How does debt consolidation work?
Debt consolidation involves merging several separate debts into one payment plan. Consolidating your debt can simplify the debt management process, and if you can secure a lower interest rate, it can lower your overall debt payments.
However, Jay Zigmont, P.hD., a certified financial planner and the founder of Childfree Wealth, cautions that if you do consolidate your debt, “lock and cut up your credit cards so that you can’t take out more debt. Too many people fill their credit cards back up after debt consolidation.”
Zigmont says the key to understanding debt consolidation is to recognize that “it just moves your debt, it does not pay it off.”
Types of debt consolidation
There are a variety of methods you can use for debt consolidation, including the following:
Balance transfer credit card
With a balance transfer credit card , you move multiple debts onto a card with a low or 0% introductory interest rate. The goal is to pay down your debt as fast as possible to take advantage of the intro rate. If you can manage this, you can save a significant amount by not paying interest.
Promotional rates typically last for a period of six to 18 months, at which point the interest rate goes up to a regular rate. You want to find a card that offers a 0% intro rate for as long as possible.
Before selecting a card, determine if there are any fees, such as a transfer fee or an annual fee. Transfer fees typically range between 3% to 5% of the total balance transfer. If there are fees, it’s worth performing a quick calculation to see if the savings outweigh the costs.
To get a 0% balance transfer credit card, you will typically need a good to excellent credit score .
Debt consolidation loan
A debt consolidation loan is a type of unsecured personal loan offered by most banks and credit unions. Many debt consolidation loans offer lower rates than a typical credit card. However, in some cases, the lower rate is only available for a certain period of time, similar to a balance transfer credit card. Then the rate goes up and you have to pay more.
If you’re considering a debt consolidation loan, make sure you compare rates and terms on different loans to assess how much interest and fees you’ll have to pay overall. In some cases, you might get an offer for a lower monthly payment, but this is because your payment terms are stretched out over a longer time, which means you might end up paying more overall.
Similar to a balance transfer credit card, you will typically need a good to excellent credit score to secure the best rates.
Home equity line of credit
A home equity line of credit (HELOC) allows you to borrow money against the equity you’ve built in your home. You can convert a percentage of the equity you’ve built and use it to consolidate debt.
The benefit of a HELOC is that it will likely provide a lower interest rate than any credit card or other high-interest debt, since it is a secured debt.
However, there is risk involved. That’s because when you move your credit card debt to a HELOC, you are putting your house at risk. “If you use a HELOC as a consolidation loan, you are literally mortgaging your house to pay for credit cards,” warned Zigmont.
So while a HELOC has the potential to save you money, you must be extremely disciplined with your debt payment.
» MORE: How to consolidate debt with mortgage refinance
401(k) loan
If your employer permits it, another option is to consolidate with a 401(k) loan. With a 401(k) loan, you can borrow money from your retirement account balance with the intention to pay the money back. You can generally borrow up to half of your account balance or $50,000, whichever is less.
Note that even though you are borrowing money from yourself, the loan still requires you to pay interest using after-tax dollars.
The benefit of a 401(k) loan is it generally offers a lower interest rate, usually a point or two above prime. Plus, there is no credit check. However, there are also risks. For instance, if you don’t repay the loan (including interest) within the specified amount of time (maximum of five years), the amount is considered income and will be taxed accordingly.
You might also have to pay an additional 10% on the amount if you aren’t at least 59½ years old or you qualify for another exemption. This also means you are reducing the amount of money you have saved for retirement.
Zigmont cautions against using a 401(k) for debt consolidation. He said, “While some people say that using a 401(k) is ‘borrowing from yourself,’ you are really stealing from your future.”
Pros and cons of debt consolidation
As with most financial decisions, there are pros and cons to debt consolidation. Here are some of the main ones to watch out for:
Pros
The pros of debt consolidation include:
- Streamline your debt repayment: Consolidating your debt results in only one payment to worry about each month rather than trying to juggle different payment dates.
- Faster debt repayment: If you take on a balance transfer credit card with a low or 0% introductory rate, you may be more motivated to pay it off during the promotional period.
- Lower monthly payments: Depending on the type of debt consolidation method you use and the terms you can secure, you might end up with lower monthly payments.
- Lower interest: With a good or excellent credit score, it’s possible to secure a debt consolidation method with a lower interest rate than you were paying on high-interest debts.
Cons
Some of the cons of debt consolidation are:
- Drop in credit score: Depending on the type of debt consolidation method you use, you might need to go through a hard credit check. A hard inquiry will generally cause a temporary dip in your credit score.
- Interest rate increase: In some cases, you risk an increase in interest rate. For example, if you don’t pay off a 0% balance transfer credit card before the promotional period is up and end up paying high credit card interest.
- Paying more over the long term: There's a chance you might end up paying more over the long run if you stretch out your payments.
- Fees: Some balance transfer methods may involve fees, including annual fees, balance transfer fees or penalty fees.
- Risk: Different consolidation methods come with varying levels of risk. For instance, if you miss a HELOC payment, you risk losing your home.
Should I consolidate my debt?
If you’re debating whether it’s a good idea to consolidate your debt, consider the following factors:
- Your credit score: If you want to secure the best rate and terms, you need to have a good to excellent credit score.
- Interest rate: Are you able to secure a lower interest rate?
- Fees: After accounting for annual fees or transfer fees, is it still worth it to consolidate?
- Debt repayment plan: Do you have a solid debt repayment plan in place? While the act of consolidation can simplify the debt repayment process, it won’t solve your debt problems. If you don’t have a plan, it’s easy to fall back into the same habits.
