Getting out of debt is challenging, especially when you have multiple creditors. If you are juggling different accounts, payment amounts and due dates but feel like you’re chipping away at an iceberg, it’s time to consider debt consolidation.
Debt consolidation is the strategy of rolling many debts into a single payment. It can save you money in interest, help you pay off debts faster, simplify your finances and give you peace of mind.
5 best debt consolidation options:
- Balance transfer credit card.
- Home equity loan or home equity line of credit (HELOC).
- Debt consolidation loan.
- Peer-to-peer loan.
- Debt management plan.
1. Balance transfer credit card
You’ll need a balance transfer card with a credit limit that is high enough to accommodate the balances you’re rolling over and an annual percentage rate (APR) low enough to make it worthwhile. The best balance transfer cards often come with zero interest or a very low interest rate for an introductory period of up to 18 months.
A balance transfer card can be a good way to consolidate debt if you pay off the card before the introductory rate expires and you don’t rack up new debt.
Use a credit card balance transfer calculator to see how long it will take you to pay off your balances.
- Pros: It’s quicker and easier to get a balance transfer credit card than it is a bank loan, and you can save a lot of money in interest by paying off the balance before the introductory rate expires. Most cards let you transfer as many balances as you want, as long as your total balance is below the new card’s credit limit. Additionally, credit card debt is usually unsecured, so no collateral is required to qualify. If you default, you don’t risk losing assets.
- Cons: The biggest danger of a balance transfer card is that you risk running up balances on your credit cards again once you’ve paid them off, which only compounds the problem. Balance transfer cards often charge a fee of 3 percent to 5 percent of the amount transferred, and that gets tacked on to your balance. When the introductory rate ends, the card reverts to a variable APR that will be considerably higher. Applying for a new credit card also triggers a hard pull on your credit report, which can lower your credit score.
2. Home equity loan or home equity line of credit (HELOC)
Home equity is the difference between the appraised value of your home and how much you owe on your mortgage. If you’re a homeowner with enough equity and a good credit history, you can borrow some of that equity at an affordable rate to consolidate your debts. Many home equity borrowers use the money to pay off higher-interest debt, such as credit cards.
Your options for borrowing from home equity include home equity loans, which give you a lump sum of money at a fixed rate, and HELOCs, which give you a credit line to draw from at a variable rate. Both can be good options for debt consolidation if you have enough equity to qualify.
- Pros: Home equity loans have lower interest rates than credit cards or personal loans, and loan amounts tend to be larger than personal loan or credit card limits. A traditional home equity loan has a fixed rate and a fixed monthly payment, which makes budgeting easier, while HELOCs have a variable rate, which could be attractive if rates are trending downward. Repayment terms typically range from five to 30 years, giving borrowers plenty of time to repay the debt.
- Cons: The main drawback of a home equity product is that when you tap into your home equity, your home is the collateral that secures the debt. If you lose your job and can’t make the loan payments, the lender can take your home by foreclosure. Home equity loans also typically have longer funding timelines and longer repayment terms. A long repayment term may feel comfortable but will cost you more in the long run. Also remember that interest on home equity loans isn’t tax deductible unless the loan is used to build or improve your property.
3. Debt consolidation loan
A debt consolidation loan an be a smart way to consolidate debt if you qualify for a low interest rate, enough funds to cover your debts and a comfortable repayment term. These types of loans are unsecured, so your rate and borrowing limit hinge on your credit profile.
- Pros: You don’t have to use any assets, such as your home or car, as collateral to qualify for a debt consolidation loan. Interest rates are typically lower than those of credit cards and are fixed, meaning that monthly payments are the same each month. You can borrow as little as $1,000 or as much as $100,000, depending on the lender and your credit. Debt consolidation loans are widely available from traditional banks, credit unions, online banks, online nonbank lenders and peer-to-peer lenders. It can take as little as a day or a few days to qualify for a debt consolidation loan and get your funds.
