How to consolidate debt into one easy monthly payment.
Credit card debt has a way of causing problems for your financial outlook. Unlike other debts that have fixed payments you can plan ahead for in your budget, the monthly bills on your credit cards vary depending on how much you owe.
Fact: All credit cards are considered revolving debt – i.e. the monthly payments vary based on what you owe.
This may mean you have to pay the whole balance off every month (like what you see with an AmEx card) or that you pay a percentage of balance plus added interest (like what you see with most Visa and MasterCard accounts). But in either case, you can’t always plan ahead for how much income your credit card payments will take up each month.
As a result, when you overcharge and rely too much on credit, your bills can get out of control and start to take over your budget. This is where debt consolidation comes in handy, because you rein in those high payments and simplify them into one low payment instead. So here is everything you need to know about this essential financial tool…
How debt consolidation works
Debt consolidation is the process of combining multiple debts into one payment. There are several reasons for consolidating and ways to do it that vary widely depending on the type of debt you have. So credit card debt consolidation is different from student loan debt consolidation.
With credit card debt consolidation, all of your unsecured debts are rolled into one payment. You have two goals when you consolidate:
- Simplify and lower your total monthly payments.
- Reduce the interest rates applied to your debt.
The first part makes it easier to manage debt in your budget. You only have one bill to worry about. And depending on which option for consolidation that you choose, you may even have fixed monthly payments, instead of the revolving system described above.
As for reducing your interest rates, the goal is to get the monthly interest charges down as low as possible. This allows you to focus on paying off the actual debt, rather than just interest added. Since more of each payment goes to eliminating the debt, you can often get out of faster even though you’re paying less each month.
No matter which solution you decide to use, your goal should be to achieve an interest rate that’s no higher than 11 percent. Ideally, you want the interest to be even less than that. If the interest rate is any higher, you won’t get the benefits you need to reduce your debt quickly.
4 options for consolidating credit card debt
There’s more than one way to consolidate – in fact, there are four. We’ve put together the following chart to help you understand each of the four options.
|Credit Card Balance Transfer||Unsecured Personal Debt Consolidation Loan||Secured Consolidation Loan (Home Equity Loan)||Debt Management Program|
|Assisted or DIY?||DIY||DIY||DIY||Assisted|
|Credit Needed to Qualify||Good (≥700)||Good (≥700)||Fair (≥600)||n/a|
|Interest Rate||Balance transfer APR based on credit score||APR based on credit score||APR based on credit score||Negotiated by a credit counselor on your behalf|
|Collateral required||None||None||Your home or another property||None|
Here is how each of these solutions work:
- Credit card balance transfer. With balance transfers, you move the balances from your existing credit cards to a credit card with a lower interest rate. Ideally, with excellent credit, you can qualify for 0% APR for up to 48 months, so you can wholly focus on paying off the debt. Be aware there may also be fees associated with transferring your balances; understand these fees before you apply.
- Unsecured debt consolidation loan. Take out an unsecured loan (a loan without collateral) and use the money you receive to pay off your credit cards and other debts. Once executed, the only debt you have to pay off is the loan, itself.
- Home equity loan. This is a secured version of the loan described above. If you can’t qualify for the low interest you need without collateral. You can borrow against the equity in your home to qualify for lower interest. Be aware, this is the highest risk option, because if something happens and you can’t make the payments, your home may be at risk of foreclosure.
- Debt management program. This is a form of assisted debt consolidation administered through a credit counseling agency. If you can’t qualify to consolidate debt on your own and/or don’t want to borrow against your home, you may be able to enroll in the program. The agency consolidates your debt and negotiates with creditors on your behalf. You pay the agency one payment and they distribute the payments amongst your creditors.
You have 5 credit cards, 2 store cards and total credit card debt of $45,000. You have a credit score of 550. You purchased your home last year using an FHA loan program. Which solution should you use?
a. Balance transfer
b. Unsecured debt consolidation loan
c. Home equity loan
d. Debt management program
Tip: Since your home was purchased with an FHA loan, it’s unlikely you have the equity necessary to use a home equity loan. With 650 credit, it’s also unlikely you can qualify for the low interest you need on the other two options.
d. Debt management program
The benefits of debt consolidation
The biggest benefit of any debt consolidation option is that you make a plan that helps you eliminate debt quickly so you can pay off your debt in-full. This can save your credit score from potential damage – and can even help you build better credit as you reduce your debt and keep up with a consistent credit history.
The second big benefit of consolidation is how much money you can save as you pay off your debt. High interest means your debt grows faster every month with more interest added. On a high-interest credit card, your debt actually cost more month to month. If you reduce the interest rate, you save money over the life of your debts.
Debt consolidation also simplifies your life by streamlining your monthly debt payments. Instead of worrying about keeping up with multiple bills, you only have one payment to worry about.
The risks of debt consolidation
With any DIY option for consolidating debt, the risk is actually really a matter of will power. When you consolidate, your other credit card balances will be zeroed out. But this doesn’t mean that you’re out of the woods with your debt load – you still have just as much debt to pay off.
So if you start spending on your credit cards before the consolidated debt is paid off in full, you’re actually making your situation worse instead of better. And it can be really tempting to start spending when you have zero balances. Your creditors may make it even tougher by increasing your credit limits because you’ve paid off your debt.
With that in mind, you have to have the discipline not to start spending before you’re done eliminating. Note that this isn’t an issue when you consolidate with a debt management program, because your accounts are actually frozen when they’re enrolled. Of course, this presents another challenge that you don’t have those credit lines to depend on every month if you need or want something. The agency will help you arrange a budget, but you still have to learn to accept living credit-free.
The biggest risk is only faced when you use a home equity loan. You’re taking unsecured debt and securing it as your borrow against your home equity. If you fall behind on your credit card payments, they can threaten as much as they want, but the creditor can’t take your home without a court order. On the other hand, the home equity loan means your home is at risk of foreclosure if you fall behind.
If you want to consolidate but you’re not sure which option is right for you, call us. We can help you connect with a certified debt professional who will evaluate your debt to help you identify the best solution for you.