What Is Debt Consolidation, and Should I Consolidate?

Debt consolidation is another option for managing your debts when you owe too much to your creditors. It involves using new debt to pay off existing debt. When done right, it can help you get out of debt faster and pay less interest on your debts. 

Although debt consolidation is not the answer to your money problems, in many situations, it can help when you use it together with other debt-management strategies. However, if your finances are in really bad shape, consolidating your debts probably won’t help much, if at all. 

In this article, we explain when debt consolidation is and isn’t a good debt-management strategy. We also review the various ways you can consolidate your debts, explain how each option works, and review their advantages and disadvantages. We then warn you against dangerous debt consolidation offers that harm, not help, your finances.

What is Debt Consolidation?

Consolidation of debts refers to the process of combining a person’s personal debts into a single larger debt. Through debt consolidation, people get one loan which they use to pay off all smaller loans or outstanding debts.

By doing so, consumers would only have to make a single monthly payment. Making payments and managing them would be easier. Getting a lower interest rate is an important aspect of debt consolidation.

A lower monthly payment is also generally achieved through the process. The debt can still be repaid faster despite the lower payment.

When Debt Consolidation Makes Sense

When you consolidate debt, you use credit to pay off multiple debts, exchanging multiple monthly payments to creditors for a single payment. When done right, debt consolidation can help you accelerate the rate at which you get out of debt, lower the amount of interest you have to pay to your creditors, and improve your credit rating. However, to achieve these potential debt-consolidation benefits, the following criteria need to apply:

  • The interest rate on the new debt is lower than the rates on the debts you consolidate. For example, say you have debt on credit cards with interest rates of 22 percent, 20 percent, and 18 percent. If you transfer the debt to a credit card with a rate of 15 percent, or you get a bank loan at a rate of 10 percent and use it to pay off the credit card debt, you improve your situation.
  • You lower the total amount of money you have to pay on your debts each month.
  • You don’t trade fixed-rate debt for variable-rate debt. The risk you take with a variable rate is that although the rate starts out low, it could move up. In the worst-case scenario, the rate could increase so much that you end up paying more each month on your debt.
  • You pay off the new debt as quickly as you can. Ideally, you apply all the money you save by consolidating (and more, if possible) to pay off the new debt.
  • You commit to not taking on any additional debt until you pay off the debt you consolidated.

Paying less on your debts isn’t the only benefit of debt consolidation. Another advantage is that by juggling fewer payment due dates, you should be able to pay your bills on time more easily. On-time payments translate into fewer late fees and less damage to your credit history. 

However, too many consumers consolidate their debts and then get deep in debt all over again because they are not good money managers, because they have spending problems, or because they feel less pressure after they’ve consolidated and get careless about their finances. For these consumers, debt consolidation becomes a dangerous no-win habit.

How To Consolidate Your Debt

You can consolidate your debts in several ways:

  • Transferring high-interest credit card debt to a credit card with a lower interest rate
  • Getting a bank loan
  • Borrowing against your whole life insurance policy
  • Borrowing from your retirement account

Deciding whether debt consolidation is right for you and which option is best can be confusing. If you need help figuring out what to do, talk to your CPA or financial advisor, or get affordable advice from a reputable nonprofit credit counseling organization. The more debt you’re thinking about consolidating, the more important it is to seek objective advice from a qualified financial professional. Otherwise, you may make an expensive mistake.

1. Transferring balances

Transferring high-interest credit card debt to a lower-interest credit card — the lower, the better — is an easy way to consolidate debt. You can make the transfer by using a lower-rate card that you already have, or you can use the Web to shop for a new card with a more attractive balance transfer option. 

Before you transfer balances, read all the information provided by the card issuer that explains the terms and conditions of the transfer — the stuff in tiny print. After you review it, you may conclude that the offer isn’t as good as it appeared at first glance. 

For example, you may find that the transfer offer comes with a lot of expensive fees and penalties and that the interest rate on the transferred debt can skyrocket if you’re just one day late with a payment. Also, higher interest rates (not the balance transfer interest rate) apply to any new purchases you make with the card, as well as to any cash advances you get from it. 

