Managing debt can be a difficult task, particularly if it has a high interest rate. Debt consolidation is the process of replacing one or more existing debts with a new one, generally with the goal of securing a lower interest rate, a simpler payment plan, a lower monthly payment or other more favorable terms.
Depending on the type of debt you have and your credit situation, there may be different options available to you – yes, even if you have bad credit. Here’s everything you need to know about how to consolidate debt.
Debt Consolidation Loan
Debt consolidation loans are personal loans that consumers use to consolidate their debt. They’re most commonly used to consolidate high-interest credit card debt.
“If you have high-interest or variable-rate debt, especially if it’s made up of balances on multiple credit cards,” says Matt Lattman, vice president of personal loans at Discover, “a personal loan for debt consolidation could allow you to pay off your debt at a lower rate and in less time.”
For starters, personal loans have fixed repayment terms, which is different from the minimum payment arrangement with credit cards. Whether your repayment term is two years or seven, you know exactly how long it’s going to take to pay off your debt.
Secondly, personal loans can offer a lower interest rate than credit cards. According to the Federal Reserve, the average interest rate on a two-year personal loan was 8.73% in May 2022, which was almost half of the average credit card interest rate of 16.65%.
Of course, your credit score will help determine your personal loan interest rate, and some lenders may offer rates ranging from the single digits up to about 36%. So, if your credit is less than stellar, this option may not be the right fit. You’ll also want to make sure that you can afford the new monthly payment, as it’ll likely be higher than your credit card minimum payments.
If you’re wondering how to get a consolidation loan, you can find personal loans offered by traditional banks, credit unions and online lenders. Take your time and shop around to ensure that you get the best offer available to you.
Balance Transfer Credit Card
Balance transfer credit cards are generally used to consolidate credit card debt, but, in many cases, you can also use one to pay off personal loans and other types of debt.
Balance transfer credit cards, which are typically designed for people with good credit, offer special introductory rates on debt transferred from another card or loan, typically a 0% annual percentage rate. Depending on the card, you may get this rate for anywhere between 12 months and 21 months. However, keep in mind that not all issuers allow personal loan transfers to their credit cards.
A balance transfer card can be a great way to pay off all, or at least a big chunk, of your debt. But if you have a balance remaining at the end of the promotional period, the card’s regular APR will kick in, so you’ll need to be disciplined to avoid repeating your present situation.
Also, balance transfer cards typically charge an upfront fee of 3% to 5% of the transferred amount, so keep that cost in mind as you compare your options. Finally, you can only transfer up to the limit on the new card, which may or may not be enough to cover your full balance. You may need to combine this option with others for it to be effective.
Home Equity Loan or Line of Credit
If you own a home and have a significant amount of equity, you may be able to take out a home equity loan or a home equity line of credit, also called a HELOC, to consolidate credit card, personal loan, auto loan or any other type of debt.
A home equity loan is an installment loan that you pay off over a fixed amount of time, while a HELOC is a revolving line of credit, similar to a credit card, that has a draw period, during which you usually pay interest only, and a fixed repayment period.
Home equity loans and HELOCs typically charge lower interest rates than consolidation loans because they’re secured by your home. But they may also charge closing costs, which eat into your savings.
Also, these options carry more risk than other debt consolidation choices because if you default on your payments, the lender can foreclose on your home.
You may qualify for a home equity loan or HELOC with a credit score of 620 or above, but the higher your score, the better your chances of a low interest rate.
Taking money from your 401(k) retirement account to pay off any kind of debt can be appealing if your credit is in poor shape, because there’s no credit check involved. That’s because you’re technically borrowing from yourself, and both the principal and interest you pay on a 401(k) loan go back into your retirement plan.
However, not all 401(k) providers offer this option, and you can only borrow up to 50% of your vested account balance, with a $50,000 maximum. The only exception is if you have less than $10,000, in which case you can borrow up to the full amount.
The biggest danger of using a 401(k) loan is that if you lose your job or switch to a new employer, your loan, which may initially have a repayment term of up to five years, may come due sooner. If you can’t pay it back within the accelerated timeline, the remaining balance will be treated as an early distribution, which may result in a 10% penalty and income taxes.
Even if you do pay back the loan on time, removing that money from your retirement account means that it’s not providing any investment gains, which can cost you more in the long run.
Debt Management Plan
Many debt consolidation options require that you have good credit, but that’s not the case with a debt management plan. These plans, administered by a credit counseling agency, can help you consolidate credit card debt, payday loans and other types of unsecured debt.