- Cons: A large, low-rate debt consolidation loan requires excellent credit. Debt consolidation loan rates are typically higher than rates on home equity loans, and if your credit isn’t very good, a debt consolidation loan could cost as much or more than a credit card. Many debt consolidation loans also come with origination fees and penalty fees for paying late and paying off the loan before the term ends. Finally, scams are rampant in the debt consolidation loan marketplace, as are subprime lenders that charge exorbitant rates and fees to consumers with bad credit.
4. Peer-to-peer loans
Peer-to-peer lending platforms such as Upstart, Prosper, LendingClub and SoFi pair borrowers and individual investors for unsecured loans that generally range from $25,000 to $50,000. Like personal loans, P2P loans are unsecured, so the borrower’s credit history is the key factor for rates, terms, borrowing limits and fees. The higher your credit score, the lower the interest rate and the more you can borrow.
- Pros: Borrowers with tainted credit might find it easier to get a loan through a peer-to-peer network than from a traditional financial institution. P2P loans can be used for nearly anything you need, and the application and approval process is quick, because everything is done online. If your application sails through to approval, it’s possible to get funding the same day. The initial application for a P2P loan triggers a soft pull on your credit file and doesn’t hurt your credit score.
- Cons: Rates on P2P loans are generally higher than those on home equity loans, and you have far less time to repay the loan than you do credit cards and home equity loans — a combination of factors that could mean higher monthly payments. Interest rates can hover near 35 percent if your credit is bad, and many P2P loans come with origination fees that are deducted from the loan proceeds. There may also be penalty fees for late payments and for paying off the loan early.
5. Debt management plan
If you want debt consolidation options that don’t require taking out a loan or applying for a balance transfer credit card, a debt management plan could be right for you — especially as an alternative to bankruptcy.
With a debt management plan, you work with a nonprofit credit counseling agency to negotiate with creditors and draft a payoff plan. You close all credit card accounts and make one monthly payment to the agency, which pays the creditors. But you still receive all billing statements from your creditors, so it’s easy to track how fast your debt is being paid off. To create a debt management plan, stick with not-for-profit agencies affiliated with the National Foundation for Credit Counseling (NFCC) or the Financial Counseling Association of America and make sure that your debt counselor is certified by the Council on Accreditation.
- Pros: With a debt management plan, you’ll get some of the best loan rates for consolidating debts and an end to penalty fees for late payments and exceeding your credit limits, says Bruce McClary, spokesman for the NFCC. Some credit-counseling agencies may work for little to nothing if you’re struggling. If you keep up with your payments and don’t go deeper into debt, a debt management plan can help improve your credit score in the long term.
- Cons: Entering into a debt management plan does not lower your balances, and having to close out credit accounts to get on a debt management plan will lower your credit score. It’s also important to realize that being on a debt management plan will shift your relationship to money, as it’s recommended that you not use credit cards while you’re on the plan. You may be contacted by your debt management company if you take on any new debt.
How to avoid falling into debt
Consumers who have borrowed and spent so much that they must borrow more to consolidate debt need to take a hard look at their spending habits. “You need to identify where the debt came from,” says Celeste Collins, executive director of OnTrack WNC Financial Education & Counseling in North Carolina. “How did this balance get there? You need a comprehensive cash flow plan and to get serious about paying this down.”
Once you’re out of the debt hole, you can avoid that predicament again. Here are some rules to live by:
- Set a budget and stick to it. Live within your means.
- Avoid impulse purchases.
- Shop around for the lowest price before making a big purchase.
- If you use a credit card, pay off the balance each month to avoid interest charges.
- Keep your finances organized and keep a close eye on your bank balances.
- Stay away from “buy now, pay later” and “interest-free financing” offers, which just defer your debt.
- Save money. Try to set aside a certain percentage of your income to be swept into savings.
The bottom line
If you have to borrow money to consolidate debt, avoid subprime lenders that cater to consumers with bad credit — these lenders offer the highest interest rates and unforgiving loan terms, and it’s always better to shop around with traditional lenders first.
Also, take every precaution to make sure that your lender is legitimate. Check the Better Business Bureau website to see whether a lender is accredited. Lenders and brokers must be registered in the states where they conduct business. Look for this information at the lender’s website or contact your state’s attorney general’s office for further verification.