Debt Consolidation: The Pros and Cons of Your Major Options

Debt consolidation is a type of debt refinancing that allows consumers to pay off other debts. In general, debt consolidation entails rolling several unsecured debts, such as credit card balances, personal loans or medical bills, into one single bill that’s paid off with a loan.

There are dozens of ways to go about consolidating debt, and some include transferring the debt to a zero or low-interest credit card, taking out a debt consolidation loan, applying for a home equity loan or paying back your debt through a debt repayment consolidation plan.

When researching consolidation plan options, you may come across what’s known as debt consolidation companies. Some of these debt consolidation companies are legitimate; according to the Consumer Financial Protection Bureau, however, others are incredibly risky.

That’s because some may be debt settlement companies that convince you to stop paying your debts and “instead pay into a special account,” the CFPB warns. “The company will then use this money to attempt to negotiate with creditors to reduce the amount of principal you pay off.”

If you’re considering this option, try to speak with a nonprofit credit counselor first because debt settlement can put your credit in jeopardy. (You can learn more about choosing a credit counselor here.)

If you don’t pay your debt, creditors could hire debt collection agencies, which could lead to a lawsuit, the CFPB says. Not paying creditors will also show up as a negative transaction on your credit report that makes it harder to borrow more money. And then there’s the risk of increasing your debt if you fail to make your payments under a debt settlement program.

Once you’ve chosen a debt consolidation method, it’s a good idea to keep the total cost as low as possible. Try not to take the maximum amount of time possible to pay off your new loan, and come up with a plan to get out of debt in three to five years.

You’ll also want to read the fine print in order to avoid surprises such as a balance transfer fees or application fees. If an offer sounds too good to be true, it probably is.

Common Types of Debt and Terms

There are several different types of consumer debt. However, the most common debts are credit card debt, medical debt, and student loans. Other debt such as personal loans and auto loans are also a relatively common occurrence and can also be considered when consolidating your debt.

Secured Debt and secured loans are debt that utilizes some form of collateral in case of nonpayment. Collateral can include a sizeable asset such as a car or a house to secure the debt.

Unsecured debt, on the other hand, does not require any such collateral and these types of debts are most commonly seen with credit cards and personal loans.

Fixed interest rate debt is when you are set at the same interest rate that is continued throughout the lifetime of the loan. This type of debt is most commonly seen with mortgages.

Variable interest rate debt is a shifting interest rate, like you would find with credit cards, and will change at some point throughout the duration of the debt.

Fixed payment terms are loans that have been scheduled to be paid off at a certain date, and these are most commonly found with mortgages and student loan debt.

The following is more in-depth information on the different types of debt you can incur as well as options to consolidate this debt and come up with a debt management plan to achieve lower and more manageable payments.

Homeowners Have Great Options

If you’ve built up some equity and interest rates seem favorable, it may make sense to refinance your home and use the additional cash you can borrow to pay off more expensive debts. Or you might be better off taking out a home equity line of credit (HELOC) or a fixed-rate home equity loan.

Pros:

• You can save a fortune by switching debts from the double-digits of typical credit card bills to the much lower rates on home equity loans and refinances.
• There’s the possibility of being able to deduct the interest on home loans, which is not possible with credit card debts.
• If you shop carefully, you’ll be able to get a good deal on closing costs, which could save money.

Cons:

• You’re putting your home on the line, which is extremely risky unless you are certain you can trust yourself to stop overspending and to faithfully pay off the home loan(s).
• If you go for a variable-rate loan, remember that what goes down may well go up, increasing your cost of borrowing.
• Don’t unwittingly extend the length of time you’ll be in debt, or it might cost you more over the long run than if you’d simply paid off those higher rate bills.

Tips:

• Don’t pocket the money that your refinancing frees up every month. Instead, use it to create an emergency fund (if you don’t already have one). Once that’s set up, use the money as prepayment against your home loan or to boost your retirement savings.
• Ditto with any tax refunds that come your way.

Cardholders Have Great Options

One of the easiest ways to consolidate your credit card debts is to call your current card issuers and ask for a better deal. If the representative seems unwilling, we recommend asking to speak with a supervisor. Lenders know the competition is tough, and it’s cheaper for them to keep you than it is to get a new customer to replace you — especially if you’re a low-maintenance borrower who pays her bills on time.

While you have them on the phone, ask about these three options:

1. Getting a special rate on any new balances that you transfer to their card.
2. Getting the interest rate lowered on new purchases.
3. Getting any annual fee waived.

Pros:

• A phone call or two to a toll-free number is all it takes.
• You have nothing to lose, and you may save yourself a lot of money — now and over the long haul.

Cons:

• If you have a spotty payment record, it may not work.
• Instead, try getting a new low-rate credit card. This is admittedly more of a hassle than making one toll-free call, but if you’re honest about your credit situation as you look over the offers, you may find a lower-rate card without too much trouble.

Tips:

• Ask that any balance transfer fees be waived.
• Don’t apply for too many new cards at one time. It can hurt your credit score.
• Watch out for teaser rates. While you can save the most by strategically transferring your debt to another low introductory rate card whenever the last “teaser” rate is about to expire, the constant balance swapping can burn you out, and if you flub it, you could pay for it. Instead, try to find a low-interest credit card
• Be sure to plow your savings into your debts.

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Can You Borrow from Your Nest Egg?

The answer is “Yes!” if you have:

1. A 401(k), 403(b) or other kinds of pension plans
2. An IRA
3. Investments, such as stocks and bonds (loans against them are called “margin” loans)

This raises many issues worthy of your consideration. If you were to withdraw retirement funds early instead, from your 401K, for example, you’d have to pay taxes and a 10% penalty.

