Debt consolidation loans, balance transfer cards and DIY payment plans all have their own pros and cons. Find out how all three methods compare and decide which option is best for you.
When your financial obligations are spread out over multiple accounts and their interest rates are sky high, paying it all down quickly and efficiently can be a challenge – especially when you’re just paying the minimum.
Consolidation loans and balance transfer credit cards can be of great use, but a payment plan you devise on your own could also do the trick.
So which method is right for you? Each has its own unique advantages and disadvantages. So you can choose with confidence, here is what you need to know about the three options.
Which debt consolidation method is right for you?
Debt consolidation loans
With a consolidation loan, you would borrow enough to cover your debts and the lender sends the money directly to your creditors. The old accounts will be paid off and you’ll be left with just one loan to manage.
For the loan to be worthwhile, it would need an interest rate that’s lower than the average rate of your old accounts.
To qualify for a low-rate debt consolidation loan, your credit scores should be in the good to excellent range. That would mean having FICO Scores in the mid-700s to 850.
Lenders also look at your debt-to-income (DTI) ratio, which is the total of your monthly debt payments and other necessary payments, divided by your gross monthly income. According to lenders like Wells Fargo, ideally, your DTI will be no higher than 35%.
For example, if your gross monthly income is $5,200 and your debt payments and bills total $1,800, your DTI would be 34% ($1,800/$5,200). That, plus a great credit rating, would put you in line for a loan with preferable terms.
But if your monthly income is $3,000, your DTI would be 60% ($1,800/$3,000), and you would have a harder time qualifying for a low-rate loan.
Fees and terms
Many lenders charge an origination fee, which typically run from 1% to 5% of the amount you borrow, and that sum is added to the loan. If the fee is 3% and the loan is $10,000, the upfront cost would be $300.
All consolidation loans have fixed monthly payments and payoff time frames. The lender sets the interest rate and your credit rating and DTI are considerations. On the very low end, these loans may have rates of about 6%, but they can be 30% or even higher.
Pros and cons
Kelly Crane, a certified financial planner and president of Napa Valley Wealth Management, says debt consolidation loans can work well if you can handle a larger monthly payment than you’re used to for the life span of the loan. The single payment can simplify your life and you’ll be able to watch your debt decline every month.
Your credit rating can benefit, too. “If you don’t have any current fixed loans, converting revolving credit into a fixed loan has the potential to positively impact your credit score by creating a mix of credit types,” says Crane.
And when you pay off high credit card balances with a loan, your credit utilization ratio broadens, which also helps raise your scores.
Of course, there are also downsides. You may not be eligible for a low-interest rate loan, for one. And though a small origination fee won’t increase the size of your loan much, a high one will. Borrow $10,000 with an 5% fee and $500 will be tacked on to the debt.
Where to get a debt consolidation loan
These products are available from various financial institutions:
- Conventional bank. Ask the bank you currently have accounts with if they offer debt consolidation loans, then check out other banks to get a feel for what they may offer. For example, SunTrust Bank offers debt consolidation loans with interest rates ranging from 6.49% to 16.79%.
- Credit union. This may be the perfect time to join a credit union. Because they are nonprofit financial institutions where you become a member, you may be eligible for better terms than what a conventional bank might offer. ABE Federal Credit Union, for example, offers consolidation loans with an interest rate that doesn’t exceed 9.9%.
- Online lender. Financial institutions that don’t have a physical location offer loans, and some specialize in debt consolidation loans. Rates span from low to extremely high. Case in point: Avant has consolidation loans with interest rates ranging from 9.9% to 35.99%.
Balance transfer credit cards
With a balance transfer credit card, you can move a variety of debts to the new account. To shift the debts over, you would provide the new issuer with the account numbers and the amount you want to transfer. The issuer will assume the debt and the consolidation will be complete.The result will be one card to manage, and with a special low interest rate for a period of time. Most balance transfer credit cards offer 0% APR for anywhere between six and 18 months, though a few will go even longer.
During the introductory period, no interest at all will be charged to the transferred debt, saving you a bundle in fees – particularly if you pay the entire balance before the real rate kicks in.
See related: How to do a balance transfer
As with consolidation loans, you will typically need to have an attractive credit rating to qualify for a balance transfer credit card with an extended 0% APR. Credit card companies don’t use the same DTI ratio as loans, but the application will ask you to provide your income and basic household expenses.
Fees and terms
Most balance transfer credit cards charge a transfer fee, which is usually between 2% to 3% of the new balance. That fee is added to the amount that you owe.
Other terms to be aware of concern the interest rates that will eventually be associated with the account:
- The real interest rate. Once the introductory period is over, the issuer will impose the normal purchase rate. For example, it might have a 0% APR for 15 months, and after that it rises to somewhere between 13.99% and 23.99%.
- Interest rate for cash advances. You can also withdraw cash from your account, but the rate is generally higher than it is for purchases, and there is no grace period. That means interest will accumulate as soon as you take the money out.
- Punitive interest rates. The credit card issuer can increase the APR if you miss a number of payments. It can be very high and nullify the introductory rate prematurely.
Pros and cons
Ande Frazier, a Long Island, New York-based behavioral finance expert and author of “Financially Free” says if you crave flexibility, the balance transfer credit card strategy may be right for you.
“You’ll have control over payments, can take advantage of the super low rates and get out of debt fast,” says Frazier.
It’s also easier to handle one credit card versus many. Furthermore, balance transfer cards usually offer rewards. So, when you’re ready to charge (and can keep your debt at zero), you can accumulate cash, points or miles to come out ahead.
Unfortunately, there are also some potential downsides to using a balance transfer credit card for debt consolidation.
“You have to be committed,” says Frazier. “It’s not good for someone with a pattern of paying off debt and then getting back into it.”
You’ll have to be extra careful to pay on time, and to not rack up balances on the old accounts again.
Where to get a balance transfer card
Virtually all credit card issuers offer balance transfer credit cards, so review them before applying. Just a few examples include:
- PenFed Gold Visa® Card: 0% for 12 months, then 17.99% (fixed).
- Citi® Double Cash Card: 0% for 18 months on balance transfers, then 13.99% to 23.99% (variable).
- Wells Fargo Platinum card: 0% for 18 months on qualifying balance transfers, then 15.49% to 24.99% (variable).
Although exceptionally long 0% APR time frames are compelling, look at the other aspects of the account as well. Not only should the real rate be low, it should have valuable features that you’ll really use.
See related: Best balance transfer credit cards
DIY payment plan
Another idea is to create your own plan that will swiftly put you in the black at a low cost. Commonly called the avalanche method, you prioritize accounts so you pay more expensive debts down first.
Here’s how it works:
- List all of your creditors in order of interest rate, along with the minimum payment.
- Figure out the maximum you can pay each month as a steady figure.
- Pay the most to the creditor with the highest interest rate and the minimum to all the rest.
- When the first creditor is satisfied, maintain the same payment but pay more to the next on your list.
- Continue this process until the last of your accounts is at a zero balance.
Regularly contact your creditors and ask if they will reduce your interest rate. If they do, reorganize the list so the account with the highest interest rate always remains at the top. This way you will be sure to pay the least amount of interest possible.
See related: How to create a budget that works for you
Pros and cons
According to Crane, the DYI plan is a solid option if you can’t consolidate with a loan or balance transfer card.
“Cut as many discretionary expenses as you can and apply those funds toward paying off your debt,” says Crane.
The more you send on a steady basis, the less you will pay in fees and the less time it will take to achieve a zero balance.
Another advantage is that you won’t need a good credit rating. In fact, it can build or repair your credit, since you’ll be driving your revolving debt down.
As for the cons, you still have multiple bills to pay, and the plan requires close attention – both to devise and administer.
How all three compare
Imagine you have the following four credit card accounts, totaling $10,000:
Here is how much each method will cost with similar payments and time frames:
|Payment method||Fees and rates||Monthly payment||Time frame||Total interest|
|Consolidation loan||$338||36 months||$1,840|
|Balance transfer credit card||$350||30 months||$688|
|DIY payment plan||Add $200 to minimum payment||$390||39 months||$2,989|
If it were only about the numbers, the balance transfer credit card technique is the clear winner, since you’ll be out of debt faster and for the least amount of money.
But since it’s not right for everyone, consider all options and land on the one that best suits your ability and needs.
Bruce McClary, vice president of communications for the National Foundation of Credit Counseling, says any method that you can handle and that will kick you off the minimum payment hamster wheel is positive.
For motivation, pull out your credit card statement and read what’s in the disclosure box.
“It will show you how long it will take to pay off your debt if you only paid the minimum,” says McClary. “It may be decades. And as for how much it will cost you, interest will pile up on interest, so you can end up owing double or triple the amount you spent.”
In short, there are no bad choices – except for keeping expensive debt going.