Debt Consolidation: Credit Cards and Loans

Debt consolidation is a means of debt refinancing that involves taking out a new loan to pay off other loans and credit card debt. People traditionally use personal loans, low-interest balance transfer credit cards, and debt management plans for debt consolidation. In general, debt consolidation loans can reduce the amount of interest you pay each month, reduce the number of creditors you have to deal with, and shorten the amount of time it will take to pay off your debts as long as you qualify and keep with the program terms.

If you're struggling to pay high interest rates on a lot of unsecured debt, consolidation may seem like an attractive solution. But debt consolidation is not always the best way to deal with debt issues, and it has drawbacks you should be aware of before you move forward with it. What's more, there are several ways to go about consolidating debt, and depending on your circumstances, one method might make more sense for you than another.

What is the Best Way to Consolidate Debt?

You have multiple options for debt consolidation:

  • Enroll in a debt consolidation program and create a debt management plan.
  • Take out a personal loan, which will typically be at a lower interest rate than what you're paying on credit cards.
  • Open a new credit card with a lower interest rate and transfer high-interest debt to the new card.
  • If you own a home, you may be able to borrow against your equity to pay off other debts.

Each option has advantages, disadvantages and challenges. Here's a closer look:

1. Work with a Reputable Credit Counseling Organization to Create a Debt Management Plan

If you're struggling with debt, you may have already been approached by companies that promise they will help you wipe out your debt. Be cautious. Such companies may charge you hefty fees for consolidating your debt, and it's possible to wind up even further in debt if you don't fully understand the company's fees and conditions.

Credit counseling through a reputable non-profit agency is almost always a better alternative. Credit counselors work to help you negotiate with your creditors and formulate a debt management plan (or DMP) to help you pay off your existing debts. The program length will depend on the information provided by your account holders, such as balances and interest rates. Any missed payments under the plan could negatively impact the program length with changes in interest rates and additional fees and charges that could increase balances.

Counseling services may negotiate reduced principle or reduced interest. They might also negotiate how the debt is reported, whether settled or paid in full. The majority of the time, a debt is reported as settled even if it's reduced interest because the consumer didn't pay as agreed, but they could agree to report it as paid in full. If the full interest amount agreed to in the contract is not paid, they have settled the debt, not paid it in full, so that is what is generally reported. Debt settlement involves accounts being reported as settled for less than originally agreed. Settled accounts can harm your credit scores.

With a debt management plan, you'll make one monthly payment to the credit counselor, who will then disburse the funds as agreed to your creditors until your debt is paid off.

Keep in mind that you'll have multiple accounts that depend on your monthly payment. One late or missed payment to a credit counselor can appear as multiple accounts with late or missed payments on your credit report.

2. Negotiate Directly with Creditors

Another option — and one that many people consider as their first step — is to contact your creditors directly. Let them know you're struggling and ask them for help. Don't wait to make the call until you just can't afford to pay them anymore or your account has been turned over to a collections agency. Reach out as soon as you know you're in trouble.

Creditors may be willing to accept a reduced payment, lower your interest rate and waive fees and penalties rather than see you default on the amount you owe.

Reducing your monthly payment often means that it will take you longer to pay off your debt and the debt will be more expensive over time, but some people see this as a necessary trade-off to avoid defaulting.

3. Take out a Personal Loan

If your credit is good, you may be able to qualify for a personal loan that you can use to pay off high-interest debts such as credit cards. Generally, personal loan interest rates are lower than interest on other types of unsecured debt, so you'll save money over the life of the debt. They're also fixed-rate loans, so the interest rate won't fluctuate the way a credit card rate can.

A personal debt consolidation loan can also help streamline your payments; you'll deal with a single payment to the lender, rather than trying to manage multiple payments to several different creditors.

However, if your credit score is low and your credit report has some blemishes, it may be difficult to get a personal loan. What's more, if you continue the credit use habits that got you in trouble in the first place - like not making on-time payments - you could wind up even deeper in debt.

