It’s no secret that most Americans are in debt.
In fact, less than half of Americans make more than they spend each month, according to information from The Pew Charitable Trusts. That shortfall has to be made up somehow, so it’s no surprise that debt levels continue to rise.
The problem appears especially poignant for Generation X, which has the highest non-mortgage debt level, according to Experian, at just over $30,000. Millennials, though, aren’t too far behind with more than $27,000 in non-mortgage debt.
One way to take figure out how to pay off debt and move forward is with the help of debt consolidation. But not everyone knows about it. In fact, 50 percent of GenXers haven’t considered debt consolidation, and 16 percent don’t even know what it is.
If you feel overwhelmed by debt, and you’re not sure what to do next, it makes sense to consider combining your loans to relieve your financial woes.
This guide will look at the pros and cons of debt consolidation, and the different options you have to take control of your debt and move forward.
Pros of Debt Consolidation
There are definite advantages associated with taking control of your debt through debt consolidation. Here are some of the upsides to using debt consolidation:
- Getting all your debt in one place. First of all, says Wendy Harrington, the Chief Marketing Officer of fintech company Figure Technologies, having it all in one place makes it easier to see where you stand and make your payments. “Many people begin to breathe easier right away,” she says.
- Lower interest rate. Credit cards have notoriously high interest rates, Harrington points out. “Interest rates for personal loans typically start around 10% APR,” she says. When you’re going from rates above 19.99% APR and consolidating to a much lower rate, you could save money.
- Pay off debt faster. In addition to lowering your interest rate, debt consolidation can help you pay off debt quicker, releasing you from your obligations years earlier than if you had to tackle each debt separately.
With debt consolidation, you can target when you pay off your debt, save money, and have fewer payments to deal with, reducing your chances of missing something.
Cons of Debt Consolidation
As with everything else, there are pros and cons of debt consolidation, and now we’ll look at some of the downsides.
- You could end up in even more debt. The biggest thing you have to watch out for, says Leslie Tayne, a financial debt resolution attorney, is falling back into old habits. “If you’re not solving the underlying issue that put you in debt, you could be worse off,” she points out. “Now you’ve freed up your credit cards and are running up new debt.”
- Loans could come with origination fees. “Some lenders charge these fees, adding to the cost of your debt,” says Tayne. Credit card balance transfers also often come with additional fees. “Consider whether it’s worth paying these fees and if you can afford them.”
- Your credit could take a hit. Finally, says Tayne, there’s a chance your credit could be negatively impacted, depending on the debt consolidation method you use. “Even with a debt consolidation loan, you could see a slight drop in your score,” she says, “but there are other types that can reduce your credit by much more.
Understanding the risks of debt consolidation can help you make a better choice with your finances, and tackle your debt in a way that makes the most sense for your situation.
How Each Debt Consolidation Method Measures Up
When understanding the pros and cons of debt consolidation, it’s important to realize that there are different paths you can take. Not each type of debt consolidation will be the right move for you, so here’s what you need to know about each kind:
Debt Consolidation Loans
With a debt consolidation loan, you take out a new loan big enough to pay off your other debts. Now, instead of making multiple payments with varying interest rates each month, you combine your loans into one payment and have one interest rate.
The main advantage to a debt consolidation loan, says Sean Fox, the co-president of Freedom Debt Relief, is that you have the potential for a lower interest rate. Additionally, most debt consolidation loans are installment loans, so you know exactly when you’ll be debt free.
On the other hand, you might need to pay an origination fee, although your interest savings might more than make up for the fee. “Plus, repayment schedules are often strict,” says Fox. “If you pay late or miss a payment, you could see your credit suffer quickly.”
For the most part, says Fox, debt consolidation loans benefit those who can make their current minimum payments but want to streamline the process and save money in interest. Beverly Harzog, a consumer finance analyst for U.S. News & World Report, points out that debt consolidation loans are also ideal for those who need between three and five years to realistically tackle their debt.
“You also need to have fairly good credit to qualify for a decent rate on a debt consolidation personal loan,” says Harzog. “Depending on what interest you’re already paying, though, even the rate you get with fair credit might be worth it.”
If you decide a debt consolidation loan is right for you, there are several reputable options to choose from, and oftentimes, speaking with a representative about your financial situation is fast and has no fees or obligation.
Balance Transfer Cards
Many credit cards offer new borrowers low interest rates for a set period of time. You might even be able to get a 0% APR balance transfer.
“The ability to transfer balances to a low- or zero-interest card is a big plus,” says Fox. He points out that paying no interest allows your entire payment to go toward getting rid of your debt. “This allows you to get out of debt faster and less expensively.”
On the downside, though, you need to watch out for the expiration on 0% APR. Some credit card introductory rates end after six months, while others are good for as many as 24 months. Fox also says you have to watch out for:
- Balance transfer fees
- Annual fees
- Credit utilization
Extra fees can be costly and reduce the benefit from balance transfer cards, while moving all your debt to one card can max it out, lowering your credit score a little bit.
Harzog says balance transfer cards are best for those who can pay off their debt within the introductory period. “You should also benefit if you have excellent credit,” she says. “The higher your credit score, the longer your intro period should be.”