The interest rates on these loans tend to be low — or even interest-free. For example, you can use money from your IRA interest-free for 60 days. However, you must roll it over to another IRA account within 60 days.

Don’t use your IRA to pay debts unless you are 100% confident the money will be replaced within two months, say, with a tax refund. Otherwise, you’ll be hit with a penalty and taxes on the funds. (Of course, while you’re using your IRA money, it won’t be earning you any interest either.)

Pros:

• If you have no credit history or a poor one, these borrowing options might make sense, since they require no credit check and are easy to get.
• The interest rates are generally low, and since you’re the lender, the interest gets paid to you (in the case of retirement funds). As far as margin loans and IRAs are concerned, you don’t have to make interest payments on them at all.

Cons:

• Should you lose your job, you might have to pay back your retirement fund loan immediately … or pay taxes and penalties and have it treated as an early withdrawal.
• You could end up robbing your retirement fund if you rely too much on these loans.
• If you fall behind on your repayments, even though they are to yourself, the IRS will treat a retirement fund loan as an early withdrawal — 10%, plus taxes.
• Since there’s always a risk of a “margin call” if the market crashes, most advisors urge caution here — that is, to keep margin borrowing at 20 to 25% of your investment account. (With a margin call, you may be called on to immediately pay back the loan, which may mean selling stock at an unfavorable time.)
• Don’t use your IRA to pay debts unless you are absolutely certain that you can come up with the funds in 60 days. Otherwise, you’ll be hit with a penalty and taxes on the funds. Speak with a tax professional before undertaking an IRA rollover to be certain your plan is sound. For example, the funds have to be returned to an IRA account (same one or different).

Debt Consolidation Using Personal Loans

From friends and family:

These loans can be your best or worst nightmare. Ideally, you offer your parents or another private lender an interest rate that’s better than what they’re getting at the savings bank.

Pros:

• Everyone can win! They get a higher rate, you get a lower rate, and you’ll be able to quickly get out of debt.
• Depending on how the deal is structured, you both may even be able to get some tax perks. Talk to a tax pro or a lawyer.

Cons:

• If you blow it, you may ruin one of the most important relationships in your life. Even exerting some heavy pressure on hesitant loved ones can make things very difficult, whether you get the loan or not.
• The IRS can be a real pain when it comes to family loans. Below-market interest rates may inspire Uncle Sam to look to your family for taxes on the interest you would have had to pay a traditional lender. And there may be tax consequences if you can’t pay back the loan.

Tips:

• Getting good tax advice is a must.
• Come up with a concrete plan before you approach family and friends. Know what interest rate you’d like to propose and how much your monthly payments will be.
• Get the agreement in writing and be sure it states what the late charges will be (not that you would dare miss a payment), and what will happen if you default on the loan.

A tip for Mom and Dad: 
If your kids ask you for a loan — for debt consolidation or any other purpose – even if you can easily afford the requested amount — take a good, hard look before you agree. If you do go for it, keep it as professional as possible. Not only will you be bailing out your children at an important time in their lives, but you’ll also be giving them an excellent borrowing experience.

From Banks and Credit Unions:

In the days of yore, when people needed a hand catching up on their bills, they strolled into the neighborhood bank, spoke to branch manager, shook hands on a loan, and got a check for the amount they needed. These days, while you can still get personal loans from banks and credit unions, there are generally lower-rate options, such as the ones we have been discussing.

The rates are better when the loan is secured, and you’ve been a bank customer for years than when the loan is unsecured and given solely against your good name. So, check where you currently bank.

Pros:

• Depending on your circumstances and the local competition between lenders, you may be able to get a great rate.
• If you set up the loan for three to five years, you will be “forced” to stay on your debt consolidation schedule. If you let the bank take the payments from your account automatically, you may get an even better rate.

Cons:

• If you have a spotty credit history with many outstanding debts, you will not be offered a great rate from a bank.
• While there are many online offers for personal loans, be wary. Only go to sites you trust before you even consider borrowing.

Remember, don’t hesitate to ask your bank or credit union to give you a better deal if they want to keep your business. And be sure to discuss the situation with a lender before your credit report is pulled. If the bank’s terms are not to your liking, there’s no reason to have its inquiry show on your credit report.

Remember, it’s important not to let yourself get so deeply into debt again. Pay your bills on time, even if all you can afford is the minimum. (Always try to send in more than the minimum.) If you’re in a financial jam because of a situation that’s beyond your control — say an illness or job loss — get help now. You do have options.

Finally, be sure that your credit score is high enough for you to be approved for your best debt consolidation option. You can view two of your credit scores for free on Credit.com.

A debt consolidation program may not be the best option for you if you think you will have trouble addressing your spending habits. It is also not a good option if you are so overwhelmed with debt that even if you consolidated, you doubt your ability to make the required monthly payments, even if they are reduced.

When Should I Consider Debt Consolidation?

It may be time to revisit the idea of debt consolidation and finding a debt management program if you find that your total amount of debt owed does not exceed fifty percent of your total income and your credit is in good enough standing to qualify for a 0% interest credit card of a very low-interest debt consolidation loan.

Also, ensure that you have enough money coming in to comfortably meet the payments each month and you have a plan in place in case something happens, and you incur more debt or find it challenging to make the required monthly payments.

A debt consolidation program works best when there is a concrete plan in place to reduce the total amount of debt in a realistic and probable way without putting your other assets, like your home, at further risk.

Always compare the total amount of debt you owe to your gross annual income and consider if you will be able to pay the debt off over the next few years or not. A loan calculator may also work to help determine a rough estimate of what the monthly payments may look like.