When your debt spirals out of control and gets too hard to handle, it’s important to find the right financial tools to help you take control and get out of the red.
Just as there are strategies to build wealth, there are ways to dig out of debt, too. Debt consolidation is one such tool to consider.
What is debt consolidation?
Debt consolidation, sometimes called credit consolidation, involves merging multiple debts into a single debt. Instead of, say, having to make separate payments to multiple credit cards each month, you can roll all of them into one payment to a single lender, often at a lower interest rate. This strategy can make it easier, and maybe even less expensive, for borrowers like you to pay off debts.
You can use low interest debt consolidation loans to clear up different kinds of debt, including:
- Credit cards
- Medical expenses
- Retail store cards
- Personal loans
- Student loans
How can you benefit from consolidating debt?
Debt consolidation can help you manage debt more effectively by saving you money on late fees, decreasing the amount of monthly payments you need to make and lowering monthly interest rates.
In a broader sense, debt consolidation can also create long-term benefits by improving your credit score.
The factors that credit bureaus look at when determining your score include late payments and credit utilization, the ratio between your available credit and the credit you’re currently using (credit card balances, mortgages, car loans, etc.). Experts recommend keeping the ratio at 30 percent or lower to show potential lenders that you can use your credit responsibly without getting overextended.
By not using credit cards and instead repaying via debt consolidation, you can lower your credit-utilization ratio which in turn positively impacts your credit score.
Which debts can you consolidate?
Although you can use debt consolidation for different purposes, it’s not an all-purpose solution.
It typically addresses unsecured consumer debt, such as credit cards, medical bills and personal loans — or debt that doesn’t require putting up property as security, as you would with an auto loan or a home mortgage. If you have concerns about debt on a vehicle or house, you may need to look into an auto refinancing loan or a mortgage refinance.
Also, you may need a specific type of debt consolidation for particular situations, such as student loan consolidation.
When debt consolidation makes sense
Debt consolidation makes sense for people looking to simplify their finances or reduce monthly payments. It’s also a great tool for people looking to minimize the amount of interest accrued from debt.
When debt consolidation doesn’t make sense
If you have a low credit score, debt consolidation may not be your best option.
People with poor credit may not qualify for a worthwhile loan. Plus, even if you do qualify, you may not actually benefit from lower interest rates. Currently, unsecured personal loans offered by Wells Fargo, for example, charge interest rates ranging from 7.49 percent to 24.49 percent, according to the bank’s website.
Undisciplined spenders won’t benefit as much either, especially if they start racking up fresh debt on the credit cards they paid off with the consolidation loan.
Different methods of debt consolidation
There are several different debt consolidation options available to you.
Some options to consider include:
1. Low interest debt consolidation loans
The typical debt consolidation loan is a personal loan that helps you manage your debt in three steps:
- The lender issues the loan in a single lump sum
- You use the money to pay off debts
- You repay the lender who issued the consolidation loan
Pros and cons:
- PRO: Consolidation loans offer the convenience of one monthly payment — no more tracking multiple statements and keeping track of which bill is due when.
- PRO: You can save money by getting a loan with a lower interest rate than what you’re currently paying on the debts you want to consolidate. Current interest rates on debt consolidation loans can be found for as low as 6 percent.
- PRO: Your credit card accounts can be paid off in full and the accounts are left open and active.
- CON: Although simpler and less costly, a debt consolidation loan is still a form of debt. You’ll need financial discipline to handle your consolidated debts responsibly and not run up new debt.
2. Personal loans
Unsecured personal loans through a bank, credit union or online lender are another way to consolidate debt from credit cards and other creditors.
A personal loan may enable you to pay a lower fixed-rate on your total debt, instead of high variable-rate APRs (annual percentage rate) often seen on credit cards. But the lowest rates often go to the those with the best credit.
Pros and cons:
- PRO: These loans typically come with lower borrowing costs than you’ll find with credit cards, reducing the overall interest you’ll pay on your debt.
- PRO: There’s only one monthly payment to make.
- PRO: The term of the loan has an end date, tying you to a date when you’ll pay off the loan and, hopefully, be debt free. In general, personal loans must be repaid in one to five years.
- CON: If your credit isn’t ideal, your interest rate could be the same as your credit cards or ever higher.
- CON: You may not qualify if your debt-to-income ratio is too high.
3. Balance transfer credit cards
If you’re looking for an easy way to consolidate credit card debt, a balance transfer offer from a bank offering low teaser rates is an option to consider.
Carrying a large balance on your card can be costly, especially if the bank is charging a high APR, or annual percentage rate.
A balance transfer credit card allows you to transfer outstanding credit card balances to the new card. Balance transfer cards often include special introductory APRs, often as low as 0 percent for a limited period, sometimes as long as 18 months.
Pros and cons:
- PRO: A balance transfer card can offer temporary relief from cards with high APRs.
- PRO: Although rules vary by provider, many cards let you transfer two to five credit balances to one account.
- CON: When the introductory period ends, any balance you have on the transfer card will be subject to a market-rate APR, which is likely to be substantially higher.
4. Home equity loan/line of credit
Although not called debt consolidation loans, these lines of credit can be used to provide money for that purpose. If you own your home, and have built up sizable equity, borrowing against your home to consolidate debt may be a good choice.
Pros and cons:
- PRO: Home equity coupled with a good credit score can help you get more affordable interest rates.
- PRO: You may be able to get a fixed interest rate with a longer term than other consolidation methods.
- CON: A home equity loan or HELOC requires using your house as collateral. Defaulting would put your house at risk of foreclosure.
Find your best way to get out of debt
Consolidating debt may not work for every situation. If your debt has become serious enough to threaten your financial well-being, you may need to consider other options for getting out of debt.
However, if things like credit card balances and medical bills are just a problem and not a crisis, look into a debt consolidation strategy.
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Find a personal loan that's right for you.