Laura answers a listener's question about the pros and cons of debt consolidation and whether it's a legitimate strategy.
Laura answers a listener's question about the pros and cons of debt consolidation and whether it's a legitimate strategy.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Maria, who says:
"I enjoy the Money Girl podcast and always learn something new from your shows. I have several debts that I want to eliminate as quickly as possible. Can you explain what debt consolidation is? I'm skeptical if it really helps you get out of debt faster. Also, are there any downsides I should know if consolidating could help me?"
Maria, I appreciate your kind words and great questions. Many people are unfamiliar with legitimate debt consolidation strategies. This post will review how consolidation works, its pros and cons, and who's a good candidate for using it to eliminate their debt faster.
Welcome back, everyone, and thanks for joining me on episode 881! I'm Laura Adams, an award-winning author, female finance spokesperson, money speaker, founder of The Money Stack, a Substack newsletter, and host of the Money Girl podcast with over 43 million downloads.
If you're getting value from the free content we love creating, subscribe and consider submitting a 5-star rating or review on your podcast app of choice! If you have a question about money for the show, leave it on our voicemail at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
What is debt consolidation?
Debt consolidation is moving one or more debts to an account or into a single payment with more favorable terms, allowing you to eliminate the balance faster. You can consolidate most unsecured debts, like credit cards, personal loans, and auto loans. The strategy involves shifting higher-interest debts to a lower- or no-interest account, so you pay less interest.
While it may seem counterintuitive to use new debt to get out of old debt, paying as little interest as possible saves money, giving you more flexibility. Debt consolidation never reduces the debt you owe, but reorganizes it, making it easier to pay off.
Depending on the terms you get offered, consolidating can be an excellent, legitimate way to reduce interest and get out of debt faster.
3 ways to consolidate debt
The best way to consolidate debt depends on your finances and the interest rates you're currently paying. Consider the following three popular consolidation options:
1. Transferring debt to a balance transfer credit card.
A balance transfer card allows you to move unsecured debt to a new or existing credit card with a 0% APR promotion that may last up to one or two years. It temporarily reduces the interest you pay, giving you some financial breathing room.
However, when the transfer promotion ends, your interest rate increases and could be very high. Therefore, this consolidation strategy works best when you're sure you can pay off the entire balance before the promotion expires.
For instance, if you get approved to transfer $6,000 from a high-rate credit card to a card charging 0% for 12 months, you could make monthly payments of at least 1/12 or $500, so it gets eliminated before your interest rate goes up.
Every transfer is subject to a fee, such as up to 5%, which gets added to your balance. However, avoiding interest during a balance transfer promotion can save a lot despite a transfer fee.
The amount you can transfer depends on the credit line an issuer offers. If you don't have good credit, you may not get approved for a balance transfer or can only put a small amount of debt on a card.
2. Taking out a personal loan.
You can get a new fixed-rate personal loan to pay off higher-rate unsecured debt. You make monthly payments during a set repayment term, such as three or five years. The rate and terms depend on factors like your income and credit.
Remember that even though a personal loan may cut your interest, the shorter your repayment schedule, the higher your monthly payments will be. You risk hurting your credit if you can't repay a personal loan as agreed.
Consolidating debt is a good option when you have large balances to pay off and want a structured repayment term. For example, if you have a credit card balance charging 23%, paying it off with a 9% fixed-rate personal loan over three years allows you to save a lot of interest over a set repayment schedule.
In addition, having a personal loan added to your credit history helps you build credit if you make payments on time. Doing a consolidation can also work in your favor by reducing your credit utilization ratio when you pay down credit card debt. Therefore, consolidation generally helps your credit and doesn't hurt it long-term.
You can enter basic information and see your loan options at sites like LightStream and LendKey.
ALSO LISTEN: How consolidating credit card debt affects your credit scores
3. Getting a home equity line of credit (HELOC) or loan.
You may qualify for a HELOC or home equity loan if you're a homeowner with at least 20% equity. For example, if your home's market value is $500,000 and your outstanding mortgage balance is $400,000, you have $100,000 in equity or 20% ($100,000 / $500,000 = 0.2).
A HELOC is a revolving line of credit with a variable interest rate that allows you to borrow an amount up to your credit line, using your home as collateral, without needing to refinance your existing mortgage. A home equity loan gives you a lump sum to repay over a set term, such as five to thirty years, with a fixed interest rate.
Since a HELOC and equity loan are secured debt, they typically charge lower interest rates than a personal loan. You can use them however you wish, such as for home renovations or paying off higher-rate debt.
However, if you use a HELOC or equity loan to buy, build, or improve your home, a portion of the interest paid is tax-deductible—but that's not the case for other uses like debt consolidation.
The main downside of tapping your home equity with a HELOC or loan is that if you default, you risk losing your home to foreclosure. Plus, there are closing costs, similar to a primary mortgage, which add to the cost of borrowing.
Consider getting multiple home equity line of credit quotes, including from your current
mortgage lender.
READ ALSO: Pros and cons of a home equity line of credit (HELOC)
What are the pros and cons of debt consolidation?
Debt consolidation gives you the following primary advantages:
The downsides of debt consolidation include:
Maria, you still must pay off the debt you owe, but reorganizing it so you pay less interest could improve your situation. Make a list of all your debts and rank them in order of priority, usually from highest to lowest interest rate.
You typically come out ahead if you can find lower-rate options to transfer or consolidate high-rate debts and avoid the downsides I reviewed.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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