What Is Debt Consolidation and What Are Your Options?

What is Debt Consolidation?

Debt consolidation is a method of restructuring your debt by lumping your credit card balances or loans into one convenient monthly payment. If you have several high-interest loans or credit bills, your debt becomes more expensive to carry, which can hinder your ability to pay it off.

Consolidating your debt allows you to pay one interest rate, so your payments will usually be lower. In turn, you can pay down your balance faster. Debt consolidation strategies include moving your debt to a balance transfer credit card, getting a debt consolidation loan, enrolling in a debt management plan or taking out a home equity loan or 401(k) loan.

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How Does Debt Consolidation Work?

The process for consolidating your debt depends on the option you choose. A balance transfer card is one of the most straightforward choices. You’ll need to apply through the credit card issuer or bank website. Taking out a home equity loan or a fixed-rate debt consolidation loan involves formally asking to borrow funds through a lending institution. Using a 401(k) loan requires you to visit your retirement fund site and navigate to the loan page.

If you’ve been turned down for consolidation loans and balance transfer cards, you can contact a debt settlement company that deals with creditors on your behalf or reach out to non-profit credit counseling agencies.

Here are your four main options for debt consolidation:

  • Seek a balance transfer credit card.
  • Get a fixed-rate debt consolidation loan.
  • Make a debt management plan.
  • Take out a home equity loan or 401(k) loan.

What are my options to pay off my debt?

Balance transfer cards, a debt consolidation loan, debt management plans and a home equity or 401(k) loan are all feasible ways to settle your outstanding balances. The right option for you depends on the types of debt you have, the amount of debt and your overall financial situation.

Balance transfer credit card

Most credit card companies offer balance transfer credit card options to help reduce your overall debt payments. These cards come with 0% intro APR on all balance transfers — debt moved from your existing card to the new card — for a specific period of time, typically between 12 and 18 months. During this time, you don’t pay any interest on the amount you’ve transferred; instead, you simply need to make your minimum payment. Without the burden penalty interest, many cardholders can start to get ahead of their debt — or even pay it off — before the introductory interest rate expires.

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Debt consolidation loan

A debt consolidation loan allows you to combine existing debts into a larger loan with a lower total interest rate. These loans may be offered by banks, credit unions or finance companies, and the terms vary depending on your current debt load, financial circumstances and existing cash flow. Since each of your existing creditors has their own fee structure and interest requirements, it’s impossible to directly combine your debts — consolidation requires a completely new loan that is then used to pay off each outstanding debt. If you have bad credit because of your debt, you can still get approved by certain lenders who work with individuals struggling financially.

If you’re concerned about your student loan debt, the government offers help to lump those balances and interest rates. Direct consolidation loans are available through the Federal Direct Loan Program.

Debt management plan

Debt management plans help create a roadmap to reduce financial stress if you’re not eligible for balance transfer credit cards or debt consolidation loans. Offered by credit counseling agencies, debt management plans involve going to each creditor individually and asking for more favorable loan terms. You make a single monthly payment to your debt management agency, which in turn disburses the money among creditors and ensures you don’t default on specific loans.

Taking out a home equity loan or 401(k) loan

If you’re a homeowner, you can use the equity you have built up in your home to pay off your debts. In many cases, home equity loans offer a lower interest rate compared to other types of debt consolidation options since it’s secured by your property.

Another way to resolve your high-interest debts is by borrowing from your 401(k) since you’re just borrowing from yourself. Interest rates for 401(k) loans are typically lower, and qualifying for one is less complicated compared to other consolidation options. Your biggest risk with this option is losing your job, which puts you on the hook to pay it back within 60 days.

When should I choose debt consolidation?

If you can’t make your minimum payments on your loans or credit cards, debt consolidation can help you get back on track. Failing to meet the minimum means your principal balance isn’t changing much, but you’re still losing money through interest. Plus, if you’re consistently late making payments, you may be saddled with a penalty APR of up to 29.99%.

Another sign that debt consolidation is a smart move is if your credit scores are good enough to be approved for a 0% credit card or low-interest debt consolidation loan. Debt consolidation is only a good idea if you have a plan to prevent it from happening again. Otherwise, you’re just putting a surface bandage over a deeply-rooted issue.

When should I avoid debt consolidation?

Before you decide to consolidate your debt, ensure it makes financial sense. For example, if the interest rates are higher for your debt consolidation loan than what you’re already paying for your existing debts, you’ll likely need to look elsewhere for a solution to your debt. Not every debt can be consolidated. When you’re exploring your debt consolidation options, sit down and crunch the numbers to see whether or not consolidating your debt saves you money or exacerbates your debt.

Avoid using debt consolidation as an easy fix for irresponsible spending. Instead, can you pay off the smaller balances sitting on multiple credit cards? Or, can you cut back on discretionary expenses to prioritize paying down debt? It’s important to address the real cause of your debt before using debt consolidation as a solution.

Too long, didn’t read?

For individuals serious about paying down debt, debt consolidation provides a light at the end of the tunnel. After you’ve started a debt consolidation plan and you’re making payments, avoid making the same mistakes that got you into debt in the first place. Stick to a budget, pay your bills and set up an emergency fund to avoid using credit for unexpected expenses.

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Michelle Wilson

Contributing Writer

Michelle Wilson is a San Diego-based writer specializing in the topics of personal finance, technology and culture. You can find her writing on sites such as HP Tech Takes and San Diego Magazine. In her spare time, she enjoys finding new cats to follow on Instagram.