If the credit card offer does not spell out what the higher rates are, contact the card issuer to find out. When a credit card company mails you a preapproved balance transfer offer, the interest rate on the offer may not apply to you. That’s because most offers entitle the credit card company to increase the interest rate after reviewing your credit history.

To be sure that a balance transfer offer will really save you money, ask the following questions:

What’s the interest rate on the offer, and how long will the rate last? Many credit card companies try to entice you with a low-rate balance transfer offer, but the offered interest rate may expire after a couple of months, and then it may increase considerably. In fact, you could find yourself paying a higher rate of interest on the transferred debt than you were paying before. If you can’t afford to pay off the new debt while the low-rate offer is in effect, don’t make the transfer unless the higher rate will still be lower than the rates you are currently paying.

Some people try to avoid higher rates on transferred credit card debt by regularly moving the debt from one card to another. Doing so damages your credit history and hurts your credit scores.

What must I do to keep the interest rate low? Know the rules! Usually, a low rate will escalate if you don’t make your card payments on time. However, if the card you use to consolidate debt includes a universal default clause, the credit card company can raise your interest rate at any time if it reviews your credit history and notices that you were late with a payment to another creditor, took on a lot of new debt, bounced a check, and so on.

The method you use to transfer credit card debt — going to the bank to get a cash advance through your credit card, writing a convenience check, or handling the transfer by phone or at the Web site of the credit card company — can affect the interest rate you end up paying on the new debt, as well as the fees you’re charged as a result of the transfer. 

Typically, getting a cash advance at your bank is the most costly option. Before you transfer credit card debt, be sure you know the interest rate and fees associated with each transfer option, and choose the one that costs the least.

If you decide to use one of the convenience checks you receive from a credit card company, be aware that some of those checks may have lower interest rates than others, and the interest rates associated with some of the checks may last longer than with others. The credit card company should spell out the terms associated with each check in the information it mails with the checks. If you’re confused, call the credit card company.

When will interest begin to accrue on the debt I transfer? Usually, the answer is “right away.”

How much is the balance transfer fee? Fees vary, but typically they are a percentage of the amount you transfer, although some credit card companies may cap the amount of the fee at $50 to $75. Some credit card companies charge a flat balance-transfer fee.

What method will the credit card company use to compute my monthly payments? Credit card companies use one of several types of balance-computation methods to determine the amount you must pay each month; some methods cost you more than others.

Look for a card that uses the adjusted balance or the average daily balance (excluding new purchases) method to figure out your minimum monthly payments. Avoid credit cards that use the two-cycle average daily balance method, if you can.

Also note whether the card has a 20-, 25- or 30-day grace period — the number of days between statements. You pay the most to use a card with a 20-day grace period.

If you plan to make purchases with the credit card after you’ve paid off the transferred card balances, also pay attention to the interest rate that applies to new purchases. Also, if you use the card to make purchases, the bank that issued you the card will probably apply your payments to the lowest interest rate balance first. So every time you make a purchase, you’re potentially converting lower-rate debt to higher-rate debt.

2. Getting a bank loan

Borrowing money from a bank (or a savings and loan or credit union) is another way to consolidate debt. However, if your finances aren’t in great shape, you may have a hard time qualifying for a loan with an attractive interest rate. 

You can use different types of loans to consolidate debt: debt consolidation loans, loans against the equity in your home, and loans to refinance your mortgage. When you’re in the market for any type of loan, it pays to shop around. 

Some lenders offer better terms on their loans, and some loan officers may be more willing than others to work with you. However, if you have a good long-standing relationship with a bank, contact it first.

Taking out a debt consolidation loan

As the name implies, a debt consolidation loan has the specific purpose of helping you pay off debt. Depending on the state of your finances and how much money you want to borrow, you may qualify for an unsecured debt consolidation loan — one that doesn’t require a lien on your assets. If you qualify for only a secured debt consolidation loan, you have to let the bank put a lien on one of your assets. 

That means that if you can’t keep up with your loan payments, you risk losing the asset. It also means that if you have no assets to put up as collateral, getting a debt consolidation loan is out of the question. If a lender tells you that the only way you can qualify for a debt consolidation loan is to have a friend or family member cosign the note, think twice before you do that. As a cosigner, your friend or family member will be as obligated as you are to repay the debt. 

