The Best Way to Consolidate Debt

American debt has reached another all-time high. According to the Federal Reserve, household debt has exceeded $4 trillion. Much of that increase is due to rising student loan balances and auto financing, which contributed $80 billion in 2018. Overall, consumers are spending about 10% of their disposable income on non-mortgage debt. Credit card debt is a big part of that, and Experian reports that the average credit card balance is more than $6,000. In fact, one in three consumers fear they will max out their credit card debt.

Managing your debt is a balancing act. Some debt is inevitable, and even desirable. Owning a home, for example, gives you a number of financial and tax advantages, so a mortgage is “good” debt. Student loans also can be deemed worthwhile because a college degree can help you get a higher-paying job. However, if you don’t manage your debt properly, it can wreak havoc on your household finances.

Your debt also affects your credit score. In fact, 30% of your credit score is tied to your credit utilization (i.e., how much credit you use versus the amount of credit you have available). Carrying a lot of debt will lower your credit score, even if your debt-to-income ratio is low. The lower your credit score, the less likely it is that you will qualify to borrow money. 

Fortunately, there are a number of ways to manage your debt, and debt consolidation is one of your options.

What Is Debt Consolidation?

As the term implies, debt consolidation is a strategy to bundle debts together into one affordable payment. The goal of debt consolidation is not to eliminate what you owe, but to restructure your debt to make it more manageable. With debt consolidation, you want to restructure your interest rates or change the repayment terms to reduce what you pay each month.

To illustrate, let’s assume that you have a $5,000 balance on a credit card with a 19% APR and a minimum payment of $200 per month. It will take you 11 years and five months to pay off the credit card (assuming you don’t add more debt), and you will pay $8,136.31 on the original $5,000 debt. If you move that $5,000 balance to a credit card with an APR of 15%, then it will take you 10 years and three months to pay off the debt at $200 per month, and your total payments would be $7,192.62—saving you $943.69. If you lower the APR and pay more than the minimum monthly payment, you can pay off the debt sooner with even greater savings.

Not everyone who owes money is a good candidate for debt consolidation. Your debt may be a problem if:

• You owe more than 40% of your income.
• You owe more than you can pay off in six months.
• You can’t easily make your monthly payments.

If you feel your debt is more than you can handle, then consider these debt consolidation strategies.

The Best Debt Consolidation Strategies

First, develop a plan to reduce your debt. This means more than moving your debt around. It also means having a concrete plan to pay down what you owe. Too often, people find a way to relieve debt pressure only to spend more on their credit cards, so they are back where they began, deep in debt.

Take a hard look at your outstanding debts. Which debts have the highest APR? Those are the best candidates for debt consolidation. Also, determine which debts will give you more flexibility when it comes to paying your monthly bills.

• Credit card balance transfer: Credit cards are the biggest problem for most consumers. Since credit cards are revolving debt, it’s easy to make a payment one month and then spend more on that card before the next bill is due. A balance transfer moves the balance from a credit card with a higher APR to another card with a lower APR, which then lowers your overall debt. Be sure you transfer to a card with a fixed lower APR and that you understand any fees that will be charged.
  
  
• Personal loan: See if you can qualify for a personal loan with a lower APR. Note a personal loan is an unsecured loan, which means you don’t need collateral. However, even at a lower APR, you want to be sure it helps your debt situation. For example, you may get a loan to consolidate your debt, but if the payment term is too short—say, 12-18 months—then the monthly payment may be more than you can handle.
  
  
• Home equity loan: If you own your home, then you have home equity that you can borrow against. Home equity is the difference between what you owe on your home (i.e., the mortgage) and its market value. With a home equity loan or home equity line of credit (HELOC), you use your home as collateral to secure a loan based on its value.
  
  
• Refinancing your mortgage: Refinancing your home loan or mortgage is a similar strategy. You are basically signing a new mortgage and converting the home equity into cash. Your mortgage and monthly payments will be higher, but you will be able to generate money to pay off your debt.
  
  
• Tapping into your 401(k) or IRA: You can borrow against your 401(k) retirement savings or your individual retirement account (IRA), but you should consider this as a last resort. Borrowing against retirement savings is generally a bad idea, largely because you have to pay taxes and penalties on early withdrawals, and it can substantially reduce your retirement savings.

If you are considering debt consolidation, think carefully before you make a move. Your goal is to reduce what you owe and make your payments more manageable, and if you make a misstep, you could find it harder to manage your debt.

Get some help with your debt consolidation strategy. Your credit union is committed to helping its members manage their money and plan for the future, and debt consolidation is part of that strategy. Contact the professionals at your local credit union for some expert advice.