Debt Consolidation

5 Common Debt Consolidation Solutions and How They Work

If your debt is unmanageable, your monthly credit card payments are too high or you just want to simplify your finances, there are debt consolidation solutions available. Debt consolidation merges multiple outstanding debts into one, often lowering your interest rate. We’ll review five common debt consolidation solutions, including debt consolidation loans, credit card balance transfers and secured personal loans, and how you can determine whether they’re right for you.

5 common debt consolidation solutions
Pros Cons
Debt consolidation loan
  • Single monthly payment
  • Fixed term and interest rate
  • May need to close other credit products
  • Potential for origination fees and prepayment penalties
Credit card balance transfer
  • Low or 0% interest rate possible during intro period
  • Revolving credit
  • Interest rate can increase after intro period
  • Temptation to continue spending
Secured personal loan
  • Can have lower interest rates than debt consolidation loans
  • Affordable payments
  • Must provide asset as collateral
  • Risk of losing collateral
Home equity loan
  • Generally, lower interest rates than secured personal loans
  • Longer repayment terms possible
  • Risk of losing home over default
  • Max out equity
Debt management plan
  • Single monthly payment
  • Structured debt management
  • May incur some fees
  • May show up on credit report, but shouldn’t affect credit score

  Debt consolidation loan

A debt consolidation loan is, in general, an unsecured personal loan that combines your various outstanding debts, such as credit cards, into one fixed-rate loan with a single monthly payment. It can take a long time to pay off credit card balances if you’re only making minimum payments because of high interest rates; a credit card consolidation loan may help you become debt-free sooner by saving you money on interest or lowering your monthly payments.

Before committing to a debt consolidation loan — which are generally available for three to five years — ask about the annual percent rate, or APR (the interest rate plus fees), to ensure it’s lower than the APR of your credit cards. Some lenders may pay off your other debts on your behalf, while some may disburse the loan amount directly to you.

Here are a few things to consider if you’re wondering how to get a debt consolidation loan:

  • You’ll need strong credit. To qualify for competitively low APRs, you should have a strong credit score (760 and up). If your credit score isn’t high, a debt consolidation loan may still be an option. However, the higher your credit score, typically the lower the APR.
  • You’ll need proof of income. Your income and other factors, such as your employment history, will often affect your loan amount and interest rate.

Is a debt consolidation loan right for you?

If making multiple debt payments is unmanageable and the terms and monthly payment amount fit into your budget, this may be a good debt consolidation solution. You should ask if there are any origination fees or prepayment penalties as you consider the pros and cons.

  Credit card balance transfer

A credit card balance transfer lets you shift multiple credit card balances onto one credit card, potentially at a low or 0% interest rate. However, that low (or 0%) interest rate is usually for an introductory period, and could increase after a certain period, such as six months up to nearly two years. When applying for a credit card balance transfer, the lender will do a credit check, and your credit score can drop slightly with each credit inquiry.

Unlike a personal loan with a fixed repayment schedule, a credit card offers revolving credit. As you pay off the outstanding balance, it becomes available again. But if you’re unable to continue charging your paid-off credit cards, you could dig yourself deeper in debt.

If you’re thinking about a balance transfer to help save money on interest or pay off debt faster, consider these key factors of this debt consolidation solution:

  • You may owe a balance transfer fee. The fee is generally a percentage — say, 3% to 5% — of the total balance you’re going to transfer. It’s important when reading the fine print to look for this fee.
  • You could owe interest after the 0% intro APR offer. If you don’t pay off your full balance before the intro period ends, you’ll be charged interest on your unpaid balance. This may end up costing you way more over time.
  • You’ll need a strong credit score. Similar to debt consolidation loans, a strong credit score helps increase your likelihood of being approved for a balance transfer. You’ll likely need an excellent credit score to be approved for the best balance transfer offers.

Is a credit card balance transfer right for you?

If you plan to pay off the full balance within the intro period, a credit card balance transfer may be a good option to help you become debt-free. An intro offer could help motivate you to pay off your debt faster because you won’t want to pay a higher interest rate.

  Secured personal loan

A secured personal loan is, like a debt consolidation loan, a type of personal loan, and also has fixed payments at a fixed interest rate for a set period. However, a secured personal loan requires an asset — often referred to as collateral — to be used as a guarantee.

The collateral ensures that the lender is repaid if the borrower is unable to make payments. If you default on the loan, the collateral could be sold to repay the outstanding balance. Collateral is generally required for borrowers with lower credit scores who need a loan. The collateral could be savings or a car, for example.

When deciding if a secured personal loan will fit your needs, consider these factors:

  • You may receive a higher loan amount. This can depend on the value of the collateral you provide.
  • Your interest rate may be lower. With collateral backing the loan, the lender assumes less risk. That equates to a lower interest rate, as compared to an unsecured loan.
  • The asset may be frozen. With a loan secured by a savings account or certificate of deposit (CD), you won’t be able to access it until the loan is repaid in full.
  • The collateral can be sold. If you default on the loan, your collateral will be used to repay it.

Is a secured personal loan right for you?

A secured personal loan may be the right debt consolidation solution if you have the right assets. If you’re having a hard time being approved for a loan, offering collateral could help you be approved. Just be sure you can repay the debt in full, lest you default and lose your collateral.

  Home equity loan

A home equity loan provides lump-sum funding, using your home as collateral. It can be a good debt consolidation solution if you own your home and have equity, defined as the difference between the value of your home and the amount you owe on the mortgage.

If your home is worth $300,000 and you have an outstanding mortgage balance of $100,000, the equity in your home is $200,000. As your mortgage is paid down, your equity increases.

A home equity loan, which typically has repayment terms from five to 20 years, generally offers lower interest rates than an unsecured personal loan. However, it does come with risks. If the value of your home decreases, you could have negative equity, which means you owe more on your home than it’s worth. If you default on payments, your home could be seized and sold by the lender to repay the outstanding loan amount.

Is a home equity loan right for you?

If you have equity in your home and are willing to use it as collateral, this could be a good option: interest rates are generally favorable as compared to other debt consolidation solutions. However, you have to ask yourself if you’re willing to put your home on the line and risk losing it if you default. Plus, you’ll generally need a credit score of at least 740 to get your best home equity loan rates.

  Debt management plan

A debt management plan is generally a no-fee or low-cost service offered by a nonprofit credit counseling organization. This type of debt consolidation program, which can last 48 months or longer, allows you to make a single monthly payment to a credit counseling organization that’ll pay your creditors.

These organizations can charge a setup fee and monthly fee, but some applicants could see these fees waived (an extreme financial hardship, as an example). You may also be required to close credit cards involved in the debt management plan, or not use others you have. If you stop making payments or cancel your debt management plan, your interest rates and monthly payments can rise to the levels they were before you started the plan, and late fees may be reinstituted.

A list of certified counselors can be found on the National Foundation for Credit Counseling website.

Is a debt management program right for you?

If you need help paying off your debt, a debt management plan could help. But it’s quite different from the other debt consolidation solutions here, so it’s important to find the one that works best for your financial situation.

If you’re asking “Is debt consolidation a good idea?” you can use our debt consolidation calculator to see estimated monthly payments and payoff periods for different types.

 

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