What is Debt Consolidation and Should I Consolidate?

With the US economy officially in recession and historic unemployment rates, many people are feeling the pressure. According to a recent NextAdvisor survey, more than half of Americans have felt anxiety about their personal finances in the past few months, with debt being a major contributor.

While debt is a daily part of life for many, if you default on payments it can become a major problem. But there are things you can do before you default on your debt. Debt consolidation can be a way to lower the interest rate or the monthly payments on your current obligations. However, this is not a solution for everyone, and with so many different debt consolidation options available, it is worth considering which one makes sense for you.

What is Debt Consolidation?

Debt consolidation is the process of consolidating all of your debts into a single payment, often with a credit or bank transfer credit card.

“Usually with debt consolidation, you want to lower your interest rate as well. So it would be [to] Save money and hassle, ”says Ted Rossman, credit card analyst at Creditcards.com. If the debt consolidation is done well, you can get rid of your debts faster and save or rebuild your credit.

Debt consolidation should not be confused with debt settlement, which all of the experts we’ve spoken to should avoid whenever possible. “If you settle for less than you owe, it is bad for your credit,” says Rossman. “And a lot of these companies will try this tactic of telling you to stop paying for a while.” Debt settlement companies use the fact that you are not paying back your debt as a leverage to negotiate a lower repayment, Rossman says . However, there is no guarantee that this strategy will work, and even if it does, an account that settles with less than you owe will have a negative impact on your credit report for seven years.

Consolidate Debt

There are six different ways to consolidate debt, but the financial instruments you can use fall into two main categories: secured and unsecured.

A secured loan is covered by something valuable that you own, such as your home or car. An unsecured debt has no underlying assets or collateral. With secured debt, the lender can take away your home or other physical property in the event of default. For this reason, unsecured debt, such as a balance transfer credit card, is a preferred and safer method of consolidation.

Secured loans are less risky to a lender than unsecured loans, so they can have better interest rates and terms. However, that doesn’t mean that a secured loan is always the best option. A home equity line of credit (HELOC) may have a better interest rate than your current debt – but if you can’t pay, your home is at stake.

Choosing the right debt consolidation strategy depends heavily on your financial situation. The catch-22 is that you must have a good credit score to qualify for the best interest rates. And those in a tough financial position may not even qualify for some of the better debt consolidation options such as debt consolidation. B. Credit cards with 0% APR or low-interest personal loans.

Lenders worry about the future of the economy and are implementing higher standards for credit transfer credit cards, home equity lines, and personal loans, Rossman says. “Unfortunately, this is a difficult time for debt consolidation right now because many of the normal avenues have either dried up or made it harder to qualify,” says Rossman.

Consolidate Debt

1. 0% APR Credit Transfer Credit Cards

While it is getting harder and harder to get right now, some credit cards offer introductory offers of 0% APR on credit transfers for a set period of time, typically 12 to 18 months. If you qualify for these card offers, you can save on interest. In order for a balance transfer card to make sense, you must be able to pay off the debts during the 0% period. Just think about the transfer fee for the balance (3 to 5%) which can wipe out your savings. If possible, apply for a card with no transfer fee and 0% APR.

2. Debt Consolidation Loans

Obtaining a personal loan from a bank or credit union is another possible debt consolidation option. A personal loan has a fixed interest rate, which is an advantage over a variable rate credit card. Your creditworthiness, income, and debt determine what interest rate you can qualify for. So before you apply, do a little research to make sure you’re actually saving money by getting a personal loan with a better interest rate – and be aware of the upfront fees, which can be up to 8% of the loan amount. Finally, if you have federal student loans that you want to consolidate, you might not want to use personal loans as you would lose certain protections that private loans don’t offer, such as: B. Forbearance options or income-based repayment plans.

3. Credit counseling center

Working with a nonprofit credit counseling agency is a great way to get free or low-cost help with your debt. Credit counselors can advise you on budgeting or money management for free, and they can even create a debt management plan (DMP) for a small fee. A DMP is similar to a debt consolidation package, but instead of taking out a loan to pay off debt, you make a payment to the counseling center, and they pay your creditors. As part of a DMP, your credit advisor will also negotiate with lenders about reduced interest rates or fees. Just keep in mind that fees will apply if you choose a DMP. Typically, a setup fee ranges from $ 50 to $ 75, and monthly administration fees range from $ 25 to $ 50. In addition, as part of the DMP, you are fundamentally obliged to close your credit card accounts.

Pro tip

If you don’t have the creditworthiness to qualify for 0% APR credit transfer credit cards or low interest personal loans, consider seeking credit counseling. You can potentially save without breaking into your retirement savings or putting your home at risk.

4. Secured Loans

Consolidating debt with a secured loan is an option that you should carefully consider, and probably as a last resort. Securing a loan with collateral is less risky for the lender, so you may get a better interest rate. But there is a significant disadvantage for you when you default. So you should only consider going this route if you have a secure source of income.

5. HELOC (Home Equity Line)

The most common type of secured loans are those that are attached to a retirement account or a home. If your home is worth more than you owe, you can take out a home loan, set up a HELOC (home equity line of credit), or get a mortgage refinance to convert that value into cash to consolidate your debt. When mortgage rates are low, like now, this can be an excellent saving opportunity. But don’t miss out on payments: if you default on a home loan, the lender could foreclose your property.

6. Pension accounts

If you have invested money in a pension account, you can either take out a loan or withdraw the money early (also take a distribution), depending on the type of account. This is a big no in general as it can upset your retirement savings, lead to penalties, and make you more vulnerable in the long run. The money in your retirement account is usually protected against bankruptcy.

When debt consolidation makes sense

Debt consolidation makes sense when you have multiple loans or credit cards with high interest rates. If you group these together under one interest rate, you can save money in the long run. It also helps in daily debt management. If you juggle multiple payment deadlines, it is easy for one payment to slip through the grid and damage your creditworthiness. Debt consolidation also makes sense for those who already have an amortization plan and a sustainable budget.

When debt consolidation is not worth it

There is no point in consolidating debt if you are not getting a lower interest rate than what you are already paying. Taking out new credit or initiating a balance transfer requires fees, and if the interest rate is uncompetitive then potential savings from the fees may be lost. Debt consolidation is also of no benefit if you do not have a plan to pay off that debt. It’s not a panacea – you still need to be careful with your budget and make your payments on time and in full.