Debt Consolidation: Pros and Cons of This Debt Relief Approach
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Debt consolidation is the process of securing a new loan, typically a debt consolidation loan, to pay off existing debt. Ideally, the new loan will have better terms like a lower interest rate so you can repay your debt for less money. Debt consolidation can reduce the number of bills you juggle each month and even speed up debt repayment, but the wrong approach for your particular situation can result in unwanted risk and cost.
As with any financial decision, there are pros and cons of loan consolidation, so you’ll need to be smart about your debt consolidation options and determine which one best aligns with your needs, goals and risk tolerance.
Pros of debt consolidation
Lower interest rates
A strong credit score and finances may allow you to access lower interest rates in the form of a balance transfer credit card or debt consolidation loan. Credit cards that offer an introductory 0% APR offer could be the most affordable way to repay debt if you’re comfortable with a repayment timeline around one to two years. That’s because the entirety of your payments will go toward the principal balance during this introductory period. Afterward, the regular APR will kick in.
Secured loans like a home equity loan or secured personal loan are also viable options, especially if you can’t access a balance transfer credit card or traditional debt consolidation loan. As secured debt, however, you’d need to put down collateral to back the loan. This collateral could be your home, car or savings. If you fall behind on payments, the lender can seize that collateral.
Note that the interest rate is just one component of a loan. Fees, monthly payments, potential penalties and overall terms should be considered, too. For example, balance transfer credit cards typically come with a balance transfer fee of 3% to 5%. You’ll need to weigh that fee to potential savings from opening a balance transfer credit card to consolidate debt.
Faster debt repayment
When you make payments on a lower-interest account, a larger percentage goes to pay off the principal when compared to a higher-interest account with the same monthly payment. Your payments provide more bang for your buck, allowing you to pay off debt faster – another one of the key benefits of debt consolidation.
But when you consolidate debt, you could also choose a shorter repayment period. For example, you might take out a debt consolidation loan with a term of 12 or 24 months. Your monthly payments would be higher as a result but overall interest costs could be lower as you’re paying off your debt sooner. The inverse is true: You could choose a longer repayment period for lower monthly payments but would face higher overall interest costs.
For borrowers with multiple debts, low-interest consolidation loans may be attractive because they allow you to reduce the number of bills you pay each month. Managing one debt instead of, say, three, makes budgeting easier and reduces the likelihood of you overlooking a payment.
Further, debt consolidation loans often have fixed payments, which streamlines your financial planning. You’ll know exactly how much you’ll pay each month and how long your payments will last.
Potentially better credit score
Some debt consolidation options could improve your credit score by lowering your credit utilization ratio, a credit-card metric that represents the percentage of available credit limit that you use. If your credit history relies primarily on revolving credit, a personal loan could also boost your score by diversifying your accounts, a factor that accounts for 10% of your score.
Be aware that applying for credit and adding a new source of credit may cause a drop in your score. That said, credit scores reflect a mix of factors, so the net effect of debt consolidation may still be positive.
Cons of debt consolidation
Debt consolidation options may impose costs in several ways. Debt consolidation loans can come with an origination fee of 0% to 8% of the loan amount, while balance transfer credit cards may impose a balance transfer fee of 3% to 5% of the transferred amount.
If you’re considering a credit card with an introductory APR, make sure you know the rate after the grace period ends and how it applies. For example, some cards apply the higher rate to new purchases, regardless of when they were made.
Lastly, home equity loans require an appraisal and lender’s fees, among other expenses. Make sure that any debt consolidation tool you use represents a net improvement – not just a short-term fix.
New lending terms
When you trade one loan for another, make sure you understand the details and how they will affect you. For example, the fixed monthly payments of a personal loan can simplify budgeting, but they may also reduce your flexibility compared to a credit card. If you have an income shortfall one month, you could choose to make only the minimum payment on a credit card. But if you transfer that balance to a personal loan, the lender will typically require the same payment amount every month.
Typical borrowing risks
Debt consolidation may also carry risk. Missing payments on secured loans, such as a home equity loan, could lead to the loss of your home or vehicle. There may be consequences for missing payments on a debt consolidation loan or credit card, too: fees, revocation of the grace-period APR or a drop in your credit score. When evaluating debt consolidation options, consider all possible scenarios and how they could affect your financial situation.
Temptation to spend
For someone who feels overwhelmed by debt, a sense of relief may be one of the biggest benefits of debt consolidation. Yet it’s important that a new lending source doesn’t exacerbate the problem. For instance, when consolidating debt with a HELOC, you may be eligible for more credit than you owe – for some, an enticement to spend. If you use a personal loan to pay off a credit card, it could be tempting to put new charges on the credit card.
5 ways to consolidate debt
1. Debt consolidation loan
- Pro: A single, lower-interest loan could simplify and reduce multiple-debt repayment.
- Con: Upfront origination fees could offset potential financial gains.
A low-interest debt consolidation loan may be smart if you have good credit, a willingness to pay origination fees (in some cases) and a desire to streamline finances with a single, fixed monthly payment. Review your loan options carefully to ensure they match your repayment ability. These loans may require higher monthly payments – a plus if you want to eliminate debt quickly, but a drawback if you might struggle to make this monthly payment.
2. Balance transfer credit card
- Pro: Interest-free periods could help you reduce principal quickly.
- Con: Balance transfer fees and the long-term interest rate may negate the benefits.
Balance transfer credit card lenders encourage borrowers to move an existing balance to a new card by offering a 0% APR for a certain period of time. These creditors may not allow you to transfer the entire balance, and they usually charge a fee on the amount you do move.
Read the fine print. For example, if you make new purchases on the card during the grace period, find out if it will be subject to a higher interest rate. If you can pay off the balance before the promotional period ends, this can be an effective way to attack debt.
3. Home equity loan
- Pro: A home equity loan can be a way to leverage equity achieved through payments or appreciation.
- Con: Your home is collateral for the loan, so there’s a chance you could lose it to a foreclosure if you stop making payments.
Home equity loans and home equity lines of credit (HELOCs) let you withdraw against the equity acquired in your home through a down payment, mortgage payments or appreciation. A lump-sum home equity loan is costlier and more complex than other debt consolidation options (for example, an appraisal is required). A HELOC is a line of credit you can draw from over time; these are simpler and less costly to obtain, but carry a variable interest rate.
4. Debt management programs
- Pro: These programs could negotiate lower interest rates or monthly payments.
- Con: Programs can come with monthly fees and users must be wary of predatory practices from debt settlement firms.
Various companies and organizations offer debt management services like negotiating with lenders on your behalf for better interest rates, lower payments or debt forgiveness and helping you develop a personalized repayment plan. These services may be free or paid, so be clear on any fee arrangements. (Often, fees are included in your monthly payment to the agency, which then distributes payments to lenders). While many of these services are legitimate, be alert to scams and predatory practices that advertise themselves as debt management programs.
5. 401(k) loan
- Pro: Loan approval may be easier because you are borrowing money from your retirement savings.
- Con: Losing your job will likely trigger a 90-day repayment obligation and an early-withdrawal penalty.
Borrowing against a 401(k) isn’t permitted under every plan, but when it is, the approval process is generally easy and interest rates are low. Some plans require a spouse’s approval to borrow against a 401(k). There are limits to how much you can withdraw and how long you’ll have to repay (generally up to five years). Because these funds are tied to employment, losing your job can change the loan terms. You may have to repay the balance within three months or risk paying income taxes on the borrowed amount and, depending on your age, pay a 10% early-withdrawal penalty.