Juggling payments to a slew of creditors? It may be time to get some relief.
If you’re overwhelmed by debt and juggling payments to a slew of creditors, consolidating your debts can offer some relief, as well as help you pay off what you owe more quickly.Debt consolidation involves taking two or more outstanding balances and rolling them into one, ideally at a better interest rate. Depending on the consolidation method, you will end up with either revolving debt or with an installment loan that has fixed monthly payments for a set period.
Each type of debt consolidation has its pros and cons, and the best choice depends on the situation, says Cary Carbonaro, certified financial planner and author of “The Money Queen’s Guide: For Women Who Want to Build Wealth and Banish Fear.”
“There really is no one-size-fits-all,” she says.
There are four common consolidation options.
- Credit card balance transfers.
- Debt management plans.
- Home equity loans or lines of credit.
- Private debt consolidations.
Each has pros and cons, and ways to shop smartly. Let’s go through them one by one.
1. Credit card balance transfer
If all your debt is on credit cards, you have good credit and you think you can pay off your debt within a year or so, a credit card balance transfer might be your best consolidation option.
To consolidate in this way, look for a 0 percent or very low-interest balance transfer offer and apply for the new card (or you may receive balance transfer offers with a current card you are carrying).
When you apply, you’ll supply the credit card number and amount you want to transfer from your old card. If you’re approved, your new credit card company will pay off the balance for you and move that balance to the new 0 percent card.
You won’t always get a high enough credit limit on the new card to transfer all your debt, says Rob Berger, founder of the personal finance site Dough Roller. In that case, you might have to apply for another balance transfer deal, he says.
“That does add some complexity,” he says. “You’ve got more credit cards to manage and more monthly bills to pay.”
Pros: A 0-percent balance transfer deal means that, aside from the initial fee, 100 percent of your payment goes toward the principal. You can pay down debt more quickly since interest fees aren’t ratcheting up the balance.
Plus, transferring a balance to a new card shouldn’t hurt your credit score much, minus the temporary ding of a hard pull of your credit, and may even help your credit score due to lowered credit utilization with the additional credit line.
Cons: Most credit card companies charge an initial balance transfer fee. About 3 percent of the transferred balance is standard. On a $5,000 balance, for example, that fee would be $150. You need to crunch numbers to compare the fee to the interest you’d pay if you don’t consolidate, she says.
Typically, with a balance transfer card, you are only allowed to transfer other credit card debt onto your new card, so it might not be the best option if you have a mix of debt to consolidate, Berger says.
Also, you have to make sure you abide by the terms of the agreement. If you make a late payment, you’ll likely lose that promotional 0 percent rate.
Finally, you’re still stuck with revolving debt, which can be trickier to manage than fixed amount installment payments. You have to be extra careful not to rack up more debt on your old card, which could be enticingly empty after the transfer.
If you don’t want to close the old account, you might have to cut up the card, Berger says. “It’s kind of like yo-yo dieting, you can end up with more debt than you started with,” he says.
How to shop: Look for an offer with no balance transfer fee, Berger says. He recommends starting with the Chase Slate card because there’s no balance transfer fee for transfers made within 60 days of account opening. At 15 months, it doesn’t offer the longest term available, though, Berger points out. If you can’t get an offer with no fee, look for the longest term to have as much time as possible to pay off your debt, he says.
2. Debt management plan
If you are overspending, debt consolidation will only be a temporary fix.
|\u2014 Cary Carbonaro|
Certified financial planner
If you have a mix of unsecured debt, your credit is shaky or you’re late on payments, a debt management plan (DMP) through a nonprofit credit counseling agency might be your best bet.
You can enter into a debt management plan by going through a reputable nonprofit credit counseling organization affiliated with either the National Foundation for Credit Counseling or the Financial Counseling Association of America, for example. Your credit counselor will look at your finances, help you draw up a budget and submit proposals to your creditors, says Melinda Opperman, chief relationship officer at Credit.org, which also offers credit counseling.
Consumers who turn to Credit.org typically are overwhelmed by debt and have five to seven credit cards, on average, says Opperman. Many also have other unsecured debt, such as medical debt, personal loans or installment loans from appliance or furniture retailers, Opperman says.
“They’re trying to manage all the different accounts, all the different due dates and potentially creditors calling because they’re late on payments,” she says.
Pros: Credit counseling agencies will negotiate with your creditors for both lower interest rates and lower monthly payments. On average, clients see monthly payments reduced by about 20 percent, and interest rates cut by up to half, Opperman says. Also, you pay one amount each month to the credit counseling agency, which handles debt repayments, making payments easier to manage.
Cons: You generally have to close all of your credit cards while you’re on a DMP so you don’t rack up more debt, Opperman says. This will cause a dip in your credit score in the short term, but your score should improve as you pay down debt.
Aside from the closed accounts, a DMP won’t hurt your credit, according to Experian. However, a statement may be placed on your file to indicate you are repaying loans through a debt management plan, and that will be visible to lenders who check your credit while you’re on the plan.
In some cases, you might be able to keep one credit card open if you need it for work to pay for hotels, car rentals and other expenses reimbursed by your employer, Opperman says. “It’s on a case-by-case basis,” she says.
