Paying off debt can feel like a losing game at times. Between struggling with interest rates and trying to find extra money to pay over the minimum, many people need a competitive edge to create momentum. Debt consolidation is one tool that can provide that. Here are some things to know about how debt consolidation works.
What Is Debt Consolidation?
To consolidate debt is to pay it off with a different loan or line of credit. Generally speaking, there are two reasons someone might want to do this:
- To obtain a lower interest rate
- To get a fixed payoff plan
As for tools to help you consolidate your debt, there are many — though they’re not all created equal. You could use a personal loan, a balance transfer credit card, a home equity line of credit or loan, and even a 401(k) loan to consolidate your debt.
How to Consolidate Debt
Debt consolidation is not a complex tool, but it can be made confusing by the companies that claim to do it. Unfortunately, many of them offer services that look more like debt settlement or debt management than they do debt consolidation. Fortunately, debt consolidation is something you can do yourself.
There are two principal ways to consolidate your debt:
Below are the processes and some pros and cons of both.
Debt Consolidation Through a Loan
To consolidate debt through a loan, you need to apply for an amount large enough to cover the debt you want to consolidate. The loan can then be used to pay off that debt.
As for types of loans, the options range from personal loans and home equity products to 401(k) loans. However, a home equity line of credit or loan uses your home as collateral, making this a risky option. You could lose your home if you can’t pay off the loan. A 401(k) loan forces you to borrow against your retirement — another risky option that may have tax consequences if you can’t pay it back. An unsecured personal loan, however, doesn’t need collateral and won’t decrease your retirement savings.
Here are some pros of using a personal loan to consolidate debt:
- You can apply for a loan that has a lower interest rate than you’re currently paying
- A personal loan has a fixed payoff date, so you’ll know exactly when your debt will be paid
Here are some cons of using a personal loan to consolidate debt:
- A balance transfer credit card will likely offer the lowest interest rates during the introductory period (many with no interest for a period of time), whereas a personal loan requires interest, even if less than your current rate
- If you take a loan with a variable interest rate, your monthly payments could increase to an amount you can’t afford
Despite balance transfer credit cards having lower interest rates, personal loans can be a better option for people who may be concerned about racking up additional debt with a new card.
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Debt Consolidation Through a Balance Transfer Credit Card
Another way to consolidate debt is through a balance transfer credit card. All you have to do is select the card you want, apply for it, and, if you’re approved, follow the process outlined by the card issuer to transfer the debt. Before selecting the card, however, you’ll need to know if the limit you’re approved for is high enough to cover the debt you want to transfer.
Here is a pro of consolidating debt through a balance transfer credit card:
- Most balance transfer credit cards offer no interest on balance transfers (and some on new purchases) for a limited period of time
Here are some cons of consolidating debt through a balance transfer credit card:
- If you pay only the minimum amount due each month, it’s highly unlikely that your debt will be paid off before the introductory period expires
- The remaining balance will then be charged at the new interest rate, which could be higher than a personal loan
- There’s no fixed payoff plan with a balance transfer credit card, so it’s up to you to figure out how much to pay each month to become debt-free
Not paying interest can create some positive momentum for your debt payoff efforts. That’s what makes balance transfer credit cards such an interesting debt consolidation option. That said, they do require more diligence on your part — both to pay the card off or do another balance transfer before the introductory period is over. It’s also important to avoid making purchases on the card while you pay off your balance transfer or you’ll only increase the balance you need to pay off. This can be a good option for someone who wants to pay as little interest as possible and who is ready to make and stick to a payoff plan of their own.
It’s All About Momentum
If you’re thinking about debt consolidation of any sort, understand that lowering the interest you’re paying is key. It’s your chance to make sure more of your payments go to your balance than might be happening right now.
Reducing your interest rates can allow paying off other types of debt more quickly as well. You can refinance your mortgage or auto loan, and you can even refinance some types of student loan debt. The key is to carefully research the pros and cons before you take on any new financial product, and then make sure you’re using that product in the most efficient way.
Paying off your debt doesn’t have to feel like a losing game. Put yourself in the driver’s seat and find the tools that will best help you, and you can finally get the momentum you need.
[Learn how to keep debt from negatively impacting your credit – read this.]