When it comes to debt, the numbers aren’t pretty: The average U.S. household has $15,706 in unpaid credit card balances, according to NerdWallet.com.
While debt can be a fact of life for many, you do have choices for managing it. One way is through debt consolidation: You combine your debts “under the same roof” with a better interest rate and one monthly payment. (Don’t confuse this with debt negotiation, which involves settling your balance with the lender.) “If you have numerous accounts with high minimum payments and interest rates, debt consolidation may be an answer,” says Kevin Gallegos, vice president of Phoenix operations for Freedom Financial Network. “It’s helpful for people who are confident they can change their habits and want to focus on just one rate and payment.”
The key here is changing your habits. What you don’t want to do is consolidate your debt and then go right back to racking up high balances. Before making any change, you may want to consult with a financial planner to help you get your monthly spending in the black, or contact an organization such as the National Federation for Credit Counseling, a non-profit organization that provides financial education to millions of consumers every year, with services that include debt and bankruptcy counseling.
How do you know if debt consolidation is right for you? We asked experts to explain three ways to consolidate debt.
1. Consolidate debt onto one credit card.
One way to consolidate debt involves transferring your credit card balances to one main card. But carefully read the fine print. “Be clear about the transfer fee,” Gallegos says. “Select a card without an annual fee, and be sure to pay off the balance before the favorable, initial rate expires. Once you make the switch, stop charging purchases on your card.”
After transferring a balance, you probably will want to keep your old card accounts active—without adding any new charges—to lower your credit utilization ratio. This ratio compares the amount of credit you’re using to your overall available credit, and counts for about a third of your credit score. The lower the ratio, the better it is for your credit rating.
To illustrate: If you transfer $2,000 from three different cards to a single card with a $10,000 limit, and then close the three original card accounts, you’ll end up with a $6,000 balance on the one new card. This exceeds the recommended maximum of 30 percent of the credit limit, which in this case is $3,000. However, if you keep those original three accounts open—while ceasing to use them—you would have a $6,000 balance on $40,000 of available credit (assuming all accounts have $10,000 limits). This gives you a much lower credit utilization ratio. Also, remember that long-standing accounts with positive payment histories favorably affect your credit score, even if you no longer use those cards.
Is credit card consolidation right for you? You may be a good candidate for credit card debt consolidation if you’d benefit from transferring multiple balances from multiple cards to one, big loan (or card), hopefully with a lower rate. You may not be a good candidate for credit card debt consolidation if you’re currently not struggling to pay down your credit card balances and your credit-utilization rate is already low.
2. Consolidate through a home equity line of credit (HELOC).
HELOCs allow consumers to open a line of credit secured by their house. Homeowners can then borrow money when needed to consolidate debt or to fund future emergencies without having to apply for a new loan at possibly higher rates. Upfront costs pose significant drawbacks, as you have to pay the same fees as you do with a first mortgage (e.g. an application fee, title search, appraisal and, of course, points). Still, with a HELOC, you typically gain access to up to 85 percent of your home’s value, minus what’s remaining on your mortgage. So for a $500,000 house with a balance of $300,000, you’d be eligible for a maximum credit limit of $125,000, according to NerdWallet.
HELOCs are considered viable finance options for those who face a big expense and lack an emergency fund. Because the line of credit is backed by collateral—your house—the interest rate tends to be lower. HELOCs are also often tax-deductible. Secured loans such as these have lower rates than unsecured ones, like your credit card, because you’re putting up a house or car or something else of value. With an unsecured loan, you’re only backed by your ability to make good on payments.
“You may be able to reduce your monthly payments via lower rates and long repayment terms,” says Kevin Haney, a former sales director for the credit bureau, Experian, who now runs SavvyonCredit.com, a credit information/education site. “You could very well have the luxury of stretching your repayment over 20 years. But there is down side: You’re borrowing against the equity of your home. If prices drop, you may owe more on the house than a new buyer is willing to pay. And by stretching payments over 20 years, you could end up paying more than you otherwise would in total interest.” Bottom line: Do the math to see if you’ll come out ahead.
Is a HELOC right for you? You may be a good candidate for a HELOC if you have a large amount of debt you want to consolidate or you want an extra cushion for future emergencies, and you have sufficient equity. You should apply only if your job and income are secure. You may not be a good candidate if you have little home equity, or you only need to refinance a smaller amount of debt. The interest savings on smaller amounts may not offset the higher closing costs of a HELOC.
3. Consolidate with a personal loan.
You can refinance debt into a fixed-installment loan, too, with one monthly payment, due date and interest rate. Converting credit card debt to a fixed-rate personal loan could improve your credit score because credit-utilization ratios don’t take installment-type loans into account. You’re essentially “wiping away” card-based debt from your utilization score, thus lowering it.
The lengthy repayment period, however, may rule out certain borrowers. “If you think you can pay off your debt within a year, it doesn’t make sense to get a personal loan,” Gallegos says.
Is a personal loan right for you? You may be a good candidate for a personal loan if you have multiple accounts you’d like to simplify into one payment and possibly lower your interest rate. You may not be a good candidate for a personal loan if you can pay off your current debt within a relatively short amount of time.