How to Consolidate Your Debt

Whether you’re just looking to put a dent in your principal balances or are struggling to make payments, you may be considering debt consolidation. After all, these loans can sound pretty promising, offering borrowers a way to get out of debt faster, pay less money, and lock in more manageable monthly payments.

However good debt consolidation may sound, though, it’s important to know what you’re getting into. These loans can be a life raft for borrowers in over their heads… but they don’t come without a price.

In podcast 323, we’ll ask you to think about a series of questions where you might discover new ways to think about debt and consolidation.

Now, let’s take a look at what debt consolidation is, important myths about these loans, and why you might (or might not) benefit from one.

All About Debt Consolidation

Debt consolidation and debt negotiation programs (DNPs) have earned some bad reputations over the years. These types of services are often associated with seedy companies more interested in helping themselves than helping consumers.

To be fair, the debt consolidation industry is largely responsible for spurring on its own questionable reputation. The Federal Trade Commission, for example, warns consumers about the false promises that 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.

But the concept behind debt consolidation is still a good one for many people overwhelmed by debt. By consolidating debt, borrowers have the ability to lower the interest rate on their debt and lower their monthly payments. This, in turn, can make paying down debt and providing for other expenses more manageable.

Before you start applying for a debt consolidation loan program, though, there are a few key things to consider.

Your credit score

Opening new accounts, even for the purpose of debt consolidation, can still weigh on your credit score. This doesn’t mean you shouldn’t ever open new accounts to get lower interest rates. Just do so with care.

Lower interest rates

One of the key goals of debt consolidation is to get a lower interest rate on your repayment. 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 avoid a consolidation altogether.

Falling back into debt

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 soon thereafter because their habits never changed.

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. Or maybe you use a 0% balance transfer offer to pay off existing credit card debt, only to rack up a balance on the original card all over again.

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 of which are sponsored by the federal government, covering education loan consolidation.

There are some predatory student loan consolidation companies out there, but there are also a lot of really great options to help you save money while paying back that educational debt (I saved $44,000 on my loans with a refi, in fact!)–but that’s an article for another day.

Related: How to Refinance a Student Loan in 15 Minutes with Sofi

Debt Consolidation Myths

Before we delve into the how-to (and what-to-avoid) of debt consolidation, let’s talk about a few prevalent myths floating around. This isn’t to say that some of them aren’t rooted in truth, but you should take each of them with a grain of salt.

Myth 1: Consolidating your bills means you’ll be in debt longer

For some borrowers, this isn’t a myth at all: it’s actually quite easy to consolidate your debt only to realize that you’ll be paying off the balance for even longer than before. It’s important to remember that this isn’t necessarily the nature of debt consolidation loans, though.

When selecting new loan terms, the borrower has the opportunity to choose his or her priorities. Do you want to pay off your debt for the lowest amount? Do you want to reduce your monthly payment? Or are you more interested in getting out of debt sooner?

By choosing a longer loan term, you can usually reduce your monthly payment by a lot. However, this will extend the length of repayment, so you may actually be in debt longer.

Myth 2: You will be tricked into rising interest rates

If you go into any financial product or service with open eyes, it’s hard to be tricked… especially into something like interest rates. However, it is true that you could wind up carrying a debt consolidation loan with rising interest rates.

Many banks offer lower rates to borrowers who choose a variable rate loan, versus a fixed-rate one. This can work out well if the market stays put or if federal rates drop while you’re paying off the debt. If the opposite happens, though, you could very well see your consolidation loan’s rate rise and rise.

If you want to avoid any chance of this happening, don’t choose a loan with a variable or hybrid rate… even if it appears to save you more money in the beginning. The only way to predict your rate for the life of your loan is to choose a fixed rate product.

Myth 3: Debt consolidation is a rip-off

Yes, there have been countless consumers “ripped off” by debt consolidation companies. As with many subsets of the financial industry, debt consolidation has no shortage of shady companies willing to prey on desperate borrowers. To those victims, I sympathize with your plight.

With that said: debt consolidation is not, as a whole, a rip-off. In fact, there are many excellent and honest companies out there, and a debt consolidation loan can be a great way to reduce your debt burden and get out from under those balances sooner.

The trick lies in choosing an ethical company and reading the fine print many, many times.

Myth 4: Debt settlement and debt consolidation are the same thing

Debt settlement and debt consolidation may have a lot of overlap when it comes to target markets and purpose, but they are not the same thing. In fact, they are quite different from one another.

Debt settlements aim to, as the name implies, settle consumers’ debt with creditors. This process can help those struggling to make monthly payments or who want to eliminate some of the balances owed… but it comes at a high price. Debt settlement can seriously damage your credit, and typically comes with a high price tag for services rendered.

