Pros and Cons of Debt Consolidation
Two pieces of folk wisdom help frame the debate over debt consolidation:
“Many hands make light work.”
“Put all your problems in one place — it’s easier to keep an eye on them.”
The first suggests that a burden of debt is easier to shoulder when divided into smaller pieces. The second suggests it is better to concentrate the burden to make it more organized.
Which is right? Your answer may indicate how you feel about debt consolidation. Learning a little bit about how debt consolidation works and various options for implementing it may help you reach the best conclusion for your situation.
What is debt consolidation?
Debt consolidation involves using a new source of credit to pay off multiple existing debts. Benefits can include making your payments easier to keep track of, lowering your interest rate, lowering your monthly payments and lowering your long-term interest expense.
That may sound good, but debt consolidation is not a miracle cure. For one thing, you need to be able to qualify for the new credit that is cheaper than at least some of your existing debts, which may not be easy if you are already struggling to pay what you owe.
For another thing, the benefits can often conflict with one another. For example, stretching debt out over a longer repayment period can make your monthly payments more affordable, but it can also raise your long-term interest expense in the process.
Most of all, debt consolidation will only work if you build a budget discipline around it — one that ensures you can meet the payment obligations of your new debt and control the rate of spending that led you to build up debt in the first place.
Pros and cons of debt consolidation methods
The effectiveness of debt consolidation depends in large part on the type and cost of debt you use to implement it. Below are several options for financing debt consolidation, along with a discussion of the pros and cons of each.
A personal loan is a loan granted to an individual for a variety of personal uses, as opposed to for commercial purposes. It can either be secured by collateral or unsecured, with secured loans typically carrying lower interest rates because they represent less risk to the lender.
Personal loans are available from banks and credit unions, as well as non-bank lenders (these are companies that specialize in lending as opposed to offering other banking services such as deposit accounts). Increasingly, peer-to-peer lenders are also sources for personal loans. These are networks that match would-be borrowers up with a variety of investors who pool their money to fund loans in order to earn interest.
Pros of using a personal loan to consolidate debt include the fact that personal loan interest rates are generally lower than those on credit cards. According to data from the Federal Reserve, the average credit card balance is assessed interest at a rate of 14.89 percent, while the average personal loan borrower pays a rate of 9.76 percent. Also, a personal loan puts your debt on a defined timeline for being paid off, as opposed to credit card debt which can be somewhat open-ended.
Cons of using a personal loan to consolidate debt include the fact that the more debt you have, the more difficult it may be to qualify for a personal loan. If you have collateral to offer, you might have a better chance qualifying, but then you put that property at risk. As for the interest rate advantage, be advised that some personal loans incur an origination fee which can add substantially to the total cost. Finally, while being on a finite repayment schedule should help you in the long run, in the near term it may make your monthly payments harder to afford than the more flexible payment terms offered by credit cards.
When it makes the most sense: Using a personal loan for debt consolidation makes the most sense if you do not have home equity or other collateral to use for a loan, but have good enough credit to qualify for a loan at a lower rate than your credit card debt.
Home equity loan
A home equity loan is a second mortgage that borrows against the equity in your home. These loans are widely available from banks, credit unions, and non-bank lenders.
One form of home equity loan is a home equity line of credit or HELOC. A HELOC lets you tap into your home’s equity only when you need it, as opposed to borrowing the money all at once. However, since debt consolidation typically relies on borrowing money upfront to pay off existing debts, a HELOC probably makes less sense for debt consolidation than a lump-sum home equity loan.
Home equity loans, on the other hand, are much like personal loans in that they have set repayment periods and, generally, fixed interest rates, which gives you an easy-to-follow payment structure.
Pros of using home equity for debt consolidation include the relatively low cost. Mortgage interest rates are generally considerably lower than credit card rates, and the longer repayment terms available for home equity loans (often up to 15 years) can make monthly payments more affordable by spreading repayment out over a longer period. Finally, if you have had some credit issues, the collateral represented by equity in your home might help you qualify for a loan without paying an excessive interest rate.
Cons of using a home equity for debt consolidation primarily include the risk of putting your house on the line if you cannot meet the repayment terms. Also, while stretching payments out over many years may be attractive in the short run, in the long run, it can result in you paying more interest than you originally would have.