If you can’t keep up with your payments, the lender will expect your cosigner to finish paying off the note, and your relationship with the cosigner may be ruined as a result. Plus, making the payments could be a real financial hardship for your cosigner, and if she falls behind on them, her credit history could be damaged.

Borrowing against your home equity

If you’re a homeowner and are current on your mortgage payments, some lenders may suggest that you consolidate your debts by borrowing against your home’s equity. Equity is the difference between your home’s current value and the amount of money you still owe on it. 

Most lenders will loan you up to 80 percent of the equity in your home. Some lenders let you borrow more than the value of your equity in some cases. Never do that! If you borrow more than the value of your equity and then you need or want to move, you won’t be able to sell your home because you owe more on it than it is worth.

Consolidating debt by using a home equity loan can be attractive for a couple of reasons:

  • It’s a relatively easy way to pay off debt, and the loan’s interest rate is lower than in some other debt consolidation options.
  • Assuming that you’re not borrowing more than $100,000, the interest you pay on the loan is tax-deductible.

However (and this is a really big however), your home secures the loan, which means that if you can’t make the loan payments, you can lose your home. If your finances are already going down the tubes, borrowing against the equity in your home is risky business and just doesn’t make sense. 

And even if you’re able to meet your financial obligations right now, if you owe a lot to your creditors and you have little or nothing in savings, a job loss, an expensive illness, or some other financial setback could make you fall behind on your home equity loan.

Also, be aware that if you sell your home and you still owe money on your mortgage and on your home equity loan, you have to pay back both loans for the sale to be complete. In other words, if your home doesn’t sell for enough to pay off everything you owe on your home, you have to come up with enough money to pay the difference. If the housing market in your area is cooling off, and especially if you paid top dollar for your home, consolidating debt by tapping your home’s equity is probably not a good move.

If you do decide that a home equity loan makes sense for you, keep the following in mind:

  • Borrow as little as possible, not necessarily the total amount that the lender says you can borrow.
  • Pay off the debt as quickly as you can. Lenders typically offer very relaxed home equity loan repayment terms, and why not? The longer it takes you to repay your home equity debt, the more money the lender earns in interest.
  • Know your rights. When you borrow against your home, the Federal Truth in Lending Act requires lenders to give you a three-day cooling-off period after you sign the loan paperwork. During this time, you can cancel the loan in writing. If you do, the lender must cancel its lien on your home and refund all the fees you’ve paid.
  • Beware of predatory home equity lenders who encourage you to lie on your loan application so you can borrow more money than you actually qualify for. These lenders gamble that you’ll default on the loan and they’ll end up with your home. The same is true of unscrupulous home equity lenders who overappraise your home (give it a greater value than it’s really worth) in order to lend you more money than you can afford to repay.
  • Also steer clear of lenders who want you to sign loan agreements before all the terms of the loan are spelled out in black and white, and avoid loans with prepayment penalties.

You can tap the equity in your home in one of two ways: by getting a home equity loan or by using a home equity line of credit. Here’s a quick overview of how each option works:

Home equity loan: The loan has a fixed or variable interest rate, and you repay it by making regular monthly payments for a set amount of money over a specific period of time. If you apply for a variable-rate loan, be sure you understand what will trigger rate increases and the likely amount of each increase. If you’re not careful, the initial rate can increase so much that you may begin having problems making your loan payments.

Home equity line of credit (HELOC): A HELOC functions a lot like a variable-rate credit card. You’re approved to borrow up to a certain amount of money — your credit limit — and you can tap the credit whenever you want, usually by writing a check. Typically, a lender will loan you up to 80 percent of the value of the equity you have in your home. The lender also reviews your credit history and/or credit score and takes a look at your overall financial condition.

Although you have to repay a home equity loan by making fixed monthly payments that include both interest and principal, with a HELOC, you usually have the option of making interest-only payments each month or paying interest and principal on the debt. If you opt to make interest-only payments, the amount of the payments depends on the applicable interest rate and on how much of your total credit limit you are using. For example, if you have a $10,000 HELOC but you’ve borrowed only $5,000 of that money, the amount of interest is calculated on the $5,000.

The problem with making interest-only payments is that the longer the principal is unpaid, the more your HELOC costs you, especially if the interest rate starts to rise. 

Also, if your HELOC expires after a certain number of years and there is no provision for renewing it, the lender will probably want you to pay the total amount you still owe in a lump sum, also known as a balloon payment. If you can’t afford to pay it, you may lose your home. Federal law requires lenders to cap the interest rate they charge on a HELOC. 

Before you sign any HELOC-related paperwork, get clear on the cap that applies. Also, find out if you can convert the HELOC to a fixed interest rate and what terms and conditions apply if you do.

See our guide to home equity loans and HELOCs to learn more about how to tap the equity of your home.

Refinancing your mortgage and getting cash out: If you’re still paying on your mortgage, refinancing the loan at a lower rate and borrowing extra money to pay off other debts may be another debt consolidation option to consider. (The new mortgage pays off your existing mortgage.) However, refinancing is a bad idea if

  • You’ve been paying on the mortgage for more than ten years, assuming it’s a 30-year note. During the first ten years of a loan, your payments mostly go toward the interest on your loan, and only a relatively small amount of each of your payments is applied to your loan principal. However, after ten years of making payments, you begin whittling down the balance on your loan principal at a faster rate. This means that with each payment you are closer to having your mortgage paid off and to owning your home outright. If you refinance your loan, however, you start all over again with a brand-new mortgage, which means that you’ll be paying mostly interest on the loan for a long time to come. Even so, if the new loan has a shorter term than your previous loan, paying mostly interest at first may not be an issue.
  • You can’t afford the payments on the new loan. If you fall behind, eventually your mortgage lender will initiate a foreclosure.

It may make sense to consolidate debt by going from a 30-year note to a 15-year note, assuming that you can afford the higher monthly payments. (You pay less interest on a 15-year mortgage, so going from a 30-year to a 15-year loan won’t mean doubling your monthly payments.) 

Run the numbers with your loan officer. You’re playing with fire if you use a mortgage refinance to consolidate debt by trading a traditional mortgage for an interest-only mortgage. Sure, your monthly payments may be lower initially, but after five years (or whenever the interest-only period ends), they will increase substantially, maybe far beyond what you can afford.

Learn more about whether you should refinance your mortgage.

3. Borrowing against your life insurance policy

If you have a whole life insurance policy, you can consolidate your debts by borrowing against the policy’s cash value. If you have this kind of policy, you pay a set amount of money each month or year, and you earn interest on the policy’s cash value. This option has two advantages:

  • You don’t have to complete an application, and there’s no credit check. 
  • After you borrow the money, you won’t have to repay it according to a set schedule. In fact, you won’t have to repay it at all.

But there’s a catch, of course. After you die, the insurance company deducts the loan’s outstanding balance from the policy proceeds. As a result, your beneficiary may end up with less than he or she was expecting, which can create a financial hardship for that person. For example, your surviving spouse or partner may need the money to help pay bills after your death, or your child may need the policy money to attend college. 

Before you borrow against your life insurance, read your policy so you understand all the loan terms and conditions. Also, be clear about any fees you may have to pay because they will affect the loan’s total cost. If you’re unsure about anything, talk with your insurance agent or broker.

4. Borrowing from your 401(k) retirement plan

If you’re employed, you may be enrolled in a 401(k) retirement plan sponsored by your employer. If your employer is a nonprofit, you may have a 403(b) retirement plan, which works like a 401(k). The money you deposit in your retirement plan is tax-deferred income. 

In other words, whatever you deposit in the account each year isn’t recognized as income until you begin withdrawing it during your retirement years. Your employer may match a certain percentage of your deposits. 

Most employers that offer 401(k) plans allow their employees to borrow the funds that are in their retirement accounts, up to $50,000 or 50 percent of the value of the account, whichever is less. If the value is less than $20,000, your plan may allow you to borrow as much as $10,000 even if that represents your plan’s total value. 

No matter how much you borrow, you have five years to repay the money, and you’re charged interest on the unpaid balance. Borrowing against your 401(k) plan may seem like an attractive way to consolidate debt — after all, you’re just borrowing your own money! 

