Debt Consolidation Done Right
Debt sucks. Like, it literally sucks your hard-earned money out of your pocket and into the pocket of someone else.
Isn’t that money you’d like to use toward your financial goals? I’d bet so.
Debt is also stressful. If you have it, you’re constantly thinking about it which distracts you from thinking about more positive things like achieving financial freedom.
But when it comes to debt elimination, you may become slightly paralyzed when trying to figure out the best and most efficient way to pay it off.
I’ve written about the different methods of paying off debt before and my opinion hasn’t changed since then.
But one question continues to come up: “What about debt consolidation? Should I do it?”
My answer to that question always comes with a preamble. Here it is.
Before You Consolidate Debt, You MUST Do This
Debt consolidation can help improve your financial position considerably.
It can lower your overall interest cost, which means more money in your pocket.
It can decrease your time in debt allowing you to begin focusing on building wealth much sooner.
It can also give you the flexibility and cash flow you may need right now to get you through a rough patch.
But there’s one thing you must do before even considering debt consolidation.
You MUST address the reason as to why you got into debt in the first place.Before consolidating #debt, you MUST address the reasons you got into debt in the first place. Click To Tweet
Unfortunately, I’ve seen too many people go through debt consolidation only to find themselves in more debt only a few short months later. Especially if they consolidated credit card debt.
Why? Well, when you consolidate credit card debt to a new account/loan, you now have available credit on those original cards.
If you haven’t set financial goals or created a budget, you’re going to continue spending like you were previously.
Where did that spending get you last time? Oh yeah, you ended up with a ton of debt.
So, I want you to make a pledge right now.
Repeat after me.
“I will not consolidate my debt until I address the reason I got into debt to begin with.”
Say it one more time.
“I will not consolidate my debt until I address the reason I got into debt to begin with.”
Now that you’ve promised to do it right, let’s go over some of the pros (and cons) of debt consolidation and some of the best ways to consolidate.
Debt Consolidation Pros and Cons
When I work with clients, debt consolidation is a hot topic when we get down to creating a debt elimination plan.
Why? Well for one, it’s being marketed to you.
There are a ton of companies out there just dying to get your money and they’d be happy to take on your debt to try and help you eliminate it.
This is why you consistently get credit card and personal loan offers in the mail, through email, and on your Facebook feed.
These companies are hoping that you don’t do what I mentioned in the previous section.
Because once they have your business for a debt consolidation loan, you can bet that they’ll start sending you other offers for car loans, credit cards, mortgages, and more.
Even if you’re not seeing those advertisements, there are plenty of other reasons you might be considering debt consolidation. Let’s take a look at a few of them.
From Many Payments to One Payment
This is the most common reason that people consolidate their debt, and it’s certainly a good one.
If you’re carrying balances on six credit cards and you can get a consolidation loan to help you get that down to one payment, that’s great. You’ll have a lower number of bills to pay each month, which should certainly decrease your stress.
But as I mentioned earlier, one consolidated payment now means that you have available credit on other accounts. You need to stand strong and avoid using them unless you can pay them off in full each month.
Debt Consolidation Could Save You Money
If you can move balances on high-interest debt to a lower interest debt and still make the same payment, you’ll save money. The math shows it to be true.
Here’s an example. Let’s say you have the following debt:
- Kohl’s Card – $763.50 Balance @24.24% and a $27 Minimum Payment
- Discover Card – $4,678.40 Balance @16.49% and a $94 Minimum Payment
- American Express – $12,966.90 Balance @15.74% and a $300 Minimum Payment
- Best Buy Card – $1,733.45 Balance @25.74% and a $55 Minimum Payment
Let’s assume that you’re able to pay $124 extra per month on the debt. If you add that to the minimum payments, you’d get a $600 total payment on debt each month.
If you used the highest interest rate method and rolled down your payments after you pay something off, you’d be debt-free in 46 months, 2 months shy of 4 years. You’d also pay a total of $6,936.69 in interest.
Now, let’s say you want to consolidate those cards into a lower rate, personal loan at SoFi.
I’m going to assume you take out a 5-year loan at 14.24% fixed. That’s actually their highest rate right now on their personal loans. You could potentially get something better depending on your credit. The monthly minimum payment on that loan would be $471.18 which is lower than the minimum payments on your original debt.
If you took out the loan, paid off the credit cards and continued to make a $600 per month payment on the new personal loan, you’d be debt-free in 44 months. That’s two months faster than if you didn’t consolidate.
Not only will you pay the debt off faster, you’ll also save money. The total interest you’d pay on the personal loan would end up being $5,701.11. That’s a saving of $1,235.58 vs. not consolidating. Remember, that’s money back in YOUR pocket.