When it makes the most sense: A home equity loan may well be the lowest-cost vehicle for debt consolidation, so it makes the most sense if you have sufficient equity in your home as well as a budget discipline that makes sure you are not putting your property at risk too by using it to secure a loan.
Another way to use the equity in your home for debt consolidation is cash-out refinancing. Unlike a home equity loan, cash-out refinancing involves both borrowings against your equity and borrowing enough to pay off your existing mortgage. Thus, it replaces your existing home loan with a new primary mortgage. Like home equity, cash-out refinancing is a product widely offered by banks, credit unions, and non-bank lenders.
Pros of using cash-out refinancing for debt consolidation include many of the advantages of home equity loans. Also, cash-out refinancing essentially includes your existing mortgage obligations in your consolidation program. This can work to your advantage if you can get a lower mortgage rate on a new loan, or if you can make your monthly mortgage payments more manageable by stretching your existing balance over a longer repayment period.
Cons of using cash-out refinancing for debt consolidation include putting more of your home’s value at risk if you are not able to keep up with payments. Also, cash-out refinancing only makes more sense than a home equity loan if you are able to get more favorable terms on the new mortgage than on your existing one. Finally, if signing up for a new mortgage lengthens your repayment period, you may end up paying more total interest over the life of the loan.
When it makes the most sense: Cash-out refinancing for debt consolidation makes the most sense under similar conditions to a home equity loan but is preferable to a home equity loan if in the process you can lower the rate on your existing mortgage.
You can read a more detailed comparison of HELOCs, home equity loans and cash-out refinancing here.
Another option for credit card consolidation is to take various credit card balances and transfer them to one card with the lowest interest rate you can find. Credit cards are offered by banks, credit unions and the credit card companies themselves, so you have lots of choices when it comes to shopping around to find a better rate.
Balances can be transferred to any credit card offering a competitive rate, but this type of consolidation often centers around balance transfer credit cards. These are cards that offer 0 percent interest for a promotional period of time, such as a year or two, allowing you to avoid paying interest on balances you transfer while you pay them down over the 0 percent period.
Advantages of balance transfer credit cards for debt consolidation include the money you would save by not paying interest for a while, plus the convenience of combining all your credit card payments into one.
Disadvantages of balance transfer credit cards for debt consolidation are often found in the fine print. Most balance transfer credit cards have something called a balance transfer fee, which is often 3 percent of the balance you’re moving to the new card. Make sure you look for that fee information and do the math because they can reduce or even wipe out the interest-rate advantage.
Also, pay attention to what happens to the interest rate in the long run, because you may end up with a more expensive credit card than the ones you were using before. Be aware that a late payment can trigger an end to the 0 percent interest period so that higher rate might kick in sooner than you think. Another thing to know: New purchases may have a different interest rate than your transferred balance. On top of that, making and paying for new purchases might hamper your ability to pay off your transferred balance before the 0 percent interest period runs out, thus dampening the benefit of making that transfer.
When it makes the most sense: Using a balance transfer credit card for debt consolidation makes the most sense if you can pay off the balance during the 0 percent interest period and if balance transfer fees don’t negate your interest rate savings.
401k, 403b, IRA retirement investments
If you have built up some money in a retirement account, it might be tempting to look at that as a source of funds for paying off debt. However, understand that if you are under age 59 ½ simply taking the money out of your retirement account is a non-starter — this will subject you to ordinary taxes on the amount withdrawn plus a 10 percent penalty, which makes this an extremely costly way to consolidate debt.
Some employer-sponsored plans, such as 401k and 403b plans, allow participants to borrow money from their balances. IRAs do not permit loans, and employers are not required to allow loans from their 401k or 403b plans. If your employer enables such loans, it has to be done via a formal process so it is not deemed an unqualified distribution and thus subject to taxes and penalties. Loans must be repaid with interest via a series of equal payments within five years. The maximum you can borrow from a qualified plan is the lesser of $50,000 or half of your plan balance.
Advantages of borrowing from a retirement plan for debt consolidation include ease of approval and cost-effectiveness. As long as your employer’s plan has loan provisions and you have the requisite balance in the plan, it should be easier to get a loan than through an outside lender. As for cost, the IRS requires the loan to be repaid with interest, but since you are paying that interest into your own retirement balance, you will get that money back eventually.