In contrast, debt consolidation takes the debt you have and simply combines it into one loan. You don’t save yourself anything in terms of principal balances–your debt is still yours–but you can save money on interest payments over time. And while debt consolidation loans can ding your credit initially, the impact is usually short-lived.

Myth 5: Debt consolidation will save you a lot of money

As with the other myths, this one is rooted in truth.

No, debt consolidation will not always save you money. In fact, by choosing a consolidation loan with longer repayment terms, you may wind up paying more in interest in the end.

However, it may save you money, depending on the loan you choose. By lowering your interest rate, reducing your repayment term, and/or adjusting your monthly payment, the potential to save money definitely exists.

DIY Debt Consolidation Techniques

This still leaves a few big questions:

• How should I go about consolidating debt?
• Should I use a debt consolidation company?
• Should I negotiate directly with my creditors?

To help answer these questions, we have compiled eight ways that you can consolidate your own debt–DIY-style. There are advantages and disadvantages to each option, which I’ll explain below.

Cash-Out Home Refinance

Cash-out refinancing is when you refinance your mortgage for more than you currently owe, in an effort to take cash (your equity) out.

For example, let’s assume you owe $150,000 on a home that is worth $250,000, and you also owe $25,000 on 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; depending on the terms of the loan, they could be significant.

Home Equity Line of Credit (HELOC)

A home equity line of credit, or HELOC, is similar to a credit card in that it’s a revolving line of credit based on the equity you hold in your home. A HELOC allows you to write checks up to the amount of your credit limit, and can be used for a number of different purposes.

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 the required payments, you could lose your home.

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, however, works more like a car loan: you borrow a set amount of money and repay it over a fixed period of time (like a car loan)

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.

Low-Interest Credit Card

Low-interest rate credit cards can be used to consolidate higher rate debt. But they don’t come without warnings of their own.

You can expect to pay between 2% and 5% of the outstanding balance as a minimum payment each month. Low-interest cards generally require excellent credit to qualify, too, so this may not be an option for some borrowers. And if you have overspending issues, even a low-interest credit card can lead you into more debt.

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. Many of these cards have no balance transfer fee, but remember, this is not the same as a 0% balance transfer. In other words, while you pay no transfer fee, you do pay interest on the amount transferred (typically between 7% to 9%)… it’s just lower that you’re likely already paying on the balance(s).

Second, you could use a low-interest card for everyday purchases, then take the money you would have spent and use it to pay down high-interest-rate debt. This requires some discipline, but is an easy option.

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.

0% Balance Transfer

Unlike a low-interest rate card, a 0% balance transfer credit 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. This makes them a great option for borrowers who want to consolidate high(er) interest debt and save money.

Most of these cards charge a balance transfer fee, which is 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.

Advantages:

• 0% 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 a balance transfer fee upfront.

Peer-to-Peer (P2P) Loan

Social lending companies, like Prosper or LendingClub, have become more mainstream in recent years. It’s with good reason, too. For many borrowers, they offer a great way to get competitive loans with terms that work.

With these online companies, you can apply for, say, a 3-year fixed-rate loan. Unlike a traditional loan, however, the money doesn’t come from a bank or other financial institution: it comes from individuals looking to invest in consumer loans. (Hence “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 limits are as high as $40,000 with the more popular companies, although you can often obtain up to two loans at once.

401(k) Loan

Some 401(k) programs allow you to borrow up to 50% of your retirement balance (maximum $50,000), if needed. You then repay the loan with interest, but the interest is paid back to your own retirement account.

This can be a good 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 immediately. If you fail to repay the loan within five years, 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 to remove your money from the stock market to repay debt, as it impacts the growth of your funds. You should consider the interest rate on the debt you would pay off, and how your money is invested in the first place, before going this route. Regardless, though, it 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.

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.

Final Thoughts

Debt isn’t always detrimental. Yes, it can be quite bad if you overextend yourself, but there are some forms of debt that are quite beneficial.We talk about this in podcast 323. Listen to the audio version below or the video at the top of this article to put your knowledge to the test with a debt consolidation quiz. Think mortgages, your education, and the like; debt doesn’t all “suck.”

In that same vein, debt consolidation isn’t always bad. Yes, there are many predatory companies looking to take advantage of desperate borrowers. And there are many bad consolidation loans that could mean paying more money and/or being in debt longer.

But not all of them.

In fact, there are also debt consolidation companies that benefit borrowers every single day. Many of them offer loans that make it easier to manage debt, lower interest charges, get out of debt sooner, lower monthly payments, or all of the above.

If you’re feeling overwhelmed by your existing debt, think about the ways that you can optimize your situation. That may mean a balance transfer, strict budget, or even a good ol’ fashioned debt snowball. Or for many of you, it might involve a properly-vetted debt consolidation loan.