How to Consolidate Your Debt

Debt consolidation and debt negotiation programs (DNP) are often associated with seedy companies more interested in helping themselves than helping consumers. The debt consolidation industry is largely responsible for earning this questionable reputation. The Federal Trade Commission, for example, warns consumers about the false promises many in the debt business make to consumers. And the FTC has even brought legal action against “non-profit” debt negotiation companies for violating federal consumer protection laws. The FTC has published an excellent article called Knee Deep in Debt that talks in part about DNPs and is definitely worth reading.

But the concept behind debt consolidation is still a good one for many people overwhelmed by debt. By consolidating debt, many can lower the interest rate on their debt and lower their monthly payments. This in turn can make paying your debt and providing for your other expenses more manageable. But this still leaves one big question—how? How should one go about consolidating debt? Should you use a debt consolidation company? Should you negotiate directly with your creditors?

To help answer these questions, below is a list of 8 ways you can consolidate your own debt. There are advantages and disadvantages to each option, which I’ll explain below. But before we get to the list, there are a few things to consider before you start a debt consolidation program:

• Credit Score: Opening a lot of new accounts for purposes of debt consolidation can weigh on your credit score. While this doesn’t mean you shouldn’t open new accounts to get lower interest rates, do so with care. You can check out How to Improve Your Credit Score for more information.
• Lower Interest: One of the key goals in debt consolidation is to get a lower interest rate on your debt. As a first step, however, contact your existing creditors to see if they will lower your interest rate. You may end up getting a better deal on some or all of your debt and not need to consolidate.
• Don’t be a Yo-Yo: Just like there are some who yo-yo diet (go up and down in weight), there are those who yo-yo debt. They pay off some debt, only to go into more debt. Debt consolidation can actually make this worse in some instances. For example, you may consolidate high interest credit card debt onto a home equity line of credit, only to charge your cards back up. If you think this is a big risk, think twice about debt consolidation, or figure out a way to discipline yourself from going into more debt.
• Student Loan Consolidation: This article does not cover the consolidation of student loans. There are separate programs, some sponsored by the federal government, covering education loan consolidation.

8 DIY Debt Consolidation Techniques

1. Cash Out Home Refinance: Cash out refinancing is when you refinance your mortgage for more than you owe. For example, let’s assume you owe $150,000 on a home that is worth $250,000, and you also owe $25,000 in high interest credit cards. In a cash out refinance, you would refi your mortgage for $175,000, paying off your original $150,000 mortgage and your $25,000 in high interest credit card debt.

Advantages

• Home mortgages offer some of the lowest interest rates available.
• The loan can be amortized over 30 years, resulting in lower payments for the consolidated debt.
• If you consolidate all of your debt in a cash out refi, you reduce your monthly payments to just your mortgage.

Disadvantages

• A home loan is secured by a mortgage on your home, meaning that if you fail to repay the loan, you could lose your home.
• Extending debt payments over 30 years could result in paying higher total interest payments on the debt.
• There are fees associated with refinancing a mortgage, and depending on the terms of the loan, they could be significant.

2. Home Equity Line of Credit: A home equity line of credit, similar to a credit card, is a revolving line that allows you to write checks up to the amount of your credit limit. A typical home equity line requires you to pay interest only on the balance for the first 10 years. The existing balance at year 10 is then converted into a loan amortized over 20 years. Once you have a home equity line established, consolidating your debt onto the line of credit is simply a matter of writing checks to pay off your other debts.

Advantages

• While interest rates on these lines of credit are higher than on a first mortgage, the rates typically are much lower than credit card rates and interest on other unsecured debt.
• Once established, it is very convenient to access the line of credit to consolidate bills.
• In many cases, there are no fees to establish a home equity line of credit.

Disadvantages

• As with a mortgage, a home equity line of credit is secured by your home. If you fail to make required payments, you could lose your home.

3. Home Equity Loan: A home equity loan is very similar to a home equity line of credit, with one major difference. With a line of credit, your outstanding balance can go up and down as you borrow and repay against the line of credit (again, much like a credit card). A home equity loan works more like a car loan. You borrow a set amount of money and repay it over a fixed period of time.

Advantages

• The advantages are the same as with a home equity line. However, you don’t write checks against a home equity loan. Instead, you receive a check from the bank in the amount of the loan that you can then use to pay off your other debts.

Disadvantages

• As with the two options above, a home equity loan is secured by your home. Fail to pay the loan, and you could lose your house.

4. Low Interest Credit Card: Low interest rate credit cards can be used to consolidate higher rate debt. Expect to pay between 2% and 5% of the outstanding balance as a minimum payment. Low interest rate cards generally require excellent credit to qualify. There are two ways to transfer high rate debt to a low interest card. First, you can use a balance transfer to a low rate card. These cards tyically charge no balance transfer fee, but remember, this is not a 0% balance transfer (see below). In other words, while you pay no transfer fee, you do pay interest on the amount transferred (typically between 7% to 9%). Second, you could use the low interest card for everyday purchases, and take the money you would have spent and use it to pay down high interest rate debt. Here is a list of low interest rate balance transfer credit cards.

Advantages

• It’s easy to apply for a low interest card online and to transfer balances to the card.
• The interest rates are not introductory teaser rates. While credit card companies can increase rates pursuant to the cardholder agreement and federal law, rates won’t go up simply because an introductory period expired.

Disadvantages

• These low interest credit cards require excellent credit, and as a result, can be difficult for many to obtain.
• It’s still a credit card, and interest rates can go up.

5. 0% Balance Transfer: Unlike a low interest rate card, a 0% balance transfer card offers no interest for a set period of time (typically 6 to 12 months). After that time, any remaining balance is charged the regular interest rate that applies to the card. In addition, these cards do charge a balance transfer fee, typically 3% to 5% of the amount transferred. For short-term debt consolidation, however, a no interest offer can save a lot of money in interest payments. Here’s a list of 0% balance transfer credit cards to consider.

Advantages

• Zero percent interest can save hundreds if not thousands of dollars in interest payments.
• It’s easy to apply online and transfer existing high interest credit card debts.

Disadvantages

• The 0% offers don’t last forever, and eventually the interest rates rise to whatever rates apply to the card.
• You will pay up front a balance transfer fee.

6. P2P Loan: Social lending from companies like Prosper or LendingClub have become more mainstream over the last year. With these online companies, you can apply for a 3-year fixed rate loan that must be paid back over 3 years. Unlike a traditional loan, however, the money doesn’t come from a bank or other financial institution. instead, the loan comes from individuals looking to invest in consumer loans. That’s why it’s called social lending or person-to-person lending.

Advantages

• P2P loans generally offer competitive interest rates to borrowers, although the rate you receive will depend on your credit history.
• The interest rate is fixed for the life of the loan.
• Loans can be obtained relatively quickly.

Disadvantages

• There are fees associated with obtaining a P2P loan. The fees vary based on a number of factors, including the amount of the loan.
• The loan limit is $25,000, although you can typically obtain up to 2 loans at one time.

7. 401k Loan: Some 401k programs allow you to borrow up to 50% of your retirement balance (maximum $50,000). You then repay the loan with interest, but the interest is paid back to your own retirement account. This can be a great way to consolidate high interest debt, but there are some significant risks to consider. For example, if you leave your job for whatever reason, you must repay the outstanding balance. If you fail to repay the loan, the IRS will consider the outstanding balance to be a distribution, and you could end up paying a 10% penalty on top of taxes. Some also believe it is a mistake with remove your money from the stock market to repay debt. Here, you should consider the interest rate on the debt you would pay off, and how your money is invested in the first place. Regardless, this is an option worth considering.

Advantages

• Interest payments are made back to your retirement account, so you don’t lose the money.
• If your company allows 401k loans, they are very easy to obtain.

Disadvantages

• The loan may be considered a distribution if you leave your job and are unable to repay the loan.
• The money borrowed will be removed from your investments.

8. Two or More of the Above: This may be obvious, but it’s worth noting. Debt consolidation does not always mean consolidating debt into a single loan. Depending on the particular circumstances, it may make sense to combine two or more of the above approaches to deal with your debt.