After reviewing the terms of your accounts, and using a debt consolidation calculator, you've decided that debt consolidation is a good solution for you. Your next step, then, is to choose a method for consolidating and paying off your debts. The four most often-used strategies are balance transfers, personal loans, cash-out refinancing and home equity loans. Here's a quick rundown of the pros and cons of each method.
Balance transfer cards are credit cards designed to replace one or more accounts with a lower-interest loan. The come with very low introductory fixed rates for a limited time. The idea is that you take advantage of this low-interest window to pay down your debts as quickly as possible. When you shop for a balance transfer card, you'll be looking at the introductory rate, the introductory period, the annual fee and the balance transfer fee. Consider all of these costs when comparing cards.
- The interest rate can be very low. Average introductory rate for balance transfer cards is about 2.5 percent. Average post-into rate is about 12.5 percent. Note: all average rates and fees quoted in this article are 2013 figures.
- Exchanging multiple accounts for one account makes paying and budgeting easier.
- Application and approval is quick and requires little effort.
- Upfront fees are low.
- You may not qualify for the advertised intro rate if your credit scores are not excellent.
- There is typically a balance transfer fee. The average balance transfer fee is 2.88 percent of the amounts transferred.
- The interest rate can spike if you're 60 days late on your payment. That rate could be much higher than the rates of the accounts you paid off.
- The introductory rate is good for a limited time, and then the rate increases. In 2013, the average introductory period is about 14 months.
Cash-out refinancing means replacing your current mortgage with a larger mortgage and taking the difference in cash. This can be used to consolidate debt or for almost any other purpose.
- Because the loan is secured by your home, the interest rate is much lower than that of debt like credit card balances. Average cash-out refinance rates in late 2013 are about five percent.
- The interest may be tax deductible (check with a tax pro).
- You can lower your monthly payment significantly, because home mortgages can have much longer terms. Stretching out your credit card debt with a ten- to thirty-year loan really lowers drops your payment.
- You can a better rate than that of your old mortgage.
- The loan is secured by your home, so if you can't make the payment, you could end up in foreclosure.
- Credit card debt can be discharged in a bankruptcy because it's unsecured. Once that debt is secured by a home, you can't discharge it with a Chapter 7 filing.
- Cash-out refinances take time. There's an application, an appraisal, a title search, etc.
- Cash-out refinancing has higher upfront costs than any other strategy. It's a good solution only if the new loan has better terms than the mortgage it replaces.
- Stretching out your repayment can increase your total interest expense, even if the interest rate is lower. This can be prevented by making extra principal payments to lower your balance.
Home Equity Loans
Home equity loans and home equity lines of credit (HELOCs) are also called second mortgages. Like cash-out refinancing, they let you trade home equity for cash, which can be used to consolidate your debts. Home equity loans can carry fixed or variable rates. Fixed rates, however, make budgeting easier. Home equity terms range between five and 25 years, with the average being 15 years.
- Because the loan is secured by your property, the interest rate is lower. Average home equity loan rates in late 2013 were about seven percent.
- The interest is likely to be tax deductible. Check with a financial advisor.
- Replacing multiple accounts with variable rates, like credit cards, with a single fixed rate loan makes managing debt much easier.
- Home equity loans have much lower costs than cash-out refinances and can be processed much more quickly.
- Stretching out your debt repayment over more years can substantially lower your payment.
- Like cash-out refinancing, a home equity loan increases the amount of debt secured by your home. Should you find yourself unable to make the payment, you could end up in foreclosure.
- Debt moved from unsecured accounts to a mortgage (which is what home equity debt is) can no longer be discharged in bankruptcy. If your finances are shaky, a mortgage is probably not your safest choice.
- Stretching out your debt over a longer timeframe may increase the total interest cost, even if the interest rate is lower. This can be avoided by accelerating your repayment with extra principal payments.
Also called signature loans or unsecured loans, personal loans have no collateral -- the lender's only security is your character and your ability to repay the debt. The rate you pay and the amount of credit you're offered depend on your credit rating -- most lenders assign their applicants a grade between A and F. If you see a "personal loan" advertised with "no credit check" or "bad credit okay," it's not a personal loan. It's a title loan or paycheck advance, and it's very expensive. Rates for real personal loans generally range between six and 36 percent in 2013.
- Personal loans almost always have fixed interest rates, making budgeting easier.
- Application and processing are very fast. You can often get a personal loan in one day.
- Personal loan fees are much lower than those of home equity loans or cash-out refinances.
- Terms range from one to five years, so you become debt-free faster.
- Personal loans can be discharged in a bankruptcy.
- Personal loans are unsecured, so their interest rates are higher than those of home equity loans or cash-out refinances.
- Because terms are shorter, payments are higher.
- If your credit isn't very good, you may not be able to get a lower rate than you're currently paying on your credit cards.
The goal of debt consolidation should be to get debt-free more quickly and / or at a lower cost. And so the one big con of all methods is that people without the discipline to stick to their debt repayment program may run their cards back up. Then they have their debt consolidation loan plus all their credit card balances. Experts estimate that this happens to between 50 and 85 percent of people who try debt consolidation. Make sure you aren't in that camp before trying any of these methods.