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As of the end of 2017, total household indebtedness was $13.15 trillion, according to the New York Federal Reserve. Collectively, Americans owe more than 26% of their income on consumer debt. With so many juggling payments between a number of different creditors, debt consolidation can be a way to refocus and take back control.
Debt consolidation is the practice of moving high-interest debts into a single, lower-interest payment. Debt consolidation does not have an impact on the principal debt due, it is not a shortcut or accounting trick. The goal is to reorganize your debts and make a positive impact on the amount put towards interest payments, lowering the total amount of time and money spent.
Take a look at “How to Pay Off Debt” for advice on making payments.
How Does Debt Consolidation Work?
There are multiple debt consolidation solutions. The right path for you depends on your overall finances:
Fixed-Rate Personal Loan
A personal loan lets people borrow money for a set timeframe (known as the loan term), and pay it back in even monthly payments. It is an unsecured loan, meaning there is no asset/property that can be reclaimed by the lender (as with a mortgage or car loan). Unlike some loans that take into account down payments or collateral, a personal loan’s APR (annual percentage rate) is based solely on the borrower’s credit history.
Once approved for a personal loan, you can roll your debt into a single loan, with hopefully a lower interest rate than the debts being consolidated. Personal loan providers offer a variety of term timelines and higher borrowing amounts than most credit card balance transfer options.
Credit Card Balance Transfer
This method moves high-interest debt to a credit card with a 0% introductory interest rate. However, when that introductory rate ends the rates can be very high. Be sure that your total balance can be paid off within that timeline, or risk high rates again. Ideally, the credit card will also have no annual fee, but this will depend on the credit score of the applicant.
Home Equity Loan or Home Equity Line of Credit (HELOC)
A homeowner who wants to borrow against their home has the ability to do so, but if you have good credit then this might not be the best option. The risk of losing your home should not be taken lightly.
Deciding between a home equity loan or home equity line of credit is a big decision in itself. Generally, both will offer a lower interest rate, but a home equity loan will be a fixed rate with a clear payoff date, while a home equity line of credit will be a variable rate loan. This means your rate could go up and harder to budget for.
You can borrow up to $50,000, or half the balance in your account, whichever is less, from a 401(k) or similar workplace plan. However, not all retirement plans allow loans against them, you will want to check with your plan administrator.
The longest repayment term allowed is five years. Similar to borrowing against your home, borrowing against your retirement is a risk. If you lose your job while paying off a 401(k) loan you might have to pay back the balance quickly to avoid the loan being categorized as an early distribution and taxed as such.
Peer to Peer Loan
The newest option for those looking to consolidate their debt. A peer to peer lending company can connect those with debt, with those looking to invest. Many offer a fixed rate and timeline for the debt holder and accept a wider range of credit scores. It is important to remember that those applying with a lower credit score should expect a higher interest rate.
When You Should Consolidate Your Debt
Debt consolidation can help align your repayment goals and reorganize many payments into a single strategy. If you are not able to negotiate a lower interest rate on your existing debts then some of the options above could be a good fit. Do the math to see if lowering the interest payments on your outstanding balance would make it possible to pay off the remaining principal in a timely fashion.
Debt consolidation can offer a relief period for those who need some time to get organized and back on track. Even if you decide to consolidate your debt, understand the risks associated with your chosen method. While consolidating your debt can affect the interest due, it will not change the principal owed.
When You Shouldn’t Consolidate Your Debt
Like everything in finance, there is no ‘one size fits all’ solution to paying down debt. Debt consolidation is just one method and should be considered in tandem with other options.
If you are a highly organized person and are able to automate payments to your debt within your budget, then you might not see the value in debt consolidation. Maybe only one of your debts has a high-interest rate. Look into negotiating that rate down to lower the associated interest payments.
If you are too far in the hole, debt consolidation can lead to more problems than solutions. If your total debt is more than half your income and paying it off in less than five years isn’t possible, then debt relief might be a better solution.
Debt consolidation is also not for those who have a small debt load that could be paid off within a year. There are risks and upfront costs that those with minimal debt should avoid when possible.
Resources for Consolidating Your Debt
To learn more about debt consolidation, please see the following resources: