What is Debt Consolidation?

What is Debt Consolidation?

Debt consolidation combines multiple debts, usually from more than one creditor, into one debt with a new creditor. You pay off your current debts with the money or credit from a new account or loan. Debt consolidation can be an effective way to reduce your total costs to pay off debt while gaining the convenience of making only one monthly payment.

Four Types of Debt Consolidation

Here are four ways different ways how debt consolidation works.

1. A personal loan that you use to pay off other debts.
2. A cash-out refinance or home equity mortgage loan that rolls your debts into your mortgage payment or pays them.
3. A balance transfer that moves balances from different credit cards (and some other debts, too) to a new credit card at a low initial interest rate.
4. A loan that you take from your own retirement account, such as a 401(k) loan.

No single debt consolidation option is the best. Each option has different loan limits, credit requirements, debt-to-income requirements, and repayment terms. To find your best debt consolidation option, learn how the various options work, then choose the one you qualify for that best fits your situation. 

Personal Debt Consolidation Loan

The most common debt consolidation loan is an unsecured personal loan. No collateral is required.  The new loan pays off different debts, consolidating them into one loan with one monthly payment at a fixed interest rate with a set number of payments.  Banks, credit unions, and online lenders offer debt consolidation loans.

Interest rates, fees, and maximum loan amounts vary from lender to lender. As of 2020, interest rates range from 5.99% to the mid 30% range. The best rates require excellent credit, generally offered to borrowers with a FICO score over 740. That doesn’t mean you need an excellent credit score to qualify for a debt consolidation loan that will save you money.

If you are considering a debt consolidation loan, compare the total costs and size of the required payments of your new loan with your current one. It takes only a few minutes to get a preliminary loan quote and determine if the loan will save you money.

Repayment terms range from 2 to 6 years. Shorter repayment terms come with lower rates but will require a higher monthly payment.

Unsecured debt consolidation lenders look at your income when deciding if you qualify for a loan, but are not as strict as mortgage lenders in determining that you can afford to repay the loan as agreed. It’s up to you to commit to a payment you are confident that you can make.

The purpose of a debt consolidation loan is to pay off existing debt, yet only some lenders offer the service of paying off your current debts directly. Some even offer discounts on their costs if you choose the direct payoff option. Having the new lender send money directly to your existing creditors eliminates the chance that you will use some or all of the money for a different purpose.

• Pros- Reduce total costs if you qualify for lower rates
• Cons- Excellent credit needed for best rates, No payment relief

Using Home Equity to Consolidate Debt

If you are a homeowner with equity in your home, consider a debt consolidation mortgage loan.

Deciding whether to refinance is simple. Start by getting a reliable estimate of how much equity you have and how it compares to the value of your home. Most mortgage lenders will not approve a loan if you are borrowing more than 80% of your home’s value. If you can’t borrow enough to pay off a significant amount of debt by consolidating it, then it is not a good option for you.

Which home equity mortgage option is best for you? One option is a cash-out refinance mortgage, which rolls together your current mortgage with your outstanding unsecured debts into a new loan. If your current mortgage rate is better than the new one, you can qualify for today, and you can afford the monthly payments, then look for a different option. The second option is a second mortgage, Home Equity Loan (HEL), or Home Equity Line of Credit (HELOC).

Because a home loan is repaid over a long time, you will end up with a lower monthly payment on the debt you consolidate, but your overall costs for paying off the debt increase. Consolidating debt into a mortgage is beneficial if your top goal is to lower your total monthly expenses. Using your home as collateral makes it easier to get lower interest rates than on an unsecured personal loan. Even if you have fair credit can get reasonable rates on a home mortgage, if your debt-to-income and loan-to-value meet lender requirements.

The most significant downside of using equity to consolidate debt is that it puts you at a higher risk of losing your home by increasing your mortgage costs (even if you are reducing your overall household debt costs). A higher balance on your mortgage also puts you at greater risk of ending up owing more than the home is worth if the prices on houses drop. During the great recession of 2009, many homeowners ended up trapped in their homes, unable to sell and pay off their current loan and left without good options if they needed to move for a job or another reason.

