If you’re struggling with accumulating debt, you’re not alone. In the second quarter of 2017, U.S. cardholders carried a total of $784 billion in credit card debt. That figure doesn’t even factor in other sources of debt like student loans and auto loans.
The reasons for racking up debt are probably familiar to many people. Thanks to interest charges, your balance can grow over time, requiring you to repay far more than you originally borrowed. Over time, the whole process can start to seem unmanageable.
But what if you could get a lower interest rate and pay off all that accumulated debt faster? That might sound too good to be true, but it’s the principle behind debt consolidation.
A definition of debt consolidation
Debt consolidation involves taking out a loan (or line of credit) that covers your debt. This new loan pays off the debt, including interest, that has accumulated across your accounts.
With all of that original debt paid, the debt consolidation loan then functions just like any other kind of installment loan — you begin paying it off in equal monthly payments.Taking on a debt consolidation loan only makes financial sense if you’re able to get a lower interest rate than you previously paid on your balances.
Paying off a debt consolidation loan is typically simpler than paying off several credit card or loan balances. You’ll have just one monthly payment, paying off the loan over a defined length of time.
Crucially, though, taking on a debt consolidation loan only makes financial sense if you’re able to get a lower interest rate than you previously paid on your balances.
How debt consolidation works
Debt consolidation loans can be powerful repayment tools. With a lower interest rate, more of your payment goes toward paying off the principal rather than the interest, helping you to save money and get out of debt faster.
For example, imagine you had $10,000 in credit card debt at an interest rate of 16%. If you consolidated your debt at a lower interest rate, you could save a significant amount of money and pay off your balance in a shorter amount of time. Take a look at the table below to see how.
|Type of debt
|Debt consolidation loan
|Length of repayment
If you qualified for a five-year $10,000 debt consolidation loan at 8% interest, your monthly payment would be about the same as it was on your credit cards. But you’d pay just $2,166 in interest — over $4,400 less than what you would’ve paid with the credit cards — and you’d have the debt paid off nearly two years earlier.
Options for debt consolidation
When it comes to debt consolidation, there are several different options available, each with its own pros and cons. Below are four common options for debt consolidation.
Credit card balance transfers
Some credit card companies allow you to transfer your higher-interest balanceonto a new card that will give you a 0% or other low interest rate for a limited time.
You’ll have a number of months — until the introductory offer expires — to pay off the balance at the lower rate. If you aggressively pay down your debt within the limited time period, you can save a lot of money.
There are some downsides to keep in mind though.
- Balance transfer fees: Many companies charge a balance transfer fee, which you pay to transfer your balance onto the new card (often between 3% and 5% of the total transferred amount). If the fee is high enough, it could negate the benefits of doing a balance transfer.
- Short promotional period: The time you have to pay off your balance with the introductory balance transfer rate is pretty short — often between nine to 21 months. After that, your interest rate will increase, so you’ll have to pay much more in interest from that point forward. If you can’t pay off your balance within the introductory period, then you could end up on the same high-interest path to debt that you were trying to escape.
Home equity loans and lines of credit
If you own a home, you might be able to borrow against your equity to consolidate your debt. The amount you can borrow will be limited by the equity you hold — basically the value of your property minus the outstanding balance of your mortgage — and other factors. But the available value may be enough to pay off your debt.
Because the loan is secured by your home, you can typically qualify for a lower interest rate than if you went in another direction for debt relief.
Using a home equity loan can be risky, though. Because your home serves as collateral to secure the loan, you could end up losing your home if you fall behind on your payments.
Not all plans allow it, but some people may be able to take out a 401(k) loan to pay off their debt. While 401(k) loans can sound like a great idea — why wouldn’t you prefer to borrow money from yourself? — there are some big negatives to this plan beyond paying interest.
If you fall behind on your payments, the unpaid balance will count as a distribution. And if you’re not at least 59½, you could face a hefty tax bill for an early distribution on the amount that you withdrew. Also, if you leave your job or are laid off, you may have to pay back the loan in full right away.
From a long-term perspective, the money you take out loses its ability to grow. Over the time it takes to repay the loan, you could miss out on market increases that could have boosted your retirement fund.
Another way to consolidate your debt is to take out a personal loan. However, there’s no guarantee the personal loan will have a good interest rate.
The interest rates on a personal loan depend on your credit health, income and other factors. If you have less-than-great credit, you might not qualify for a low-interest loan.Need to consolidate debt?
How to avoid racking up more debt
While debt consolidation can help you pay off high-interest debts, it’s not a magic solution. If you pursue debt consolidation, you might have to make significant lifestyle changes to make sure you don’t pile up even more debt.
Before applying for any of the options listed above, make a broader plan to repay your consolidation loan by following these three steps.
- Identify the root problem — Review your statements to see where you overspend. For example, you might find out you’re spending far too much on eating out, or maybe you go on shopping sprees when you’re feeling stressed. Once you face those root causes, you can make the right adjustments.
- Create a budget — Coming up with a realistic budget and sticking to it is the next step after taking a hard look at your spending habits. It’s all about setting limits and avoiding carrying credit card balances from month to month.
- Stay focused — Repaying your debt can take months, or even years. Review your statements regularly to hold yourself accountable and stay tuned in. This will keep your progress and your financial goals top of mind.
Using a debt consolidation loan to pay off your expensive credit card debt can be a smart way to save money. Before you pick one though, it’s important to understand how debt consolidation works and the potential benefits and drawbacks of each available option.
Doing your homework will help you make sound financial decisions that empower you to tackle your debt head-on.
Original article written by Kat Tretina at Credit Karma