If you can’t pay off your card during the introductory period, Harzog suggests looking into a debt consolidation loan instead. “Having your rate rocket back up to credit card rates can undo all your good work if you have a lot of debt,” she points out.
Check with different credit cards to see if they offer balance transfer promotions. Double-check your credit score, and look for cards aimed at those with good to excellent credit to find the best balance transfer cards.
Debt Management Programs
With debt management programs, your debt is consolidated by a company that takes your debt and attempts to negotiate with creditors. You send one payment to the company each month, and that company sends payments to your creditors, or even attempts to negotiate a settlement with them for less than you.
The only real benefit to debt management programs, other than getting your debt in one place, is the fact that you could end up repaying less than you currently owe.
However, it’s important to be careful with these programs, warns Harzog. “In some cases, negotiations go forward because you’re paying the company, not your creditors. As months go by, your credit is going to take a major hit.”
Another downside is that debt management companies, no matter how they operate, often charge fees. You need to make sure it’s worth the cost to hire one of these companies before moving forward.
“In general, if you can’t make minimum payments, you shouldn’t use debt-based debt consolidation,” says Fox. “You should look into debt settlement or credit counseling.”
Harzog recommends only turning to these companies if your credit is already suffering, or if you’re on the verge of bankruptcy and this is your best bet for getting a fresh start.
Start by going to NFCC.org to find reputable credit counselors. The Department of Justice also offers a helpful search tool that can help you find credit counselors that can take you through your options.
Home Equity Loans
If you have built up equity in your home, it’s possible to get a loan against that equity and use it to pay off your debt. A home equity loan is an installment, so you borrow once and have the same payment for the life of the loan.
“Because your home is collateral, you can usually get a lower interest rate,” says Harrington, pointing out that you could get a 6% APR or lower rate, saving you money over a personal debt consolidation loan. “It’s one way to save money on your debt.”
The downside to using a home equity loan, says Harrington, is that your debt is now secured by your home. “If you fall behind on payments, you risk losing your home,” she warns.
Home equity loans are best for those who need a little more time to pay off their debts, and want a lower rate than what they could get with an unsecured personal loan. However, it’s important to understand the risks involved when you take unsecured debt, like credit cards and payday loans, and secure it with your home.
To get a home equity loan, start by checking with your bank to see if you qualify. Compare terms with other banks and credit unions in your area to see what kind of deal you can get. There are also websites that compare home equity loans from different online lenders to help you get the best deal.
Home Equity Lines of Credit (HELOCS)
Like home equity loans, HELOCs are based on the amount of equity you’ve built up in your home over time. However, HELOCs are revolving debt, so you have a credit line that you can borrow against, and your payments vary depending on how much you owe.
With a HELOC, you can borrow what you need, up to your credit line limit. Like a home equity loan, you can usually get a lower interest rate than you’d see with an unsecured debt consolidation loan. Also, if you don’t have enough equity to pay off all your other debt at once, a HELOC lets you tackle each debt as you can.
The downside, Harrington points out, is similar to a home equity loan, in that your home is on the line.
You should only use a HELOC if you’ve left yourself some financial breathing, says Fox. “Using your house to pay off unsecured debt can be risky.”
As with home equity loans, find out if there are specials from your bank or credit union, and do some rate shopping to see if you can get a good deal on the interest rate.
Retirement Nest Egg
Any discussion of the pros and cons of debt consolidation also needs to look at how you might do it by tapping your retirement account. You can withdraw money from your 401(k), 403(b), or IRA to pay off your debt.
Fox points out that some 401(k) and 403(b) accounts allow you to borrow money up to five years. “You repay the account with interest, which means you basically borrow from yourself and repay yourself with interest,” he says.
Withdrawing money early directly from any retirement account, though, will trigger an IRS penalty, and you’ll need to pay taxes on the amount as well. That amount could be more expensive than paying off the debt.
There’s a downside to borrowing the money, too. Fox says that if you leave your job, the whole outstanding balance on your 401(k) loan becomes due immediately. There’s no mechanism for borrowing against your IRA. Instead, if you take money out, you need to have it back in there within 60 days to avoid penalties.
“This option should be used as a last resort,” Fox says. “That money is meant for retirement, and it isn’t growing wealth for your future if you’ve pulled it out.”
Contact your retirement account custodian or you company HR department to find out the requirements for using your nest egg to pay off debt.
Should You Consider Borrowing from Family or Friends?
You can also turn to family and friends for the money to consolidate your debt.
“You can probably negotiate a lower interest rate than you would obtain from a bank,” says Fox. Plus, you might have a little more flexibility in making your payments.
On the other hand, though, the risk of borrowing from family and friends is that you could damage your relationships. “There might also be the expectation of a favor years down the road,” Fox says. “You could even find yourself with a legal action against you, brought by a family member or good friend.”
Only consider this route if you know you can put the terms in writing, and you can reasonably expect to follow through.
How to Decide If Consolidation Is Right For You
Now that you know the pros and cons of debt consolidation, it’s time to make a decision about whether it’s right for you.
In many cases, it’s possible to make a debt payment plan on your own and follow it. However, if you’re overwhelmed by the number of payments you have each month, or feel like the high interest rates are keeping you from making progress, debt consolidation can be a good option.
“Just make sure you understand what works for you,” says Harzog. “Review your options and be practical about what to expect.”