• Pros- Low-interest rate, Low monthly payment, Low rates even with fair credit
• Cons- Increased principal balance means higher risk, Turns unsecured debt to secured, Extending repayment term can add costs

401(k) Loan to Consolidate Debt

Consolidating debt with a 401(k) loan is an option for some people. You need to have enough funds in your 401(k) to take out a loan that pays off your debt. Some 401(k) plans don’t allow loans. Most do but speak with your plan administrator to find out your plan’s rules. The amount you can borrow is based only on your 401(k) contributions; employer matching funds in your account can’t be used. There is also a cap on the loan amount of $50,000 or 50% of your account contributions, whichever is smaller.

The major pros of a 401(k) loan to consolidate debt are:

• Low-interest rates
• No credit requirements

Interest rates on 401(k) loans are 1% to 2% above the prime interest rate, which, as of December 2019, is 4.75%. That is a much lower interest rate than is available on most credit cards. The exact rate will be made clear to you before you agree to the loan.

A 401(k) loan doesn’t weigh your credit score, so it is a low-interest rate option for you if you have less than excellent credit. To get a comparable interest rate for an unsecured debt consolidation loan, you would need a credit score above 750.

A low-interest rate may not be a strong enough reason to consolidate debt this way. There are downsides and risks. 

• Default- If you don’t make the required payments, the loan is treated as a withdrawal, subject to a 10% penalty and taxes.
• Risk- If you leave your job while the loan is in repayment, you have 60 days to pay it in full, or the remaining balance is treated as a withdrawal and its penalties and taxes.
• Lost retirement income- You put money into a retirement account to build up funds for when you retire. Removing them means you will have less in the account when you retire, especially if your 401(k) doesn’t permit contributions to your account until the loan is repaid.

Because of the substantial risks and downsides, a 401K loan to consolidate debt is the right choice for very few people. You need to have no other reasonable option, current debts with very high-interest rates, and confidence that your job is secure and will continue.

• Pros- Credit score is not used, interest rate is low
• Cons- Risk of penalties and taxes, sets back retirement savings

Balance Transfers to Consolidate Debt

A balance transfer is the best solution for some people who the excellent credit that is required to get the promotional 0% interest rates. If you have less than outstanding credit, then consider other debt consolidation solutions.

Even with excellent credit, consolidating debt with a balance transfer is not necessarily the right choice. The 0% interest rate is temporary, and once the low-rate period ends, expect a serious hike. If you can pay down the debt significantly during the low-rate period, then it may make sense.

Other things to keep in mind about a balance transfer are:

• Dollar limits- The amount you can consolidate is limited to the credit limit the creditor approves. For example, you could apply to consolidate $15,000 from various cards and be approved to transfer only $7,500.
• New creditors only- You can't do a balance transfer from a creditor to a new account with the same creditor. For example, so if you have a high-interest balance with Chase, you can't transfer that balance to a new Chase account with an attractive balance transfer offer.
• Fees- A fee of 3% of the amount you transfer is common, though there are some no-fee balance transfer offers.
• Types of debt- With some balance transfer offers, you can only transfer credit card debt to the new account. In contrast, others allow you to consolidate a broader range of liabilities, including personal loans, auto loans, and even student loans.
• Length of 0% or Low-interest Period- Balance transfer offers can vary widely in how long the "teaser rate" lasts before it resets. Some are only as few as six months of low interest, while others can be up to twenty-one months.

Because of these five factors, if you are considering a balance transfer to consolidate debt, shop around to find the best deal you can get. Check your credit score before comparison shopping. Find out the creditor's requirements, too. Restrict your shopping to offers for which you have a good chance at qualifying, so you don't take a hit on your credit score associated with a credit card application for no good reason.

• Pro - 0% interest and no fees on the best offers which reduces total cost if you pay down the principal
• Con- Requires excellent credit

How to Make Debt Consolidation Work

Debt Consolidation can be an effective solution for paying off debt and stay out of debt moving forward.

Here are some quick debt consolidation tips to keep in mind:

1. Your credit score is critical to qualify for a personal loan and is a substantial factor in the rate. It is not a good option for people with poor or no credit.
2. If you are going to change jobs, a 401K is not a good idea because you have to pay the entire loan back in a short period, or you will owe taxes and penalties.
3. If you want a lower monthly payment, then consider using the equity in your home to pay off your debt. You need to keep your new loan size to 80%-85% of your home's appraised value.
4. A balance transfer requires excellent credit. Make sure that you can pay off all or most of the debt during the low-interest period.