With mounting consumer debt on the rise, many individuals seek debt consolidation solutions as a way to combine several monthly payments, lower interest rates, or reduce the balance of debt overall.
While making financial decisions to consolidate debt, these 10 tips can help.
1. Document Debt—You can’t fix what you don’t see.
In order to consolidate debt you must first break it down by individual accounts. This includes any personal loan balances and payments, credit cards, doctor bills, payday loans, and student loans. It does not include any maintenance costs, such as those you incur while “maintaining” your life. These include food, utilities, insurances and dues you may pay to belong to a particular organization, such as a union. The reason these are not included in debt consolidation is because these are open-ended expenses that can never be paid off. While these are definitely costs you may be able to reduce or modify, they are not part of your debt consolidation plan.
2. Rank Debt
When documenting debt it is important to rank accounts by interest rate. List the debts in order of highest to lowest rate. This helps you prioritize the bills you wish to include in possible debt consolidation, and further identifies accounts that can be paid off some other way.
3. Ignore New Purchasing Power
While working hard to consolidate (and ultimately pay off) debt, it can also be tempting to start spending again. Once balances and monthly payments are combined, more money is generally available in the budget. Rather than simply combining debt for the purpose of making payments more manageable and freeing up cash, it’s important to use any leftover funds to make extra payments, pay down on principal, or pay off another account.
Putting more money in the bank may give you peace of mind, but it doesn’t make much sense if the interest you earn is lower than the rate you’re already paying for debt.
4. Consider Balance Transfers—Your New Best Friends
One debt consolidation method involves utilizing introductory, teaser interest rates offered by banks and credit card companies. Low or 0% interest rate accounts may be offered for balance transfers up to a specified amount, for a limited period of time. Banks may issue a debit or credit card, or open a line of credit (LOC) depending on the offer. Initially, little or no interest is charged on the newly transferred balances, however there is generally a transfer fee of 2%-3% per account.
Combining credit card balances under one low rate account can only work if the debt is paid in full before the introductory rate expires (usually 6-24 months) or the remaining balance is transferred to another new account.
5. Explore Refinance Options
If you own your own home you may be able to take advantage of low interest rates and refinance the mortgage. In addition to lowering your monthly payment you may be able to take a portion of your home’s equity to consolidate credit card and loan balances and pay them off. Keep in mind however, negotiating a new home loan costs money. While fees and points can generally be rolled into the new mortgage payment, there may be up front charges involved in the process.
6. Use Home Equity—Loan or Line of Credit
A home equity loan or line of credit (HELOC) can be used to consolidate and payoff debt. This differs from a mortgage refinance in one important way. A loan or HELOC essentially uses the equity in the home and the home itself as a guarantee to the lender. The new loan can be used to consolidate and payoff debt, but the existing mortgage still stands. Much like an auto loan, secured by the auto itself, a home equity loan or home equity line of credit is backed by the home and any built up equity.
Home Equity Loan vs. Home Equity Line of Credit
A home equity loan is a separate loan, secured by the equity in the home. The current mortgage does not change, nor do the regular mortgage payments.
A home equity line of credit, also referred to as HELOC is a bit like having a credit card tied to the equity in the home. It may be open ended so that the borrower can use the credit to payoff balances, or for purchases up to a preapproved amount.
Both a home equity loan and a home equity line of credit can be used to consolidate loans or credit card balances. By making just one monthly payment, bill consolidation is made easier. If an individual defaults on either account however, the home equity lender can force foreclosure, once the primary mortgage lien is satisfied.
7. Investigate a Debt Consolidation Loan
A debt consolidation loan is a loan made for the purpose of consolidating debt balances. Many banks and credit unions offer debt consolidation loans, as do debt consolidation lenders. Because the loan is used to combine high interest credit card balances, loans and other debt, there is no security such as a home or auto to ensure the money is repaid. This costs extra, due to the risk incurred by the lender. Debt consolidation loans are categorized under unsecured personal loans, with typical interest rates ranging from 8% to 23%. This, like all other loans depends on the borrower’s credit score. A debt consolidation loan makes sense if the borrower can combine debt into one monthly payment that either saves money, lowers the interest rate overall or spreads payments over a longer period of time making debt more manageable.
8. Loan Against your Life Insurance
If you have already unsuccessfully tried other avenues for debt consolidation, you may want to consider borrowing against a life insurance policy, if you have one. Generally you are allowed to borrow up to the cash value of the policy and can use this money to consolidate debt. You can choose to take the money from the proceeds of the loan without making payments to the insurance company, or set up a payment plan designed to replace the principal benefit. This option should only be considered after all other avenues have been explored since you are essentially draining an asset and reducing the payout to beneficiaries.
9. Borrow From Your Future—Retirement Loan
Another way to consolidate debt involves borrowing from a retirement account. Just like borrowing from life insurance, this should only be considered as a last resort. If borrowing from a 401k account, it’s important to note that any loan must be repaid within a five-year period. If it is not, the money borrowed will be treated as an early withdrawal and be taxed heavily, and subject to penalties. Further, if you borrow from a 401k established at work and you leave your employer, you will be required to repay the loan within 60 days of termination. Failure to do so will result in financial penalties as well.
10. Know the Drawbacks
Before you take steps to consolidate debt you must know there are drawbacks involved with combining loan balances, credit card debt, and other bills. Though you might secure a great introductory rate initially through your bank or credit card provider, you must be prepared to redistribute debt and finances once again when the trial period ends. In some cases you will also be extending debt far beyond the original payoff period in order to lower payments. This could end up costing thousands of dollars more in the long run, had you paid the debt in full based on the original terms. The temptation to spend again is always a drawback as well, once you get in a better financial position and the pressure is off.
The decision to consolidate debt is an important one and should not be taken lightly. It is critical to consider all risks, plans, and possibilities before applying for or entering into any financial contract.