Different ways to consolidate debt
Are you struggling to make multiple payments to several credit card companies each month? Debt consolidation can help you roll several high-interest debts into a single, lower interest payment and may even help you pay off debt faster.
There are several ways to consolidate debt, but which is the right one? Here are the pros and cons of each.
Balance transfer credit card
Many credit card companies offer a 0% or low-interest introductory period for balance transfers to encourage borrowers to consolidate their debt on one card.
Pros:
One payment, one due date. This makes it easier to manage your payments.
You can save money on interest. The average interest rate assessed on credit card balances in November of 2023 was 22.75%. If you can pay off your balance within the 0% interest period, you may save a significant amount on interest.
Cons:
You will likely have to pay a balance transfer fee. The balance transfer fee is typically a percentage of the amount you transfer, usually around 3%-5%.
The promotional rate will expire. The 0% or low-interest introductory period is only available for a specific amount of time. By law, the promotional period must last for at least six months, but it could run as long as 21 months.
One late payment and you'll lose your benefits. If you pay late or have a payment returned during the introductory period, you could trigger a higher interest rate. After two late payments in a row, the credit card issuer can apply a penalty rate until you've made six consecutive on-time payments.
Personal loan
Personal loans can be used for a variety of purposes, including debt consolidation. These loans are available from banks, credit unions, non-bank lenders or peer-to-peer lending networks.
Pros:
Low interest rates. Interest rates on personal loans are typically lower than those on credit cards. According to the Federal Reserve, the average interest rate assessed on personal loans in November 2023 was 12.35%.
You'll pay off the debt in a defined time frame. Personal loans typically have fixed monthly payments and defined loan terms. If you take out a 24-month personal loan and make payments as scheduled, you'll pay off the balance within that 24-month term. Conversely, credit cards are open-ended, and it can take years to get out of debt making just the monthly minimum payment.
Cons:
You may have to pay an origination fee. Personal loans often come with origination fees between 1%-10% of the amount borrowed. That can add substantially to the total cost of borrowing.
Higher interest rates. While the rates offered by personal loans are typically lower than those of credit cards, they are usually unsecured loans. That means the rate you'll pay will likely be higher than the rate you'd get via a secured loan, like a home equity loan.
Prepayment penalties. You may think you're "getting ahead of it" by paying your loan off early but some personal loans have prepayment penalties which means you could pay more paying off your loan early.
Home equity loan/Home equity line of credit
Tapping your home's equity for debt consolidation may help you reduce your interest rate and pay off your debt faster.
Pros:
Lower interest rates. Home equity loans are secured by your house, so home equity lenders are usually willing to offer lower rates than you would find with an unsecured loan.
More affordable payments. Home equity loans typically have longer repayment terms than personal loans, often up to 30 years. That can make the monthly payments more affordable because payments are spread out over an extended period.
Fixed interest rates. Rates on home equity loans are typically fixed. That makes it easier to calculate your total cost of borrowing than an adjustable rate option like a credit card.
Cons:
Longer repayment terms. While stretching out repayment over several years can keep your monthly payments low, in the long run, it may result in paying more in interest.
You're putting your home at risk. If you run into financial troubles and cannot make your loan payments, the lender could foreclose on your property.
401(k) loan
Some 401(k) plans allow participants to borrow from their retirement savings. If you've built up some money in a retirement account, that may be a source of funds for consolidating your debt.
Pros:
Easy approval. As long as your employer's plan allows loans, it can be easier to borrow from your 401(k) than getting approved for a loan from an outside lender.
You'll pay interest – to yourself. IRS rules require 401(k) loans be repaid with interest. However, the interest you pay adds to your own account balance.
Cons:
Your paycheck may decrease. Plans often require employees to repay the loan through payroll deductions so your monthly take-home pay will be reduced by the loan payment.
Shorter repayment period. 401(k) plans typically require that loans be repaid within five years. This could mean your monthly payments will be higher than loans with a longer term.
Missed retirement savings. Some plans do not allow participants to contribute to the plan while they have a loan outstanding. You'll also miss out on any matching contributions from your employer during that time.
Your loan could turn into a taxable distribution. If you are laid off or leave your job while you have a 401(k) loan outstanding, you may have to pay the loan back in full. If you're not able to repay the loan, the employer treats the unpaid balance as a taxable distribution. You may also face a 10% early withdrawal penalty if you are under age 59½.
Bottom Line
Deciding on a method for consolidating your debts involves balancing your present-day needs for affordable monthly payments with your future financial goals. Before you decide on any of these options, make sure you understand what the total cost will be over the life of the loan and have a repayment plan in place. And whichever method you choose, debt consolidation should be accompanied by a real effort to rein in your spending. When you do that, debt consolidation becomes an opportunity to get out of debt rather than simply shuffling balances from one creditor to another.
