Debt Consolidation: Is it a Good Deal?
Is your credit card debt continuing to haunt you? Ready to pay it off once and for all? Consolidating your debt could be the first big step toward achieving that goal.
According to the Federal Reserve Bank of New York, U.S. consumer credit card debt totaled $930 billion at the end of 2019 — and that was before the current crisis that has hit many Americans financially. 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 is it?
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. In most cases, this is made possible via a credit card offering a promotional rate to entice new users.
As mentioned, oftentimes credit card companies will 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, although 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 that 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 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 lower than that of credit cards (depending on the quality of your credit). 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.
Something else to note is that select lenders may also offer ways to lower your interest rate. For example, SoFi provides a .25% interest rate reduction to borrowers who sign up for their AutoPay program. That may not sound like much but i could make a significant monetary difference over the life of your loan.
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 — 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, SuperMoney offers a personal loan comparison tool that can come in handy when weighing your options.
Option #3: A Home Equity Loan or Line of Credit
What is it?
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, the obvious: you need to own a home in order to take advantage of a home equity loan or line 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 you 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.
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.
Option #4: 401(k) loan
What is it?
If you have a 401(k) through your employer, you may be allowed to borrow money from your account to pay off debt. In most cases, you’ll select the terms of the loan (e.g. how long of a period you want to pay it back over), with payments being deducted from your paychecks just as your 401(k) contributions are.
With a 401(k) loan, not only will you often be able to borrow money at a lower interest rate than you would via a personal loan but that rate will also not be dependent on your credit (most loans of this type won’t require a credit check). That could make them attractive for those with less-than-stellar credit. Plus, while they may not be as speedy as some FinTech lender options, 401(k) loans are typically pretty straightforward and pay out quickly.
The biggest risk with 401(k) loans revolves around what happens if you were to lose your job. In such a scenario — whether the termination is voluntary or not — you’ll have to fully repay the balance of your loan right away. If you fail to meet the given deadline, the remaining amount will be considered a distribution, which will mean paying taxes on the money as well as a 10% penalty if you’re under 59 and a half years old.
Outside of that risk, borrowing from your 401(k) could end up costing you more than you think. That’s because, by pulling your money out of your account and thus out of the market, you could be hurting your upside investment potential. Similarly, you’ll also miss out on the benefits of compounding interest.
Is it a good deal?
While 401(k) loans may seem like a smart idea to some, there are plenty of reasons why financial experts often advise against them — including the potential risks associated with job loss and the chance you might hurt your investment growth potential. Of course, calculating these impacts can be difficult. Therefore the best plan of action may be to do your own research and consider all of the elements before deciding for yourself.
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 each 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.
Also published on Medium.