Improved Cash Flow
If you’re living on the bare minimums (basic food, shelter, transportation, etc.) but still consistently overdraft your checking account or using a credit card to float from paycheck-to-paycheck, you may need some relief in a number of your monthly bill payments.
Debt consolidation can possibly help with that.
For example, you may be able to consolidate your debt in a way that extends the repayment period out additional years. This would lower your monthly payment, but could possibly increase your overall cost. However, it may be worth it if you’re paying huge overdraft fees and high-interest rates on your credit cards.
You could also get some relief if you can qualify for a lower interest rate.
By lowering the interest rate on your debt and keeping the length of your repayment the same, more of your monthly payment will go toward principal. This will lower the overall cost of the debt, and therefore reduce the monthly payment.
Debt Consolidation Reviews
There are many places and products designed to help you consolidate your debt. To get the best product to fit your needs, I recommend taking a look at each opportunity. Let’s go over a few of your options.
A personal loan is where a lender will loan you money based solely on your promise to pay them back. There is no collateral attached to the loan. In other words, if you don’t pay the loan back, no one will come and take any of your possessions.
You should also know that some institutions may actually rebrand their personal loans as debt consolidation loans. In most cases, you can use the names interchangeably.
With good credit, a personal loan can provide you with a much lower interest rate vs. the rates on the majority of credit cards. As you learned earlier, this can lower your overall cost and potentially give you a lower monthly payment.
Here are a few places to take a look at.
Your Personal Bank and/or Credit Union
If you’re looking to consolidate, the best place to start is your personal bank and/or credit union.
Since you already have a relationship with them, you may be able to talk directly with someone you’ve been working with for several years. That kind of personal relationship allows you to provide additional details on what you’re trying to accomplish with the loan.
In addition to your personal bank, check the rates at several other banks in your area. It doesn’t hurt to take a peek and you can easily view their rates on their website.
Online Finance Companies
With the continued growth in technology, many additional options to consolidate your debt have become available.
One of those options is a company called SoFi (short for Social Finance, Inc.).
SoFi is an online loan company that gets its funding from venture capital and offers highly competitive rates on its loan products.
Peer-to-peer lending can help you get the money you need to consolidate your debt directly from individual investors.
The top peer-to-peer lending platform out there is Lending Club. With Lending Club, you apply for a loan and if approved, your loan will be funded by hundreds of individuals looking for a good investment.
Compared to SoFi, you’ll be more likely to be approved by Lending Club if you have sub-par credit.
Credit Card Balance Transfers
Have you received some 0% credit card offers in the mail recently?
If so, they could be a good place to consolidate your debt.
Actually, the first place you may want to look is with the credit card companies you already have an account with.
If you have an account that has a $0 balance, check with that company to see if they’re offering any type of balance transfer special. You don’t typically want to use a balance transfer to a card that already has a balance on it.
Before considering this as an option, be aware that the majority of balance transfers come with a transfer fee. That fee is usually 3%. So make sure you add that cost into your determination. Obviously, it would be even better if you can find a card that offers a great rate plus no fee to transfer.
Just know that you may not be able to secure enough credit to consolidate all of your debt and may end up needing to use other sources that I’ve already mentioned.
One of the first places that most people look to consolidate is with a home equity loan (HEL) or line of credit (HELOC).
It’s certainly one of the lower cost options, but I personally don’t think it’s the best option.
With a home equity loan or line of credit, you’re basically consolidating your unsecured debt into a secured debt. That’s adding risk to your home.
Before, if you didn’t pay your unsecured debts, your creditor wasn’t going to come and take the stuff you bought. However, if you don’t make your mortgage payment (to include your new home equity loan), your creditor could foreclose on your property.
Therefore, I usually only suggest using this option if you’ll still have at least 20% equity in your home AFTER consolidating the debt and also have quite a quite a bit of cash flow flexibility in your monthly budget, including the new payment.
If you’re not sure if using your home equity is a good idea, schedule a financial checkup and we can chat about it.
If you end up choosing this option, you should shop around for the best rate and terms. A good place to start is with your local bank and/or credit union.
First, let me say that I’m talking about borrowing from your retirement account, not withdrawing from your account.
The key benefit with borrowing is that it’s a tax-free transaction (assuming you pay it back) and you’re also able to get the money borrowed, back into your retirement account (you’re paying yourself back). You’re also still able to continue to contribute to your account through payroll deductions, which is a good idea especially if you receive a match on your contributions.
