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Debt Consolidation Strategies
The purpose of debt consolidation is to make it easier for you to pay your bills and pay down your debt. The concept is simple enough: Take out a new loan to pay off your old debts, leaving you with a single monthly payment that is hopefully smaller and includes a lower interest rate.
The size of the monthly payment is sensitive to the term of the new loan. By stretching out repayments, your monthly bill is smaller and more affordable. However, you’ll end up paying interest over a longer period, increasing the overall cost of your debt. You can mitigate the extra cost to some extent when the interest rate on your new loan is below the weighted average rate of your old debt.
Consolidation vs Incrementalism
Consolidation is the quickest way to eliminate multiple debts. Your one new loan pays off your existing loans and credit card balances – a fast and easy solution. However, some folks prefer to avoid a new loan or simply can’t get approved for one. For them, an incremental approach to debt reduction is their best alternative.
There are two main methods, known as snowball and avalanche, for incrementally paying down debt. They are usually used to pay down multiple credit card balances, but can also be used for loans or a mix of loans and credit card debt:
- The snowball method: In this method, you first pay off the debt with the smallest balance. After you’ve dispatched that debt, move on to the next one with the smallest balance. Continue until you’re out of debt. This method can give you the confidence to stick to your repayment plan because it lets you pay off the first debt relatively quickly.
- The avalanche method: Using this method entails first paying off the debt with the highest interest rate. Work your way down the debt roster until you pay off the one that charges the least. The avalanche method saves you the most in interest and will get you out of debt faster than the snowball method. However, it might seem like it’s taking longer to see progress. If that’s a problem for you, stick to the snowball method.
The incremental approach makes sense when you can’t get a consolidation loan. However, it must be managed carefully, because you will continue making multiple payments each month to different creditors on different due dates. If you aren’t well-organized, you run the risk of missing a payment and triggering penalties, such as late fees and possibly a higher interest rate. A mismatch in the timing of your income and debt payments can also cause you to miss a due date.
Consolidation creates a much easier scenario. You now have to remember (and manage your cash for) a single monthly payment. It’s much easier to stay on track this way, but it also requires discipline: You don’t want to create new debt as you are paying off your consolidation loan, lest you find yourself in a deeper hole than before. Getting out of debt is serious business — to succeed, you’ll need to straighten out and fly right.
9 Ways to Consolidate Debt
1. Personal Loan
One of the most popular ways to consolidate debt is through a personal loan. It’s an attractive option because you don’t have to pledge collateral to get a personal loan. Moreover, you can stretch out repayment over many years, and interest rates on personal loans usually beat those for credit cards, certainly for payday loans. These are usually unsecured loans, meaning you don’t have to pledge (and risk the loss of) collateral property.
RELATED: Personal Loans vs. Credit Cards: What’s the Difference?
2. Credit Card Debt Consolidation
This is the balance transfer method for paying off credit card debt, in which you transfer the balances on all your credit cards to a new card that charges no interest on transfers during the introductory period. Note that you’ll likely pay a one-time fee, usually around 3%, for each transfer. This type of consolidation has the virtue of simplicity, as you won’t have to juggle multiple minimum payments and due dates each month. Some cards have introductory periods of up to 18 months for 0% APR balance transfers.
Once you’re all done, continue to use your old credit cards at least once a year, because you don’t want to hurt your credit score by reducing the average age of your credit accounts. That will happen if you close an account or leave it dormant for too long.
Keep your credit card credit utilization ratio (i.e., credit used / credit available) below 30% and your debt-to-income ratio below 36% to facilitate future loans while preserving your credit score.
RELATED: How to Reduce Your Debt-to-Income Ratio
3. Borrow from Your 401K
If you have an employer-sponsored 401K, you may be able to borrow from it, as long as your employer plan permits it. It may be possible to borrow up to 50% of your balance, up to $50,000 within a 12-month period. It’s not a taxable withdrawal, and the small amount of interest you pay goes back into your account. You usually must repay in full within five years or else the loan will be classified as a taxable withdrawal, perhaps subject to a 10% early withdrawal penalty.
4. Borrow from Your Cash Value Life Insurance
If you have whole life or some other kind of cash-value (i.e., not term) life insurance policy, you can borrow from it without the need to repay. However, any outstanding loans will reduce the death benefit. Thus, you should repay the loan to protect your beneficiaries.
5. Ask Family and Friends for a Loan
You might be able to get very favorable terms, but you risk alienating the lender if you fail to repay. You may also be expected to return the favor at some future date. Failure to repay might even land you in court or have you ex-communicated from Thanksgiving dinner.
6. Take a Title Loan
If you have outright title to a car, boat, airplane, or other expensive plaything, you can get a title loan by using the property as collateral. This means the lender can repo the vehicle without first going to court if you default on the loan. It’s an option, but not advised.
7. Refinance Your Home
You can refinance your home for more than your current mortgage balance and use the excess cash to consolidate your other debts. Any points you pay should be tax-deductible. Make sure you can afford the new mortgage, lest you lose the home to foreclosure.
8. Take a Home Equity Loan
As an alternative to refinancing your home, you can cash out your equity, which is the surplus of the home’s resale value minus the mortgage balance. The interest may be deductible, but once again you increase the risk of foreclosure if you default on the loan.
RELATED: Cash Out Refinancing Versus Home Equity Loan
9. Settle Your Debts
This is consolidation without the loan. You work with a settlement company that negotiates on your behalf. Funding is created by stopping payments on your current debt as the settlement company works out a plan in which your creditors forgive some of your debt. Once the plan is in place, you make a single monthly payment to the settlement company, which then distributes it to your creditors in the agreed manner. There is the risk that a lender will take you to court rather than forgive debt, and in any event your credit score will swoon.
The Failure Factor
We would be remiss if we didn’t devote a little space to why some debt consolidation initiatives fail, in the hopes you can avoid this outcome if you understand it.
One of the biggest reasons why debt consolidation can fail in the long run is its success in the short run. That is, consolidation results in lower monthly payments, reducing pressure on your finances. However, some debtors fall back into their old bad habits of spending too much and managing money poorly. For this subset of consolidation customers, the practice simply feeds a debt addiction that only gets worse when the pressure is off. You may find yourself continuing to overspend, leading to additional debt that can spiral out of control.
RELATED: How to Shed Your Credit Card Addiction
Debt spirals are no joke. They can cost you your home, your credit score, and quality time before a bankruptcy judge. Bankruptcies remain on your credit report for 7 to 10 years, depressing your credit score and sending up warning flares to prospective employers, landlords, and creditors.
Credit counseling is a good idea if you have trouble managing your debt. The service is usually available for free and can help you establish good financial habits. It’s a smart idea to speak to a credit counselor before pursuing a credit settlement strategy, as you may find some less-radical options and in no event will it hurt your credit score.
For many people, a personal loan is the optimal funding source for debt consolidation, as it doesn’t require collateral or a 401K account. Check Match Financial for our recommendations of personal loans currently available.
Eric Bank is a business and personal finance writer who has been featured in Credible, Wisebread, CardRates, Zacks and many other outlets. He holds an M.B.A. from New York University and an M.S. in Finance from DePaul University.