While DMPs sometimes can help you negotiate lower interest rates, few creditors will eliminate interest charges. During the repayment period, creditors also will close or suspend your lines of credit with a few exceptions, such as allowing you to maintain a credit card for work travel.
How to find one: Be careful when choosing a credit counseling agency to work with, as some make fraudulent claims or charge hidden fees. The Federal Trade Commission recommends checking credit counseling services you’re interest in with your state attorney general’s office and your local consumer protection agency to ensure you are working with a reputable organization.
How much can I save with debt consolidation?
Savings for each situation will differ based on the amount of debt, interest rates, and the debt consolidation strategy. LendingTree’s online debt relief calculator allows you to enter your debt balances and interest rates and will calculate what you may save with a debt consolidation loan.
A warning about debt relief companies
Not all debt relief firms are looking out for your best interest, and it’s worthwhile to do some research before choosing an agency to work with. Avoid “debt settlement” schemes, which may encourage you to take out a loan you can’t pay back or agencies that ask for thousands of dollars to pay for “credit repair” that you could do yourself.
No debt consolidation program or tool will work, however, if you don’t curb your own spending habits. Racking up more debt while paying off debt is unproductive, as it eventually could leave you in a bigger hold than you started with. Remember that debt consolidation doesn’t immediately solve your debt problems — it makes debt more manageable so that you can pay off your debt in a timely manner. With disciplined spending and a sustained focus on paying down your debt, you will be well on the way to financial freedom.
Disclaimer: This article may contain links to MagnifyMoney, which is a subsidiary of LendingTree.