With a debt management plan, the agency can potentially help you secure lower interest rates and lower payment amounts. You’ll make one monthly payment to the agency, which then distributes the funds to your creditors.
You’ll typically pay modest upfront and ongoing fees throughout the three-to-five-year repayment plan, but it can be worth it to keep your finances under control. Also, note that you may need to close your credit card accounts, which can impact your credit by increasing your credit utilization rate, until you pay down the balances.
Student Loan Consolidation
- Federal consolidation. With the Direct Consolidation Loan program, you can consolidate one or more federal student loans to take advantage of a single monthly payment, a longer repayment term – up to 30 years – or other federal loan benefits that you don’t currently qualify for. There’s no credit check required, but you can’t get a lower interest rate with this option. In fact, the Education Department will take the weighted-average rate of your loans and round them up to the nearest one-eighth of a percent, thereby increasing your costs just a little.
- Private refinancing. Student loan borrowers can refinance both federal and private student loans with a private lender, typically with the goal of obtaining a lower interest rate, a shorter or longer repayment period – typically between five and 20 years – or a lower monthly payment. However, your eligibility and loan terms depend on your credit and financial situation, making refinancing difficult if your credit score and income aren’t solid. Also, refinancing federal student loans will result in losing access to several benefits, including forgiveness programs, income-driven repayment plans and generous forbearance and deferment options.
When Is Debt Consolidation Worth It?
Debt consolidation can be worth it if you have high-interest debt or you’re struggling to keep up with your monthly payments. Depending on the method, you may be able to cut your interest rate, save on your monthly payment and take advantage of other benefits.
“If you have several loans to pay off, consolidating to a single loan might make it easier to keep track of everything,” says Lattman.
But depending on your credit history and financial situation, some debt consolidation methods may not be worth it, or they may not be an option at all. Take your time to research each approach and consider the pros and cons for your particular situation.
If you decide to move forward with debt consolidation, it’s important to evaluate your spending and make changes to avoid putting yourself in this position again. While closing your credit card accounts may not be necessary, for instance, you may choose to cut them up or remove them from your online accounts to restrict your spending.
“I have seen many people consolidate their debts into a loan and continue to run the credit cards back up,” says Kendall Clayborne, a certified financial planner for SoFi. “This usually makes it harder for them to get out of debt, as they are left with double the payments to worry about and fewer options to consolidate again.”
Also, if your credit is in poor shape, review your credit reports and identify areas you can improve so that you’ll have more affordable credit options in the future when you need them.
Debt Consolidation Alternatives
If using another credit card, loan or program to consolidate your debt isn’t the right fit for you, here are some other potential options:
- Debt snowball method. With this debt payoff approach, you’ll pay the minimum amount on all of your debts and add any extra money you can afford to your payment on the account with the lowest balance. Once that balance is paid in full, you’ll add the total amount you were paying to the minimum payment on the account with the next-lowest balance. You’ll keep doing this until you’ve paid off all of your debts. “I like this method because it keeps people motivated and helps them see progress quicker,” says Clayborne.
- Debt avalanche method. Similar to the debt snowball method, the debt avalanche method targets your accounts with the highest interest rates first instead of the lowest balances. You may opt for this approach if you want to maximize your interest savings.
- Debt settlement. If you’re behind on your payments, the above debt consolidation options, including a debt management plan, may not help. With debt settlement, you can negotiate with your creditors to pay less than what you owe to settle the debt. Keep in mind, though, that you may need to make a lump-sum payment, which can take a while to save up. Also, debt settlement can have a significant negative impact on your credit score, so think carefully before proceeding. You can negotiate with your creditors on your own or enlist the help of a debt settlement company or debt attorney.
- Bankruptcy. If your financial situation is dire and you don’t see any other way out, you may consider bankruptcy as a last resort. Depending on the type of bankruptcy you qualify for, you may be able to get on a restructured payment plan or have your debts wiped out altogether after liquidating some of your assets. Because bankruptcy can wreck your credit, consult with a bankruptcy attorney before approaching this option to ensure that it’s the right move.
Take care to consider every option and research how it can help and hurt your situation. While debt consolidation and its alternatives aren’t ideal, they can help you get back on your feet financially.
While some of these approaches may negatively impact your credit score, it’s important to see the big picture. “Focus on what is best for your financial health as a whole and not solely focus on your credit score,” says Clayborne. “If you are able to get these debts paid off and make on-time payments, it may actually help your credit score over the long run anyway.”