Borrowers who seek to consolidate their debts today have more options than ever before. Student loans, credit cards, car payments and other types of debt can be moved around in many different ways to get ahead of the curve. Knowing the pros and cons of each strategy can help you determine which path is best for you and save you thousands of dollars – and your credit score as well.
1. Credit Card Consolidation
This strategy is probably the most effective if you are able to move your current credit card balances onto a new card that is charging a teaser rate of zero percent interest. For example, if you just opened a new card that will charge nothing for the next 18 months – and you have $5,000 of debt charging you 26% interest – moving your balance over is a logical move. Be sure to use the grace period to pay down as much of your balance as possible so that your balance (and payment) will be as low as possible when the interest kicks back in.
You could also use this card to pay off other types of debt, such as student loans or car loans, but this makes sense only if you know you will have the resources to do so. For example, you are being threatened with repossession of your car, but know you will receive a Christmas bonus that will enable you to pay off the remaining loan balance. Moving some or all of what you owe onto a credit card could allow you to keep your car until the bonus comes through. This will also prevent having a repossession appear on your credit report. If you have trouble controlling your spending, however, credit card consolidation may simply provide an avenue for racking up further debt. If this is the case, consider alternative consolidation strategies.
2. Home Equity
Homeowners who have accumulated material equity in their residences may be able to tap into this to pay off other debts. (See Using Home Equity Loans For Debt Consolidation.) This can be a good idea if the other debts are high-interest or in serious default, but be sure to run the numbers on this idea before taking action. When you've borrowed against your house, you could face foreclosure if you can't pay the bill. However, responsible spenders who are simply looking for a lower-cost alternative to their current debt structure can exchange the nondeductible interest charged on their current obligations for deductible interest on their home loan. A cash-out refinance may be another viable alternative, especially if you are already planning to refinance your loan. This could allow you to get a lower rate on your new first mortgage, pay off your other debts with the cash you get and then pour the money that was previously going to those debts back into your home.
3. Personal Loan
A friend or relative willing to front you money may be the best possible alternative when your credit is bad. Of course, this works best when they charge you a reasonable interest rate and you are certain that you can make the payments. But this option can be fraught with peril; not repaying the loan may fracture your relationship. It is a good idea to write out a clear contract that delineates the loan's term, the consequences of late payments or a default, and how interest will be computed and charged.
4. Debt Consolidation Loan
Many companies offer personal loans that allow you to consolidate your debts into a single monthly payment. The idea is that they negotiate with your creditors to get you lower payments, then lend you enough to cover them with a low-enough monthly payment for you to afford. You then make this payment to the company, which will forward a portion to each creditor. Be sure to carefully research any company that you use for this; a legitimate firm will help you improve your credit score and actually get you back on your feet. However, a substantial percentage of these companies are unscrupulous predators that charge a hefty sum up front and make only a cursory attempt to negotiate with your creditors for lower payments. Check out the National Foundation for Credit Counseling for advice and read Credit And Debt Management: Credit Counseling before you sign with anyone.
5. Student Loans
Paying educational costs can be taxing for both parents and students. But there are a few rules to remember when you consolidate these loans that don’t apply to most other types of debt. Federal student loans usually have a cap on their interest rates that prevents them from rising above a certain level, so think carefully before you fold them into some other type of debt. If you want to consolidate them separately, go to the Federal Direct Consolidation Loans website. Private student loans may be a better target for consolidation, but remember that you don’t have to itemize deductions to be able to write off student-loan interest. Three lenders that currently offer consolidation programs for private student loans: Chase, Wells Fargo and Student Loan Network.
6. Secured Loans
If you own other property you can use as loan collateral, this may be a better alternative than taking out a home loan, as it allows you to avoid risking your residence in the event you default on the loan. A vacation home or other recreational item is probably the best choice here, as pledging your vehicle or other necessary item can be almost as disruptive as being threatened with foreclosure.
7. Loans from Qualified Plans
This strategy has two main advantages. First, your retirement plan administrator will probably charge a reasonable interest rate. For example, government employees who borrow from their Thrift Savings Plans will only pay the interest rate that is currently paid out by the government bond fund (G Fund). There is also no underwriting or credit check for this type of loan. However, failure to repay the loan according to the terms set forth by your plan charter can result in a taxable distribution and early withdrawal penalty – and also deny you the long-term growth you could have reaped from keeping the money in your retirement plan.
The Bottom Line
You can consolidate debts in many ways, but some strategies carry greater risk than others. The strategies shown here reveal that there is often a tradeoff between the amount of risk and liability that you carry and the terms of the consolidation. For more information about how to consolidate your debts effectively, consult a consumer credit counselor or your financial adviser.