Take it from someone who’s been there — getting out of debt is rarely simple or painless. It’s a process that takes a great deal of time and requires a significant amount of patience. While there are a number of options to consider (including debt management and bankruptcy), the first step you should take — the least drastic one — is debt consolidation. This article looks at five alternatives, and weight the pros and cons of each.
By Elizabeth V. Greene (ConsumerSolution.org)
Debt consolidation is accomplished by taking out a new loan to pay off your existing debts. This does three things:
- It saves you time. Debt consolidation doesn’t require negotiating with your creditors.
- It simplifies your bill-paying process. By grouping all of your debts into one loan, you’ll pay a single bill every month instead of many.
- It saves you money by reducing the total amount of interest you pay to creditors.
There are various ways to take out a new loan to consolidate debt. Let’s look at five, and weight the pros and cons of each method.
1. Transfer Your Balance
One of the easiest ways to consolidate debt is by transferring high interest rate credit card balances to a single card with a lower annual percentage rate. Not only will you save money on monthly finance charges, most balance transfers come with a low introductory rate, or a fixed rate that is often less than what you’re currently paying. Of course, the key to a successful balance transfer is to find an interest rate that’s lower than the interest rates on your current debt, or there’s little point to making the switch.
Most offers of zero or low interest only last for a limited amount of time. Once the introductory period ends, the interest rate on your new credit card may rise, increasing your payment amount. Many credit card companies will also increase your interest rate if you’re late on a payment. It’s important to know exactly when the low-rate on your balance transfer will end so you can decide whether the introductory or fixed rate is right for you. If you aren’t in a position to pay off the balance transfer before the introductory rate expires, it’s in your best interest to pick the fixed rate instead.
2. A Debt Consolidation Loan
Taking out a personal loan from a bank or credit union is another way to consolidate debt. These unsecured loans charge simple interest and typically have three to five year terms. However, it’s important to keep in mind that each lender will have their own requirements, and you’ll likely need excellent credit in order to qualify for the lowest interest rate.
Contact prospective lenders and explain why you’re seeking a loan. Each lender will tell you whether you’re eligible for a loan from their institution, and what interest rate you can get. As with a balance transfer, you’ll want a loan with interest lower than the rates on your current debts to be worthwhile.
Avoid lending institutions that aren’t banks or credit unions. Many online services promise loans regardless of your credit, but they often charge large upfront fees — or worse, take the information you submit with your application and use it fraudulently.
3. Home Equity Loan
If you own your residence, a home equity loan is an option for consolidating your debts. This allows you to borrow against the equity in your home through a loan from the lender — often at a rate much lower than what credit card companies charge. As an added bonus, the interest on home equity loans is tax deductible, saving even more money in the long run.
How much you can borrow, as well as the rate of interest charged, will be based on the following:
- A combined loan-to-value ratio of 80% to 90% of the home’s appraised value.
- Your credit score.
- Your payment history.
It is likely that you’ll need to hire a certified appraiser to ascertain any value your home has gained before you’ll be able to determine the amount you can borrow.
Home equity loans come with a huge caveat — failure to repay may result in losing your home. The foreclosure’s effect on your credit score will be severe, and you may find yourself unable to obtain any other form of financing for years to come. Before embarking on a home equity loan, carefully analyze your income and determine whether you’ll be able to make your payment each month.
4. Cash-Out Home Refinance
If you’ve been considering refinancing your home, a cash-out refinance will allow you to:
- take advantage of historically low interest rates
- and convert your home’s equity into cash that you can use to pay off your debts.
Consolidating debt through a cash-out refinance lets you make fixed payments over a set period of time, rather than having to pay a revolving balance every month. However, there are a few things to be aware of:
- A cash-out refinance will increase your mortgage balance by the amount of debt you’re paying off. This might cause your monthly payment to increase.
- If the cash you take out of your home leaves you with a loan-to-value ratio of more than 80%, post-refinance, you’ll have to buy private mortgage insurance — which can be very expensive.
- You will pay significantly more in interest over the life of the homeowner’s loan than you would if you paid your debt over a period of three to five years.
It’s important to take all of these things into account before going through with the refinance.
4. 401(k) Loan
If you’re desperate to pay off your debt, and have an employer-sponsored retirement account, a 410(k) loan may be an option. The benefits to a 401(k) loan are:
- You’re borrowing money from yourself, rather than from someone else.
- The debt disappears from your credit reports — 401(k) loans aren’t reported to the credit bureaus.
Nonetheless, it’s generally not a good idea to take a loan from your retirement account unless absolutely necessary. Most retirement plans require you to repay the loan within five years. If you’re unable to do so by the deadline, it’s treated as an early withdrawal and you’re likely to end up losing one-quarter to one-half of your loan balance to taxes and penalties. If you quit or lose your job, you have just 60 days to pay back the loan — which may leave you struggling with more debt and no immediate income to pay it off. Even if you do pay off your loan balance in full and on time, you’ve still borrowed money that should have been left alone to grow. In short, you’re hurting yourself in the long run.
Most people who consolidate their debt end up growing it back over time. The key to truly getting out of debt is to change your spending habits. If you pay for things with cash, save money for unexpected expenses, and live within your means, you’ll be able to live debt free — and that’s a feeling money can’t buy.