4. Transfer Credit Card Balances to a Lower-Interest or No-Interest Credit Card

Another option for people with good credit scores may be to transfer balances from high-interest credit cards to a card with a lower interest rate. Some credit card issuers offer very low rates or even zero interest as a promotion to entice new customers to open accounts with them or transfer balances from another card. After the promotional period ends, the interest rate typically goes up.

This approach can work if you know you'll be able to pay off the entire debt before the promotional period expires. It's also important to avoid making additional credit card charges while you're paying off a high balance to not further increase your debt. Also, be sure to read the terms and conditions carefully. Some cards have interest rates that skyrocket if a payment is missed.

The act of opening a credit card can be helpful or hurtful depending on your credit history. An inquiry can negatively impact your credit score. However, adding a credit card can positively impact your credit utilization ratio — the total amount of credit you're using versus how much you have available — which is a factor in determining your credit scores.

Whether or not you should close your old credit cards is a personal decision, but it also can impact credit scores. Keeping cards open can improve your credit utilization ratio, and a long history of open accounts in good standing is often seen as a feather in your cap. However, if having credit available will tempt you into further increasing your debt, closing the accounts may be the better solution for your personal situation right now.

5. Tap Your Home Equity

If you own a home and have equity in it, you might think about tapping into that equity to pay off high-interest unsecured debt. A home equity loan or line of credit (also called a HELOC) will generally have a much lower interest rate than credit cards, and you'll reduce the number of creditors you pay each month. That may be helpful if you've lost track of certain accounts in the past.

However, most credit experts agree it's not a good idea to borrow against your home in order to pay off unsecured debt such as credit cards. "Unsecured" means there is no physical property for a creditor to take from you if you default on the debt. The worst a creditor can do is send your account to collections or take you to court to force repayment. A home equity loan or line of credit uses your home as collateral for the loan, so if you use one to pay off credit cards you're basically turning an unsecured debt into one that could result in a claim against your property if you default.

Does Debt Consolidation Hurt Your Credit?

How debt consolidation affects your credit will depend on a number of factors, including how many of your outstanding debts are past due and what type of consolidation you choose.

If a debt consolidation company suggests you stop paying your bills as leverage to force creditors to negotiate, be aware missed or late payments appear on credit reports and can negatively affect your credit scores as a result. If the company also requires you to close credit card accounts, that will affect your credit utilization ratio and the overall length of open accounts that comprise your payments history, which are popular determining factors in many credit scoring models.

Failing to pay according to the debt management plan your credit counselor works out for you, or defaulting on a personal debt consolidation loan will also appear on your credit report as negative information. That kind of negative information will remain on a credit report for seven years.

However, if you make on-time payments for your personal loan or debt management plan, you could pay off your debt and build positive credit history at the same time. As you pay down your debt, your credit utilization ratio will improve, which is also a positive thing for your credit.

Debt consolidation loans aren't always the right choice for individuals struggling with debt. It may be a helpful debt management tactic if:

  • Your total debt is a manageable amount — less than half your annual gross income — but at a high interest rate that you want to reduce.
  • Your debt is unsecured (credit cards).
  • You are serious about paying off your debt within three to five years.
  • You are confident you can make the payments to pay off your debt within that time frame.
  • You are ready to learn and adopt new credit management habits and build your credit as part of your debt consolidation plan.

Consolidating Student Loans

If you're thinking about consolidating your student loans, there are a few extra factors to consider. Depending on the lender you choose for consolidation, you may lose some of the perks of the student loan, such as deferment or forbearance.

Moving Beyond Debt

Both high unsecured debt and debt consolidation can affect your credit. Reviewing your credit report is the best way to understand how those factors might be affecting the way lenders perceive you and your credit-worthiness.

If you decide debt consolidation is right for you, it's important to practice good credit management going forward — regardless of what type of debt consolidation you choose. Good credit management habits can help ensure you don't fall into unmanageable debt again.