Debt consolidation: pros and cons

In a previous blog post, I discussed different types of debt and presented several options for eliminating debt. However, one option I didn't cover in depth was debt consolidation — that is, paying off multiple debts with one loan. In this blog, I will discuss different types of debt consolidation and the pros and cons of each.

Common Types of Debt Consolidation

1) Promotional Rates on Credit Card Balance Transfers

There are many offers for credit cards that provide favorable interest rates for balance transfers from another credit card. For example, the promotional rate might be as low as 0% interest on a balance transfer for a set amount of time. After that, the interest rate on any balance increases to the rate set by the credit card company.  

I strongly encourage you to also read the fine print in these offers and understand any fees, interest rates, interest payments and payment structure. If you are applying online for the card, that means reading the terms and conditions before checking the box saying you agree to them.

Pros:

• You could get the benefit of that promotional rate if you pay it off before the promotional period ends. If you have a great credit score and you are a very organized person, you could keep switching to a new promo card before the promotion on the current card ends, and as a result, keep your credit card balance at a zero percent to low percentage interest rate. It’s a game that requires you to be aware of the “rules.” That means reading the fine print.

Cons:

• If you have poor credit, you will probably not get the card.
• Some credit card deals charge a percentage of the balance transfer as a fee up front that is added to the balance.
• You have to pay the amount of the balance transfer IN FULL before the promotional period ends to reap the benefit of the lower interest rate. For example, your promotional rate is 0% for 12 months. During that time, interest accumulates at the higher interest rate. At month 13, all the accumulated interest is due at once, in addition to the ongoing minimum payment and interest rate.
• You need to hold off on making purchases on the new card during the promotional period. Those purchases must be paid off before payments are applied to the balance transfer. Adding charges to the card makes it more difficult to pay off the promotional balance, which must be paid in full before the promotional deadline ends and you then have to pay the accumulated interest.

2) Unsecured Loans

There is no collateral needed for unsecured loans. These loans are much like credit cards, except that the payment and the term (length of the loan) are fixed. It is good to compare loans from different lenders.

To get the loan, you would need to credit qualify and meet the debt-to-income requirements. Those requirements are determined on a case-by-case basis.  

Pros:

• You do not have to put up any assets (home, auto or other property) as collateral for these loans.
• You might qualify for a good interest rate and affordable payments, especially if you already have a relationship with your credit union or bank.

Cons:

• If you have poor credit, you might not get a loan.
• There might be hidden fees.
• Some loans list payment terms but not their interest rates. This is a red flag; the amount you have to pay back might be a lot more than you originally borrowed.
• Verify that the payment structure is manageable. If the monthly payments look affordable, that could be a sign that it is an interest only loan. For this type of loan, the full amount of the principle borrowed is due at the end of the loan in a full lump sum called a balloon payment. Again, check the fine print.

3) Home Equity Loan/Line of Credit

If you own your home and have available equity in your home, you might qualify for a loan or line of credit against your equity. The lender then places a lien on your home, giving them the right to collect the full amount due in the case of missed payments. If you cannot make payments on your credit cards for several months, it stays as unsecured debt and you’re not placing your home at risk. If you cannot make payments for several months on your home equity loan or line of credit, you have the potential to lose your entire home to foreclosure.

Home equity loans or lines of credit (HELOC) are often taken out to help pay for repairs or improvements to your home to help build equity faster. They are also taken out sometimes to just have an available credit line in case of emergencies. They are riskier if they are used to pay off credit card debt. However, some people still use this option to pay off credit card debt if the interest rate is extremely low and they have backup assets to cover the loan and avoid foreclosure.

Pros:

• Because the home equity line of credit is secured with collateral, you might get a lower interest rate.
• If you do get a loan (versus a line of credit), the loan rate is fixed for a specific time period and does not vary.

Cons:

• If you get into a situation where you lose your job or become ill and cannot make payments, you could potentially lose your home to foreclosure. Be sure you have backup assets or other safety nets if using this option.
• If you borrow against your home to pay off credit card debt, you risk not having enough equity left over if you ever need to take out a future HELOC to help pay for emergencies — e.g., a needed, expensive repair on your home.
• You need to meet all underwriting criteria to be approved; for example, your level of debts cannot exceed a certain threshold compared to your income.
• If your credit is poor, you might not receive the loan.

4) Vehicle Loans

If you have paid off your car and are looking for an option with a lower interest rate to consolidate your credit card debt, a loan using your vehicle as collateral might be an option.

The lender will let you know, based on the year, make, model and condition of your vehicle, how large a loan you can receive. Once the loan is written, a lien is placed upon your vehicle. If you are unable to make payments, the lender could demand the full amount of the loan to be due and payable.

Pros:

• Much like a home loan, because it is secured with collateral, you might get a lower interest rate.
• If you have poorer credit, you might still qualify for a vehicle loan, especially if you have a relationship with your credit union or bank.

Cons:

• If you fail to make payments, your car could be repossessed and sold to cover the amount of the loan you still owe.
• If you lose your vehicle, the lender sells it, and the sale does not cover the full amount of the loan, you will be stuck with paying the remaining loan balance, even if you don’t own the car.

5) Loans Against Your Retirement Account

Your retirement fund can be used as collateral for a loan. However, many retirement accounts have rules about when you can take a loan out against them. Often loans against retirement funds need to meet certain parameters, such as purchasing a primary dwelling or taking out funds for hardship. Credit card debt would not qualify as a hardship. 

If you cannot make the payments on the retirement loan, funds from your retirement account would be withdrawn. The total funds taken out would include the loan amount, the income taxes owed on the withdrawal, and an early penalty (10% of the funds withdrawn for most retirement funds) if you are below the minimum age that the plan allows for withdrawals (59.5 years).

Pros:

• Having retirement assets to pay debt could be a plus, but one with many tax consequences and possible liquidation of your future retirement if you are unable to pay back the loan. I refer you to a certified financial planner or tax accountant to help you make that decision.

         Please note: we do not provide retirement planning services or investment advice.

Cons:

• If you cannot make the payments, your retirement funds are depleted to cover the amount owed.
• You might have to pay early withdrawal penalties and taxes, which might be a hefty sum. When the loan is secured as collateral, it affects the rate of growth of your retirement funds overall.

Debt consolidation might not be the best solution for managing and eventually eliminating your debt. Our Debt Management Plan (DMP) is another option. A DMP takes your unsecured debt (most credit card debt) and combines the payments into one monthly payment. LSS Financial Counseling works with your creditors to reduce the interest rate on your debt, potentially saving you thousands of dollars in interest. With a DMP, you can also pay off your debt in five years or less.

LSS Financial Counseling has certified, nonjudgmental financial counselors who can work with you to decide what options are best for your specific situation. Call 888.577.2227, or get your support online.

Author Sarah Jannusch is a Certified Financial Counselor with LSS Financial Counseling.