We compare the alternatives
Is Debt Consolidation a Good Idea?
by Jonathan Dyer
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Is your credit card debt calling to you? Ready to pay it off once and for all? Consolidating your debt could be the answer.
This year, U.S. consumers are on track to reach a combined $1 trillion in credit card debt. Add in the fact that credit cards often carry notoriously high interest rates and it's easy to see why so many Americans might be considering consolidation. Let's take a look at three popular debt consolidation options, how they work, what the benefits and drawbacks are, and whether or not they're ultimately a good deal.
Option #1: A Credit Card Balance Transfer
What it is
One of the most common "tricks" that consumers will use to consolidate their debt is called a balance transfer. Simply put, this means that they will pay off one card by moving the amount they owe to another card that carries a lower interest rate.
Credit card companies will often offer low (even 0%) interest rates when you first sign up for a card. This is what's known as an introductory rate. Make sure to check how long the rate lasts as most offers expire in less than a year, but some can be substantially longer. If you can pay off your debt during the introductory period, it could end up saving you a bundle in interest charges compared to a regular credit card.
The first pitfall of balance transfers is that they require you to be approved for a new credit card that has a low interest rate offer. If you have a lot of outstanding debt, you are unlikely to get a low interest rate on the balance transfer offer, which makes it a bad deal right from the start.
It's also worth noting that all of this reshuffling of your revolving credit could negatively impact your credit score, at least temporarily. Worst of all, if you don't pay off your debt in the allotted amount of time, the regular interest rate will take effect, which may in fact be higher than the rate you were paying on your original card. When this happens, your debt balance is likely to shoot right back up.
On top of that, most cards will charge a balance transfer fee, up to 5% of the total balance transfer amount. Suddenly that low introductory interest rate can turn expensive.
Is it a good deal?
When done right, taking advantage of introductory rates with a balance transfer can be a great deal. However, in order for the plan to work, consumers need to remain committed to paying off their debt by the deadline of the introductory offer.
Additionally, balance transfer fees could end up cancelling out some of your interest savings if you're not careful. To help you better decide, Bankrate offers a balance transfer calculator so you can crunch the numbers and see if it makes sense for you.
Option #2: A Personal Loan
What is it?
A personal loan allows you to borrow a lump sum of money that is then paid back in installments over time. Typically, loan payments are due monthly, but that will depend on the lender. In addition to paying off your credit cards, personal loans can also be used for other debts or expenses you may have.
While you'd be extremely hard-pressed to find a 0% interest personal loan, the rates on these loans are typically much lower than that of credit cards. Additionally, unlike balance transfers that give you the option to only make minimum payments, personal loans combine your principal with the interest you owe to provide you a standardized monthly payment amount. This can be encouraging and motivating for consumers, as it gives them a clear plan and end date for becoming debt free.
As mentioned, personal loans rarely if ever offer 0% interest or introductory rates. Another downside is that many lenders will charge what's known as an origination fee that is typically between 1 to 6%, which will be deducted from the amount you receive. For example, if you borrowed $10,000 with a 3% origination fee, you would actually receive $9,700. Speaking of fees, you should also be cautious of loans that charge a prepayment penalty.
Is it a good deal?
Many people prefer personal loans to balance transfers because it gives you a clear plan for paying off your debt. Plus, as long as you avoid loans that charge prepayment penalties, you may be able to save even more money by paying off your loan early. To help you figure out what your monthly payment would be and how much you could save versus a credit card, marketplace lender Lending Club offers a personal loan calculator that can come in handy when weighing your options.
Option #3: A Home Equity Loan or Line of Credit
What it is
If you own your home and have been making payments on it for a while, you will earn what's called equity. Basically equity is a measurement of not only what you've paid on your mortgage but also what your home is worth. If you've paid a significant amount or your home's value has increased, you may be able to borrow against this equity in order to pay off your credit card debt.
Home equity loans (HELs), also referred to as second mortgages, often carry very low interest rates and have long-terms, allowing you to pay it back with smaller payments (although this could also just needlessly extend the amount of time you're in debt). On top of that, there are also home equity lines of credit (HELOCs). These allow you to not only pay off your credit card debt now but also tap into your home's equity for future home improvement projects.
First, you need to own a home in order to take advantage of a home equity loans or lines of credit. Additionally not every homeowner will qualify, especially those who only purchased recently or whose houses may be "under water" (meaning you owe more than your home is worth). Another big downside is that by taking out a home equity loan, you are putting up your home as collateral. This means that failure to repay your loan could result in losing your home. Lastly, HELs and HELOCs may also come with conditions that not every owner will be happy about, including stipulations about not renting out your home.
Compare HELOC rates.
Is it a good deal?
For homeowners with a good amount of equity that want to pay off their credit cards, both HELs and HELOCs can be great options. Just be sure to research and read all the fine print so you understand what you're getting yourself into. You will also want to compare a fixed-rate option to a variable rate one, both of which have their own sets of pros and cons.
Overall, debt consolidation can be a smart move if you're seriously looking to dig your way out of debt. There are several different methods and plans for consolidation that have their own advantages and disadvantages. By considering each option carefully to determine which is best for you, you could save yourself thousands in interest and, more importantly, be on your way to being debt free.
Reviewed April 2017
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