What Is Debt Consolidation, and Should I Consolidate?

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With the U.S. economy officially in a recession and historic unemployment numbers, many people are feeling the squeeze. According to a recent NextAdvisor survey, more than half of all Americans have felt anxiety over their personal finances in recent months, with debt being a significant contributor.

While debt is an everyday part of life for many, it can snowball into big problems when you fall behind on payments. There are signs the economy is starting to improve, but the worst could still be ahead for some. A special stimulus provision that added $600 to weekly unemployment benefits is set to expire at the end of July. Anecdotally, many bankruptcy attorneys are expecting an increase in filings throughout the rest of the year, says Joseph Hogue, a financial analyst and host of Let’s Talk Money!, a personal finance YouTube channel. 

There are things you can do before you fall too behind on your debt. Debt consolidation may be a way to lower the interest rate or monthly payments of your current obligations. But this isn’t a solution for everyone, and with so many different ways to consolidate debt, you should be thoughtful about what might make sense for you.

What is Debt Consolidation?

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

“Typically with debt consolidation, you’re also looking to lower your interest rate. So it would be [to] save money and save hassle,” says Ted Rossman, a credit card analyst with Creditcards.com. When done well, debt consolidation can help you get out of debt faster and save, or rebuild, your credit.

Debt consolidation shouldn’t be confused with debt settlement, which all of the experts we talked to said to avoid if possible. “When you settle for less than you owe, it’s a bad thing for your credit score,” Rossman says. “And also, a lot of those companies will try this tactic where they tell you to stop paying for a while.” Debt-settlement companies will use the fact that you aren’t paying back your debt as leverage to negotiate a smaller payback, says Rossman. However, there is no guarantee this strategy will work, and even if it does, an account that is settled for less than you owe will negatively impact your credit report for seven years.

How to Consolidate Debt

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

A secured loan is backed by something of value you own, like your home or car. An unsecured debt has no underlying asset or collateral attached to it. With secured debt, if you default, the lender can take your home or other physical property. For that reason, unsecured debt, like that of a balance transfer credit card, is a preferable and safer way to consolidate.

Secured loans are less risky for a lender than unsecured loans, so they can have better interest rates and terms. But that doesn’t mean 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 house is on the line. 

Choosing the right debt consolidation strategy depends a lot on your financial situation. The catch-22 is that to qualify for the best interest rates, you’ll need to have a high credit rating. And those in dire financial situations may not even be able to qualify for some of the better debt consolidation options, like 0% APR credit cards or low interest personal loans. 

Lenders are worried about the future of the economy, so they are implementing higher standards for balance transfer credit cards, home equity lines, and personal loans, says Rossman. “Unfortunately, it’s a tough time right now for debt consolidation because a lot of the normal avenues have either dried up or they’re just harder to qualify for,” Rossman says. 

0% APR balance transfer credit cards

While they are increasingly tough to come by right now, some credit cards have introductory offers of 0% APR on balance transfers for a set time period, usually 12 to 18 months. If you can qualify for these card offers, you can save on interest. For a balance transfer card to make sense, you’ll need to be able to pay off the debt during the 0% period.

When you consider that many credit cards have interest rates from 14 to 24% it’s easy to see the potential for saving with a zero interest rate, but there is some fine print you’ll want to be aware of. Many of these cards charge a balance transfer fee (3 to 5%), which eats into your savings. So apply for a card with no balance transfer fee and 0% APR, if possible.

Another drawback to consolidating with a credit card is you’ll need to get approved for a high enough credit line to cover your other debts. Unfortunately, you won’t know how big a credit line you’ll be approved for before applying. So there is a possibility you won’t be approved for as much as you’d need to consolidate other debt. Also, you typically can’t transfer balances between cards issued by the same bank.

Debt-consolidation loan

Taking out a personal loan with a bank or credit union is another potential option for consolidating debt. A personal loan will have a fixed interest rate, which is an advantage over a credit card with a variable rate. Your credit score, income, and debt will determine what interest rate you can qualify for. So before you apply, shop around to ensure you will actually be saving money by getting a personal loan with a better interest rate.

If you have federal student loans you’re interested in consolidating, you may not want to use a personal loan. Federal student loans have certain protections that private loans don’t, such as forbearance options or income-based repayment plans. To consolidate federal student loans while maintaining those protections, apply for a consolidation through the government.

A personal loan isn’t the answer for everyone. Depending on your credit score, you may only qualify for an interest rate that’s just as high as what you’d pay on a credit card, if you qualify for the loan at all. Also, personal loans often come with up-front origination fees of up to 8%. Some loans are advertised as having no origination fee, but your lender will either add the amount to the loan total or charge higher interest rates instead. So you’re paying extra for the loan one way or another.

Credit counseling agency

Working with a nonprofit credit counseling agency is a great way to get free or low-cost help with your debt. Credit counselors can give you free advice on budgeting or money management and even set you up with a debt-management plan (DMP) for a small fee. A DMP is similar to debt consolidation, but instead of taking out a loan to pay off your debts you make one payment to the counseling agency, and they pay your creditors. Under a DMP, your credit counselor also negotiates with the lenders for reduced interest rates or fees.

A DMP with a nonprofit credit counseling agency can be a good option for those whose debt is becoming unmanageable, says Bruce McClary, the vice president of communications with the National Foundation for Credit Counseling (NFCC). If you’ve already missed payments, causing your credit rating to decrease, you’re less likely to qualify for 0% APR balance transfer credit cards or low-interest personal loans. In that situation, credit counseling is one of your better options, McClary believes. And while debt settlement can have a significant negative impact on your credit, working with a credit counselor can do the opposite. According to research done by The Ohio State University, the average credit counseling participant saw a 50-point increase in their credit score after 18 months.

Pro Tip

If you don’t have the credit score to qualify for 0% APR balance transfer credit cards or low-interest personal loans, consider credit counseling. You may be able to save without dipping into your retirement funds or putting your house on the line.

When it comes to shopping for a credit counseling agency, Hogue warns that some agencies can be fronts for debt-settlement programs. They may offer debt or credit counseling, then try to sell you their products, Hogue says. So narrow your search to nonprofits that are accredited by groups such as the NFCC or the Financial Counseling Association of America (FCAA). 

And know that if you choose to go with a DMP, there will be fees. Typically a setup fee is around $50 to $75, and monthly administrative fees range from $25 to $50. Also, you are generally required to close your credit card accounts as part of the DMP.

Secured loans

Consolidating debt with a secured loan is an option you’ll want to consider carefully, and probably as a last resort. Securing a loan with collateral is less risky for the lender, so you might be able to get a better interest rate. But it comes with a significant downside for you if you default. So you should consider this route only if you have a secure source of income.

HELOC (Home Equity Line of Credit)

The most common type of secured loans are those attached to a retirement account or a home. If your home is worth more than you owe, you could take out a home equity loan, set up a HELOC (home equity line of credit), or do a cash-out mortgage refinance to turn that value into cash to consolidate your debt.

Using your home as collateral for a loan is more involved than other types of loans you can apply for because you will follow an underwriting process similar to a mortgage. You’ll pay an application fee, have the home appraised, and need to prove your credit worthiness. 

When mortgage rates are low, like they are now, this can be an excellent opportunity to save, but there are big risks to consider. If you default on a loan that’s backed by your home the lender could foreclose on your property. So carefully assess your ability to repay your debt before putting your home on the line.

Retirement accounts

If you have money invested in a retirement account, you can either take out a loan or withdraw the money early (aka take a distribution), depending on the type of account. 

This is generally a big no-no, because it can throw your retirement plan offtrack, result in penalties, and leave you more vulnerable in the long term. Money in your retirement account is typically protected from bankruptcy.

However, as part of the CARES Act pandemic stimulus package, Congress temporarily eased early withdrawal penalties, and personal finance experts say you can take advantage if you have no other emergency savings to draw upon.  

The amount you can borrow from your 401(k) account this year increased to $100,000 or 100% of your vested account balance (whichever is higher), up from $50,000 or 50% of your vested balance. Typically, that money would be added to your taxable income for the year and you’d also be hit with a 10% penalty, but the CARES Act has waived those fees — as long as you repay the distribution within three years. The rule applies if you’ve experienced a pandemic-related financial hardship or if someone in your family (you, your spouse, or a dependent) tested positive for COVID-19. 

If you decide to go with a loan, and not a straight withdrawal, a big consideration is your job security. Under normal circumstances, you have five years to pay back a 401(k) loan. However, if you quit or lose your job, you have to pay back the loan by your next tax filing deadline or roll it over into another qualified retirement account. Otherwise, the loan will be treated as a distribution and be subject to a 10% penalty (if you’re under 59 and a half) and will be counted as taxable income.  

Even with the potential for early withdrawal penalties being waived, most experts don’t recommend taking money out of your retirement account early without having a plan to pay it back, except as a last resort. Any time you need to withdraw funds from a retirement account you’re looking at the prospect of having to increase your retirement savings in the future or adjust your retirement goals, says McClary.