Debt consolidation can be a confusing term. It really just means combining and downsizing debts so they are easier to repay. In effect, you’re getting all debts “under one roof” and at a good interest rate – and you can do so in one of several ways.
In considering these common options, keep in mind that debt consolidation is best for someone with one or more accounts – particularly credit card accounts – that carry high interest rates. Consolidating that debt into one account with a lower interest rate means you would have only one payment each month. You’ll also be able to pay off the debt sooner because the payments will be lower with the reduced interest rate.
Debt consolidation (personal) loan
When talking about a “debt consolidation loan,” most people are referring to a personal loan. If you have credit card accounts bearing high interest rates, a personal loan could enable you to take out a loan with a lower interest rate, use the proceeds to pay off all the account balances, and then have just one payment a month – and one due date – for the personal loan (with a lower interest rate).
- Interest rate. Those with excellent credit could qualify for a rate as low as 7%, although rates typically range from about 10% to as high as 36%, according to Bankrate.
- Discounts. Some lenders may offer a discounted rate if there is a co-borrower with sufficient income, or if the applicant has a certain level of retirement savings.
- Promise of debt payoff. Most personal loans have terms of 24 to 60 months with strict payment schedules. That means you can’t fall into the trap of making minimum payments for years on end; there is a set timeframe to pay off the loan.
- Interest rate. Depending on your situation, another debt consolidation method could offer a lower interest rate.
- Origination fee. Personal loans generally come with origination fees of 1-5% of the loan amount.
- Impact of missed or late payments. Either of these will be reflected in credit profiles, so it is important to be sure you will be able to make the payment every month before applying.
- It’s a loan. You’ll still have a debt payment to make every month.
This is a transfer of a credit card balance to a card offering a low or zero interest rate.
- Good credit is rewarded. A balance-transfer card is generally available only to consumers with very good credit.
- Less-expensive debt payoff. The ability to transfer balances to a low- or zero-interest card give you the ability to pay off debt faster and more inexpensively.
- Promotional rates. The promotional rates will expire, often in 6 to 12 months, although some offers extend up to 21 months. You must be positive that you can, and will, pay off the balance before then.
- Fees. Every offer comes with a fee, usually a percentage of the amount you transfer to the card. This is often 3-5%. So if you transfer a balance of $10,000, the fee might be $300-$500. Online calculators can help you compare the fee to how much you would you pay in interest on your original card.
- Temptation to make charges on the new card. Doing so can start the cycle of debt all over again.
- As noted above, balance transfer cards are aimed at those with good credit, so if your score is low, you may not qualify.
Home equity: Four strategies
Using proceeds from your home to pay off debt can be an effective strategy. Four home equity strategies exist, three of which are loans. With any of these loan options (home equity line of credit, home equity loan, cash-out refinance), there is a risk of losing the home. They all use the home as collateral, so you could face a foreclosure if you do not keep up with payments for any reason. A home equity agreement is not a loan, so there are no associated monthly payments to make.
For all home equity options, a homeowner must have enough equity in their home, and good enough credit to qualify.
Home equity line of credit (HELOC)
With a HELOC, a consumer can draw money from it over time. It comes with a variable interest rate.
- Flexibility. You can borrow multiple times from an available maximum amount.
- Interest rate. It will generally be less than the rate on credit card accounts.
- Total interest. You’ll pay interest compounded only on the amount you draw, versus the total equity available in the credit line extended to you.
- Possibility of interest-only payments. The lender may offer this option. However, that means you’ll have a balloon payment – the repayment of the entire balance due – at the end of the repayment period.
- Variable interest rate. When rates rise, so will the payment.
- Draw restrictions. Some HELOCs require the homeowners to borrow a minimum amount each time, maintain a certain amount outstanding, or withdrawal of a specified amount when the HELOC is established.
- Possible balloon payment.
- Potential freezing of the HELOC. If your home loses significant value or your bank thinks you will not be able to repay the loan, it is possible they could freeze the HELOC, effectively cutting off the line of credit.
Home equity loan
With a home equity loan, a homeowner receives a lump sum of money upfront, then pays it back in monthly payments over the set term.
- Fixed interest rate. Monthly payments will not change.
- Interest rate. It will generally be less than the rate on credit card accounts.
- One lump sum. In general, a homeowner receives one amount, one time, and does not have the option of obtaining more payments later.
- You still have the burden of monthly debt payments
A cash-out refinance involves taking out a new mortgage for more than what you owe on your existing mortgage, then taking the balance in cash at closing. Typically, a homeowner would consider a cash-out refinance when the terms (such as interest rate) of the new mortgage are more favorable.
- Interest rate. It will generally be less than the rate on credit card accounts. Even with mortgage rates on the rise, almost 14 percentage points separate the current average 30-year mortgage rate (about 6.5-7%) from the average credit card interest rate (about 20%). Moving credit card debt to something that charges you only 7% effectively equates to a 13% return on your money.
- No additional debt payment beyond the mortgage payment. Since a cash-out refi replaces one mortgage with another, there is no additional monthly payment.
- Closing costs. As with any mortgage, closing costs can add up. These can include mortgage broker fees, a loan application fee, fees to obtain credit reports, title search and title insurance fees, loan origination, underwriting and appraisal fees.
Home equity agreement
A home equity agreement is a no-loan, interest-free option for homeowners who want to access the equity they’ve built in their homes. Homeowners receive a lump-sum cash payment in exchange for a portion of the home’s future value. They can buy back the equity any time during the term of the agreement (typically 10 years), or if they sell their home during that time period.
- Cash upfront. Homeowners receive a percent of the equity in their homes upfront.
- No monthly payments. The HEA is not a loan, so there are no monthly payments and there is no interest.
- Lower qualification threshold than for traditional loan products.
- Flexible income requirements.
- Obligation to buy back your equity, within a designated time interval (usually 10 years).
Borrow from a retirement account
A consumer could borrow from an account, then use the proceeds to pay off debt.
- Most plans allow borrowing from the balance.
- Pay-back period.; You must pay the amount back in five years (or pay taxes and penalties).
- Impact of changing jobs. If you leave the job associated with the retirement account from which you borrowed, the loan will come due immediately.
- Intended use. Borrowing from a retirement account is generally not considered a good option, as the money in the retirement plan is, after all, designated for life in retirement years.
With whatever option you decide to pursue, take time to read the fine print and fully understand your choice. Make sure you also understand the real reason you have the debt to pay off in the first place, the finite nature of the choice you make and how it fits into your long-term financial planning.
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