You have no loan application to complete and no credit check. However, unless you’re absolutely sure that you can and will repay the loan within the required amount of time, taking money out of your retirement account to pay off debt is a really bad idea. Here’s why:

If you don’t repay every penny within five years (and assuming that you’re younger than 591⁄2 when you borrow the money), you have to pay a 10-percent penalty on the unpaid balance. On top of that, the IRS treats whatever money you don’t repay as an early withdrawal from your retirement account, which means that you’re taxed on it as though it’s earned income. As a result, on April 15, you can end up owing Uncle Sam a whole lot more in taxes than you anticipated, and you may not have enough money to pay them.

You may promise yourself that you’ll repay your retirement account loan, but with no lender (or debt collector) pressuring you into paying what you owe, are you disciplined enough to do that? If you’re like a lot of consumers, you’ll keep promising yourself that you’ll pay back the loan, but you’ll never get around to it. Or if you begin having trouble paying for essentials, those expenses will take priority, and you may have no money left to put toward repaying your retirement account loan.

Every dollar you borrow represents one less dollar you’ll have for your retirement if you don’t repay the loan. Using your retirement account as a piggy bank could make your so-called golden years not so golden.

While the loan is unpaid, your retirement account earns less tax-deferred interest. Therefore, the account will have less money when you retire.

If your employer matches the contributions you make to your retirement plan, those contributions may end while you’re repaying the loan. This also means less money for your retirement.

Your employer may charge you a steep loan application fee — a couple hundred dollars or more. The fee increases the total cost of the loan.

If you leave your job before you’ve paid off the loan — regardless of whether you leave because you found a better job, you were fired or laid off, or your employer went belly up — your employer will probably require that you repay the full amount of your outstanding loan balance within a very short period of time, somewhere between 30 and 90 days. If you can’t come up with the bucks, the IRS will treat the unpaid money as an early withdrawal for tax purposes, and you’ll also have to pay the 10-percent early withdrawal penalty.

Use the online 401(k) calculator to figure out whether borrowing from your 401(k) is a good idea.

If you’re younger than 59.5, you may qualify for an early hardship withdrawal from your 401(k), even if your plan doesn’t permit you to borrow from it. A withdrawal differs from a loan because you take the money out of your account without the option of repaying it. 

Therefore, you are permanently reducing the amount of money you’ll have for your retirement. To be eligible for a hardship withdrawal, you must prove to your employer that you have “an immediate and heavy financial need” and that you’ve exhausted all other financial avenues for handling the need.

Although your employer determines what constitutes “an immediate and heavy financial need,” avoiding eviction or foreclosure or paying steep medical bills almost certainly qualifies. You have to pay federal taxes on the money you take out for the year in which you get the money, and you also have to pay a 10-percent early withdrawal penalty. There’s no free lunch in life, is there?

Avoiding Debt-Consolidation Scams

When your debts are creating a lot of stress, your judgment may get clouded. You may start grasping at straws and do something really stupid that you would never do if you were thinking clearly — like fall for one of the many debt consolidations offers out there that are outrageously expensive, and maybe even scams. Here are some of the worst offenders to avoid:

Debt-counseling firms that promise to lend you money to help pay off your debts: If you get a loan from one of these outfits, it will not only have a high-interest rate, but you may have to secure the loan with your home. Watch out! 

Finance company loans: These companies often use advertising to make their debt consolidation loans sound like the answer to your prayers. They are not. Finance company loans typically have high rates of interest and exorbitant fees. As if that’s not bad enough, working with a finance company will further damage your credit history.

Lenders who promise you a substantial loan (probably more than you can afford to repay), no questions asked, in exchange for your paying them a substantial upfront fee: No reputable lender will make such a promise. Not only will these disreputable lenders charge you a high percentage rate on the borrowed money, but they will also put a lien on your home or on another asset you don’t want to lose.

Companies that promise to negotiate a debt consolidation loan for you and to use the proceeds to pay off your creditors: In turn, they tell you to begin sending them money each month to repay the loan. The problem with many of these companies is that they never get you a loan or pay off your creditors. You send the company money every month while your credit history is being damaged even more, and you’re being charged interest and late fees on your unpaid debts.

Leave a Comment