» MORE: How to manage your money
FAQ
Does debt consolidation impact your credit score?
Yes, consolidating your debt can impact your credit score. If a hard credit inquiry is required to take on a new credit card or loan, this can cause a temporary decline in your score. However, if consolidating your debt helps you stick to a repayment plan, it can increase your score in the long run.
Is debt consolidation free?
The cost of debt consolidation will depend on the method you use. Consolidating your debt can involve different fees, including balance transfer fees, annual fees, origination fees or closing cost fees.
Is debt consolidation the same as debt settlement?
No, debt consolidation is when you merge multiple debts and pay them off using one large loan or credit card. Debt settlement is when you hire a company to negotiate your debt with your creditors.
Can debt consolidation stop wage garnishment?
The act of consolidating your debt won’t stop wage garnishment. However, if consolidating your debt allows you to pay off the lender that is garnishing your wages, then the garnishment will stop.
Are debt consolidation loans taxable?
Debt consolidation loans are not taxable. Since you are not earning money on a debt consolidation loan, there is no additional income to tax.
Bottom line
Debt consolidation is when you roll multiple debts, such as credit cards, student loans, or personal loans, into a single monthly payment. There are several debt consolidation methods, including a balance transfer credit card, debt consolidation loans, a HELOC and a 401(k) loan. Before deciding which is right for you, compare the benefits and risks associated with each.
Debt consolidation can simplify the overall debt repayment process and has the potential to result in cost savings. However, it’s important you have a plan in place for how you intend to repay the money you consolidate and for how you will avoid taking on new debt.
Sources
ConsumerAffairs writers primarily rely on government data, industry experts and original research from other reputable publications to inform their work. To learn more about the content on our site, visit our FAQ page. Specific sources for this article include:
- Consumer Financial Protection Bureau, “ What do I need to know about consolidating my credit card debt? ” Accessed March 19, 2023.
- IRS, “ Considering a loan from your 401(k) plan? ” Accessed March 19, 2023.
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Debt consolidation is a process that involves merging multiple debts into one payment plan. It can simplify the debt management process and potentially lower overall debt payments if a lower interest rate can be secured. However, it's important to note that debt consolidation does not pay off the debt; it simply moves it to a different form of repayment. It's crucial to understand the different types of debt consolidation methods available and weigh their pros and cons before making a decision.
Types of Debt Consolidation Methods
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Balance Transfer Credit Card: This method involves transferring multiple debts onto a credit card with a low or 0% introductory interest rate. The goal is to pay off the debt quickly during the promotional period to take advantage of the low rate. It's important to consider any fees associated with balance transfers and determine if the savings outweigh the costs. A good to excellent credit score is typically required to qualify for a 0% balance transfer credit card.
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Debt Consolidation Loan: A debt consolidation loan is an unsecured personal loan offered by banks and credit unions. These loans often have lower interest rates compared to credit cards. However, it's essential to compare rates and terms from different lenders to assess the overall interest and fees that will be paid. Stretching out the payment terms may result in paying more overall. Similar to a balance transfer credit card, a good to excellent credit score is usually required for the best rates.
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Home Equity Line of Credit (HELOC): A HELOC allows borrowers to borrow money against the equity they've built in their homes. This method often offers a lower interest rate compared to credit cards or other high-interest debts since it is a secured debt. However, using a HELOC as a consolidation loan means putting your house at risk. It's crucial to be disciplined with debt payments to avoid jeopardizing your home.
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401(k) Loan: If permitted by your employer, consolidating with a 401(k) loan is another option. This involves borrowing money from your retirement account balance and repaying it over time. 401(k) loans generally offer lower interest rates, but there are risks involved. Failure to repay the loan within the specified time frame may result in taxes and penalties. Additionally, borrowing from your retirement account reduces the amount of money saved for retirement.
Pros and Cons of Debt Consolidation
Debt consolidation has both pros and cons that should be considered before making a decision:
Pros:
- Streamlined debt repayment with a single monthly payment.
- Potential for faster debt repayment with low or 0% introductory rates.
- Possibility of lower monthly payments and interest rates with good credit.
- Simplifies the overall debt repayment process.
Cons:
- Temporary drop in credit score due to hard credit inquiries.
- Risk of increased interest rates if promotional periods end.
- Possibility of paying more over the long term if payments are stretched out.
- Potential fees associated with balance transfers or loans.
- Different consolidation methods come with varying levels of risk.
Factors to Consider
When deciding whether to consolidate debt, consider the following factors:
- Credit score: A good to excellent credit score is typically required to secure the best rates and terms.
- Interest rate: Assess if you can secure a lower interest rate through consolidation.
- Fees: Take into account any fees associated with the consolidation method and determine if the savings outweigh the costs.
- Debt repayment plan: Have a solid plan in place for repaying the consolidated debt and avoiding new debt.
Impact on Credit Score and Other FAQs
- Debt consolidation can impact your credit score temporarily if a hard credit inquiry is required. However, if it helps you stick to a repayment plan, it can increase your score in the long run.
- The cost of debt consolidation depends on the method used and may involve various fees.
- Debt consolidation is different from debt settlement. Consolidation involves merging debts into one payment plan, while settlement involves negotiating debt with creditors.
- Debt consolidation does not stop wage garnishment. However, if it allows you to pay off the lender garnishing your wages, the garnishment will stop.
- Debt consolidation loans are not taxable since they do not generate additional income.
In conclusion, debt consolidation can simplify the debt repayment process and potentially result in cost savings. However, it's crucial to carefully consider the different methods, their pros and cons, and have a solid repayment plan in place. It's also important to maintain discipline to avoid falling back into the same debt habits.