Disadvantages of borrowing from a retirement plan for debt consolidation boil down to the fact that this method is not as cost-free as it may seem. Though it doesn’t seem to cost you anything, in the long run, to pay yourself interest, your retirement account is missing out on investment growth while the loan amount is out of the account, so there is an opportunity cost. Worse, if you fail to keep up with your loan repayments you may incur taxes and penalties. Finally, some employers require you to pay off loan balances in full if you leave the company, so that may leave you especially vulnerable to those taxes and penalties if you cannot come up with the full repayment in one lump sum.
When it makes the most sense: Because of the risk of tax consequences, borrowing from a qualified retirement plan rarely makes sense. You should consider it only if you are confident in your job security and your ability to repay the loan on time, and if you have a plan in mind for catching up on your retirement savings.
Family or friends
Perhaps someone you know can loan you the money to pay off your credit card balances, and you’ll pay that friend back when you can. Well, even this form of debt consolidation is not as simple as it seems.
Advantages of borrowing from family or friends for debt consolidation include not having to go through a formal loan approval process (basically, it’s just a matter of whether someone with money trusts you) and avoiding some of the fees and paperwork often associated with applying for credit.
Disadvantages of borrowing from family or friends for debt consolidation center around the fact that this approach is not as informal — nor as cost-free — as it seems. If the loan (plus any other money received from the same individual during the year) exceeds $15,000, it may be subject to gift tax unless you commit to repaying it with interest. To properly document this, you should have a formal loan agreement including a repayment schedule with principal and interest. Besides tax purposes, that documentation is probably a good idea anyway to avoid misunderstandings between you and the lender. Even if you take care of all these details, you still have to worry about what kind of strain owing this money will put on your relationship with the lender.
When it makes the most sense: borrowing from family or friends makes sense if you don’t qualify for more formal loan approval, and you and the lender are both confident in your ability to repay at a fair interest rate.
Breaking down the key components of debt consolidation
To help you consider the pros and cons of consolidating debt in the various ways described above, below is a summary of the key components of these different debt consolidation methods.
For the most part, the information in this table does not represent hard-and-fast rules, but rather general standards and practices followed in the lending business.
|Understanding Debt Consolidation Methods|
|Personal Loan||Home Equity Loan / HELOC / Cash Out Refinance||Balance Transfer||Retirement Funds||Family and Friends|
|Costs to consider||Origination fees and ongoing interest rate.||Closing costs & ongoing interest rate.
HEL may incur prepayment penalties.
HELOCs may incur transaction fees.
|Ongoing rates and fees for your new card, plus balance transfer fees.||Missing out on potential investment gains. Possible taxes and penalties if you fail to repay.||Interest costs or potential tax impact.|
|Interest rates||National average is 9.76%, but rates vary greatly depending on terms and credit scores||Average for mortgages overall is 3.36% to 3.94%;
home equity rates will differ depending on the length of the loan & whether or not it is a secondary mortgage.
|National average is 14.89%, but rates vary greatly depending on terms and credit scores||Should be competitive with personal loan rates to avoid tax consequences||Should be competitive with personal loan rates to avoid tax consequences|
|Eligibility requirements||Regular employment, documented ability to repay, & a low debt-to-income ratio, generally below 36 percent.
Collateral to secure the loan can ease requirements.
|Equity in your home, regular employment & ability to repay.
The latter generally means a debt-to-equity ratio under 45 percent.
|Stable income and ability to repay, including taking into account other debt.||A sufficient balance in a retirement plan that allows loans.||Depends on the potential lender.|
|Credit score required||Usually 580 or above.||Usually 620 or above.||580 or above||N/A||N/A|
|Typical length of repayment term||Two to seven years.||5 to 15 years for a HEL, or as much as 20 years after the initial draw period for a HELOC.||Variable.||5 years maximum.||To be determined by the borrower and lender.|
Deciding on a method of financing for debt consolidation involves balancing the present and the future. For the present, you need to consider how affordable the monthly payments of the new financing structure will be, and for the future, you need to consider what the total cost will be over the life of the loan.
Whichever method you choose, debt consolidation should be accompanied by a program to rein in your spending, so that it becomes an opportunity to get on top of your debts rather than simply a means of enabling more debt.