If you were to just withdraw the money, in almost all circumstances the taxes and penalties associated with the withdraw (usually >40%!) are too steep to justify the benefits. You’re also unable to put that money back in at a future date. In other words, you can’t go back.
The only type of account you can borrow from is a qualified, employer-sponsored plan such as a 401(k), 403(b), etc. If you have one, check with your HR department regarding their policies on loans.
A benefit to using this type of loan is that your credit is a non-factor. So even with poor credit, you’re still going to be able to access money, assuming you have a balance in your account.
Even if you just take a loan, there are still some risks involved.
For example, if you don’t pay the loan back or leave that employer before paying back the loan, it typically becomes due in full. If you can’t pay it back at that time, the remaining amount of the loan will likely be classified as a withdraw (or distribution) subjecting you to the taxes and penalties I already mentioned.
As your financial coach, I recommend using retirement money to consolidate debt only if you’ve exhausted all of the other options we’ve discussed.
In fact, I’ve only recommended it to one person throughout my career. That individual was paying for the bare essentials in their budget and after paying the minimums on their debt, they were actually over budget.
They needed the loan to give them cash flow flexibility in their budget. It gave them the breathing room they needed to gain momentum.
Again, if you’re questioning whether this is the best option for your circumstances, schedule a financial checkup and we can chat about it.
Debt Management Plans
A debt management plan (DMP) is a product offered by non-profit, credit counseling agencies and is designed to provide you with a payment schedule to pay off your consumer debt.
In a nutshell, the credit counseling agency will contact your creditors on your behalf and negotiate a payment schedule to ensure all of the debts are paid off within 60 months.
If accepted, you would then make a consolidated, monthly payment to the credit counseling agency who would then distribute that payment to your creditors based on the negotiated schedule. Included in the monthly payment would be a nominal fee paid directly to the credit counseling agency.
One of the requirements of being on a DMP is that you will typically have to close the accounts that are included in the plan.
Now as we discussed earlier, this can actually be a good thing as you’ll no longer have access to that available line of credit.
Because you’re closing accounts and negotiating payment plans, you need to know that DMPs can hurt your credit. Just how badly depends on individual circumstances.
Just as with retirement account loans, I’d suggest using a DMP if you’re limited on options due to bad credit, etc. For an example of how a DMP can work to your advantage, check out the story of Travis Pizel who paid off $109,000 in credit card debt.
To find a non-profit credit counseling agency in your area, check out the National Foundation for Credit Counseling.
Debt Consolidation Products to Avoid
While there are many places to help you pay off your debt, there are also some places that you should avoid.
Debt Settlement Companies
Debt settlement companies typically promise you the world when it comes to helping you eliminate your debt.
They’ll try to hook you by guaranteeing all of your debt will go away, collection calls will stop, and more. Unfortunately, that’s usually not the results you’ll see.
If you work with a debt settlement company, they’ll typically tell you to stop making payments to your creditors and instead, take all of the money you would have paid them and place it into an account where the company will later use that money to settle your debts for less than you owe.
This is bad news for your credit.
Since you’ll no longer be making payments, you’ll become late for all of those creditors who will also add interest, late fees, etc. to your overall bill.
Several months later, they’ll sell your debt to a collection agency for pennies on the dollar. This is where the debt settlement company will step in and try to negotiate a much lower payment to settle your debt in full. However, the damage to your credit was already done and it’ll take many years to fully recover.
There are also many scams associated with debt settlement companies.
The Consumer Financial Protection Bureau (CFPB) warns that you should be very wary of companies that charge upfront fees before they actually settle your debt. That’s my advice as well. I’ve already mentioned much better options available for taking care of your debt.
Payday loans are typically short-term loans of $500 or less which need to be paid back within a few weeks (your next paycheck).
While it sounds like a good deal, the fees associated with these loans range from $10 to $30 for each $100 borrowed. Again, that doesn’t sound that bad. But since the loans are very short-term, this can equate to an annual percentage rate of 400% plus!
If that’s the case, you’d be better keeping the debt on your 29.99% credit card and just work on paying that down until your credit is good enough for some of the options I’ve already mentioned.
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In conclusion, I’ll repeat that I’m not totally against debt consolidation. It can save you a considerable amount of money, time, and can reduce your overall stress levels.
But in order to reap those rewards, you MUST address the reason as to why you got into debt. If you’re looking for a place to start, head on over to The 9 Steps to Financial Freedom.
For good measure, say this out loud one more time: “I will not consolidate my debt until I address the reason I got into debt to begin with.”
Now get out there and take care of your money, so it can take care of you later.
Your financial coach,