How to shop: Look for a reputable nonprofit credit counseling agency. Make sure you’re clear on how the DMP works and how much it will cost you in fees each month. Debt management plans are low-cost, but they aren’t free, says accredited financial counselor Lacey Langford.
3. Home equity loan or line of credit
If you’re a homeowner with more than 20 percent equity in your home, and you have a mix of debt, tapping your home could help you solve your debt woes.
You have three main options: a home equity loan, a home equity line of credit or a cash-out refinance, says Anthony Piccone, president of 7th Level Mortgage, a New Jersey mortgage lender.
A home equity loan and a home equity line of credit (HELOC) are both second mortgages, which means you need good to excellent credit to qualify because the lender is taking a larger risk, Piccone says.
With a home equity loan, you generally get a lump sum that you repay in installments over a set time period. With a HELOC, you get a revolving line of credit. “You can use it, pay it down, use it, pay it down, just like a credit card,” Piccone says.
So, if you’re worried you could rack up debt again, as many people do, the home equity loan might be a better choice than the HELOC, he says, as the repayment period is for a set period of time.
In recent years, home equity loans and HELOCs have been excellent debt consolidation options because interest rates have been low. Typically, a home equity loan has a fixed APR, while a HELOC has a variable APR that moves in step with the prime rate.
Rates have been so low that consumers have been able to take credit card debt at 16 or 20 percent interest or higher, and move it into a home equity loan or line of credit anywhere from 4 to 10 percent. “Financially, that’s a good move,” Piccone says.
However, interest rates are expected to rise this year, so he now recommends considering a cash-out refinance, which is a first mortgage, easier to qualify for and available with a fixed rate so you can lock in a low rate now.
With a cash-out refinance, you take out a new mortgage, which pays off your old one, and provides you with a cash payment of some of your home equity. For example, if your house is worth $150,000 and you owe $70,000, you could take out a new mortgage for $90,000 and receive a lump sum of $20,000, minus closing costs and fees.
Pros: Because these are secured loans, you’re likely to get a lower interest rate than you would for an unsecured loan. Another benefit is that the interest charges on these loans are tax deductible, Carbonaro says. Finally, you can use them to consolidate any type of debt.
Depending on your current credit profile, a home equity loan or HELOC could have a small positive effect on your credit by rounding out your mix of credit. Having different types of loans is considered a positive, and accounts for 10 percent of your FICO score. A home equity loan is considered an installment loan, while a HELOC is considered revolving credit like a credit card.
Cons: You turn unsecured debt (credit card debt) into secured debt, with your home as the collateral. If you default, you could lose your home. These loans also have closing costs, so they can add hundreds of dollars, or more, upfront.
For example, you will likely have to pay for a home appraisal, which can set you back $300 to $400 or more. With a cash-out refinance, you will likely have to pay more closing costs, likely including a loan origination fee, title fee and title insurance.
Because a HELOC is considered revolving credit, using most or all of the available credit on your HELOC can hurt your credit score, according to Experian’s FICO Score Factors Guide.
How to shop: Ask friends, family members and your financial adviser for referrals to a mortgage professional. “As for the name of a person, not a company,” Piccone says. Get a handful of names and call and talk to each one, he recommends. Shop around to get the best deal.
4. Private debt consolidation loan
An option that doesn’t involve putting up your home: an unsecured personal loan, which allows you to pay off your debt in installments at a fixed interest rate over a set period of time.
To get a personal loan, you can apply with a bank or a peer-to-peer lending company. You typically need good to excellent credit. The interest rate you get will depend on your credit history, your outstanding debt, the amount of your loan and how long you need to pay it off.
With an unsecured loan, you don’t risk your home, but you will pay a higher interest rate than you would pay on a home equity loan or HELOC.
For example, LightStream, a division of SunTrust Bank, offers debt consolidation loans at rates that range from 4.99 to 14.49 percent. The “sweet spot” that gets you the lowest interest rate if you qualify is borrowing between $10,000 and $24,999 for two to three years. If you borrow a smaller or larger amount or take longer to pay it off, the rate goes up.
Pros: Like a DMP and a home equity loan, this is an installment loan with a set payment each month for a fixed period of time. That makes it easier to budget. Once again, you’ll have to make sure you don’t run up balances on your old credit cards after you pay them off with the loan. Another upside: adding an installment loan to your “credit mix” can boost your credit score.
Cons: Unsecured personal loans can be more difficult to get than other types of credit, Carbonaro says. Depending on the lender and your credit, your interest rate might not be any lower than what you’re paying now on your credit card, Berger says. While peer-to-peer lenders have a reputation for offering lower rates, the truth is that rates can go up into the high 20s or higher, especially if your credit is not impeccable, he says.
How to shop: Check rates with banks, credit unions and peer-to-peer lenders to see who is advertising the best deals. “The theory behind peer-to-peer lending is you is take the middleman out so you get a lower interest rate,” Berger says. “The only way to know for sure is to shop around.”
Apply once or twice and, if you get rejected, consider one of the other consolidation options. Remember that each time you apply, the lender does a “hard pull” on your credit, which causes a slight dip in your score. In most cases, each hard inquiry shaves off less about five points from your score and has the most impact on your credit in the first year of the inquiry, according to myFICO.com.
No matter which debt consolidation method you choose, streamlining your finances is key. However, “if you are overspending, debt consolidation will only be a temporary fix,” Carbonaro says.