The first rule of debt consolidation is: Act early. If you apply while the problem's not yet acute, and your credit score remains healthy, you're likely to qualify for a wider variety of loans with competitive interest rates. But if you wait until you're really struggling and your credit's shot, you may well fail to get approved for any borrowing at all – and, if you do, you're almost certain to be charged cripplingly expensive rates.
Debt Consolidation Options
There are five main types of debt consolidation products, and each has its pros and cons:
1. Balance Transfer Credit Cards
Balance transfer credit cards may be your best bet if the sum you want to consolidate is relatively small, four figures or less. These can provide you with an introductory interest-free period of up to 18 months, although you almost always have to pay a one-time balance transfer fee, which is typically 3 percent, and usually added to your statement.
The breather these give you from high finance charges can provide you with a real opportunity to eliminate your card debt, but you're unlikely to do that unless you first draw up a repayment plan – and stick to it. You need to be sure you can pay down the amount you transfer within the introductory period. The standard rates you have to pay once the 0-percent APR deal ends may be higher on balance transfer products than on normal credit cards.
2. Refinance Your Mortgage
No loan can beat the 0-percent rate offered by balance transfer plastic, but the next lowest APR you're likely to find is through a cash-out refinancing of your mortgage. One of these could slash your monthly outgoings on high-interest debt, and relieve a whole lot of pressure on your day-to-day cash flow.
However, you won't be cutting your overall indebtedness, and the total cost of your current debts could actually rise unless you take steps to prepay your principal balance. That's because you're spreading payments over a very long period -- maybe 30 years -- and that's expensive, even if the APR you're paying is very low. You're also almost certain to add closing costs to your debt mountain when you choose this route. Finally, a refinance means you're going to turn debt that's currently unsecured into a secured loan: In other words, you're increasing the risk of your home being foreclosed on if you fail to keep up with the higher payments.
3. Home Equity Loans and Credit Lines
Home equity loans provide you with a one-off lump sum that's repaid in equal installments over a fixed period. Home equity lines of credit (HELOCs) give you, as their name implies, a line of credit: You borrow only what you need, and are charged interest only on what you borrow. Because both these loans are secured by the equity in your home, rates are generally highly competitive, though probably not quite as low as on a mortgage refinance.
The fact the loan or credit line is secured by your home also means that both types of borrowing have similar disadvantages to a refinancing, although:
- If you shop around, you may well find a loan with no closing costs.
- You are unlikely to have the loan/credit for as long a period, so the total cost of borrowing can often be lower.
The Federal Trade Commission has an excellent information page for these products on its website.
4. Personal Loans
A personal loan is likely to come with a higher APR than any of the others. But that's because it's unsecured debt, which is a big plus for folks who don't own homes or don't want their debt secured by their homes. And there's a good chance that the rate it charges is going to be a fraction of that you're currently paying on your credit cards and other high-interest debt.
If you can afford the higher rates charged for a personal loan, and still pay down your debts over a few years, this form of borrowing may be the smartest choice for you.
5. Student Loan Consolidation
You are not stuck with your current student loan payments. Depending on what your interest rate was when you took out your loans, you may be able to qualify for significantly lower rates with a student loan consolidation, saving you thousands of dollars over the life of your loan.
Lenders are going to look at your current credit score when determining your interest rate. If your credit score is excellent, you will qualify for the best rates. Refinancing your student loans will not only lower your rate and your payment, but it will also consolidate all of your loans into one. You’ll no longer need to pay five different lenders each month and will instead only pay the one.
Note that if you do choose to refinance your loans, you will lose your eligibility for Federal loan forgiveness programs. If you already are not eligible for those programs, this shouldn’t be an issue. However, it’s always important to fully understand your options before making a decision.
The Dangers of Debt Consolidation
Most people get into debt for one of two reasons: they've recently experienced a once-time problem (unemployment, illness... whatever) that's unlikely to recur, or they habitually overspend. If you fall into the latter group, debt consolidation is unlikely to solve your problem. Think of it as the financial equivalent of taking a couple of Advil for a brain tumor: you may briefly feel a bit better, but your long-term prospects are grim -- unless you take further action.
Debt consolidation won't in itself reduce your indebtedness. In fact, it may give you opportunities to borrow more: are you honestly going to resist the temptations presented by all those newly zeroed card balances? Some experts estimate that as many as 70 percent of those who go through the process end up owing more than when they started.
And consolidation won't necessarily even cut the total cost of your debt. Even with ultra-low rates, you can easily pay more in total interest if you stretch out your payments over many years.
If your problems stem from overspending, review your debt-to-income ratio and by all means consolidate your debts, but do so as part of a determined effort to improve your long-term finances. That means drawing up a sensible household budget that balances your books, and provides you with the resources to pay down everything you owe as quickly as you realistically can. Sounds painful? It probably will be. But the alternative is to continue to kick the can down the road. And one day, when you're retired and there's no road left, you may bitterly regret that.