What’s the Smartest Way to Consolidate Debt?
Consolidating multiple debts into a single, convenient monthly payment is an appealing option for many people. You can use this strategy to get a reprieve from high interest rates or to reduce the amount of money you pay each month.
One of the first things you’ll discover as you explore debt consolidation is that there are many different ways to approach it. Two popular possibilities include specialized debt consolidation loans from banks or alternative lenders and low-interest balance transfer credit cards. You can also explore other options, like tapping into your home equity or retirement assets.
Which approach is best? Well, that depends. To figure it out, you’ll need to consider the particulars of your personal situation in the context of which debt consolidation strategies are available to you. In this guide, we’ll examine each approach and weigh in on when each of them is best used.
Explore the Four Main Debt Consolidation Options
The four main debt consolidation options include:
- Balance transfer cards
- Debt consolidation loans
- Borrowing against home equity
- Borrowing against other assets
Each has their own set of strengths and drawbacks, and there are times and circumstances under which some options are better than others. Let’s take a closer look.
Balance Transfer Cards
Many banks and credit card companies have developed specialized credit cards known as balance transfer cards. They are purpose-built for consumers looking to consolidate existing credit card debt by transferring their existing balances over to the new card. Balance transfer cards offer many advantages, including:
- Low introductory interest rates, which can even reach 0% APR in some cases
- Cashback features on spending
- Compatibility with points-based reward programs
Introductory interest rates are usually valid for the first 12 to 18 months, so to take full advantage of these cards, you should try to pay off your balance within a relatively compact timeframe. Regular interest rates kick in when the introductory period expires. These are usually lower than the rates attached to typical credit cards, so you still stand to save money even if you carry a balance into this period.
The primary advantage of balance transfer cards is their low interest rates. However, they come with a trade-off: most cards cap the amount of money you can transfer at relatively low levels. This means balance transfer cards are of limited value to people looking to consolidate higher amounts of debt.
Balance transfer cards are usually best for people:
- Carrying smaller amounts of debt ($10,000 or less)
- Who have the means to pay off their debt in full during the introductory interest period
- Who won’t misuse the card to accrue new debt
Debt Consolidation Loans
Another of the easiest and most straightforward approaches to debt consolidation is taking out a personal loan at a lower interest rate. You can then use the loan proceeds to eliminate your existing debts, then pay off the new loan to become debt-free.
These loans usually work in one of two ways. First, you could source a specialized debt consolidation loan from a niche provider. With this approach, your new lender will distribute the loan proceeds to pay off your existing debts. You will then become responsible for paying off the consolidation loan.
Alternatively, you could seek a regular personal loan from a financial institution. If you’re approved, you will gain actual control of the loan proceeds. It will be up to you to distribute the funds to pay off your existing debts. The lender will not do it for you.
Debt consolidation loans are usually best for people:
- With relatively high FICO credit scores
- Looking to consolidate more debt than they can transfer to a specialized credit card
- Who want to diversify by using different kinds of credit
Borrowing against Home Equity
If you’re a homeowner and you’ve built up a significant amount of equity, you can also use that equity to finance your debt consolidation. Most people do this by taking out a home equity loan or using their home equity to open a line of credit.
With interest rates continuing to sit at record low levels, there’s a lot to like about this approach. Home equity loans and lines of credit usually offer some of the best interest rates on the market, since you are effectively offering your home equity as a form of collateral. This greatly reduces the lender’s risk, enabling them to extend advantageous rates.
Another advantage of this technique is that it essentially turns your credit card debt, which is a type of “bad debt” since you get nothing for it in the long run, into “good debt” that delivers an asset or reward (your home) in the end. However, you need to exercise caution if you decide to leverage this strategy, as it puts your home at risk. If you default on your payments, you could end up in foreclosure in a worst-case scenario.
Borrowing against home equity is usually best for homeowners with stable incomes. If you decide to get a home equity line of credit, you can also reuse the line of credit for other purposes once you have paid off the balance.
Borrowing Against Other Assets
Finally, you can also borrow against assets like retirement savings or life insurance plans if you have them. Here’s how a retirement account loan works:
- You secure a personal loan using the assets in your retirement account
- Apply the loan proceeds to your existing debts
- Pay the money and interest back into your retirement account
Retirement account loans are usually easy to get if you have the required assets. However, they do carry some risks. If you don’t pay back the loan in time, you may become liable for additional income taxes and other financial penalties. Thus, they are best for people who:
- Don’t have any home equity to borrow against
- Don’t qualify for balance transfer credit cards or carry more debt than you can transfer to a card
- Have a credit score that’s too low to get an advantageous interest rate on a personal loan
If you hold a life insurance plan, most issuers will also allow you to borrow against its value. This is a less risky approach, but you will only be able to borrow up to the policy’s maximum cash value. It will also deny your beneficiaries the proceeds they would otherwise have received if you pass away before you repay the loan.
How to Determine Which Option Is Best for You
Personal finance experts generally recommend exploring balance transfer cards and standard or specialized consolidation loans before examining alternatives. Remember that you can also use a combination of strategies to cover your debt: for instance, you could apply as much of it as you can to a balance transfer card, then take out a loan to cover the rest.
Your options and the interest rates you qualify for will both depend heavily on your FICO credit score. Thus, you should start by obtaining your score and copies of your credit report. Dispute any inaccurate information, ensuring your score is where it rightfully should be. Then, check to see what kind of interest rates you can get based on your current standing.
If you can’t find a way to make the numbers work because of poor credit, consider other options like borrowing against your home equity or other qualified assets. Should this still leave you in search of a solution, you can then explore alternatives like professional debt counseling and negotiating debts at reduced rates through debt resolution.