How to Choose the Right Debt Consolidation Solution for Your Money

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Perhaps you’re considering filing for bankruptcy. Maybe you’re distressed by the credit card bills piling up every month, and the fact that the bill pile never shrinks. Perhaps your unsecured loans, credit card bills and late payment fees have snowballed into a debtvalanche.

There’s an alternative to hiding from your creditors, or throwing your hands up in surrender. Consider debt consolidation — the process of combining all your unsecured debts into one pot, usually at a lower interest rate.

How does debt consolidation work

Once you consolidate debt, you’ll just have one monthly payment to make, which should make your bills easier to manage. Still, reducing your interest rate on current debt is the primary benefit of debt consolidation, said Laura D. Adams, author of “The Debt-Free Blueprint” — a lower interest rate means more money in your bank account.

“With an increase in your income, you have more money available to put toward your debt, so you can pay it off faster,” Adams said.

Options for debt consolidation depend on what you own now (such as a home), your tolerance for risk and your ability to make monthly payments. Each debt consolidation solution has pros and cons, and there isn’t one right answer for every individual.

Debt consolidation loan

An unsecured debt consolidation loan may offer a lower interest rate than a regular credit card, and if you can’t repay your lender, you won’t lose any property like you would with a secured loan. These loans typically have a fixed interest rate, and terms generally range from two to seven years.

If you pay off an installment loan over years, it shows credit agencies that you can handle different types of credit. An ability to handle a mix of credit types can potentially boost your credit score.

Pros:

  • You pay the total loan off via set monthly payments.
  • Collateral isn’t required for an unsecured personal loan.
  • The interest rate is fixed, and won’t fluctuate like it does with a credit card or line of credit.

Cons:

  • There may be fees, such as loan origination fees.
  • Without collateral to secure the loan, your interest rate may be higher than it would be with a secured loan.

Credit card balance transfer

With this strategy, you transfer all existing credit card debts onto one new card with a 0% or ultra-low interest rate for a promotional period of time. That may help you pay off debt faster and spend less while doing so.

Balance transfer offers are plentiful, but it’s ideal to find one without a balance transfer fee, Adams said. They do exist for borrowers with good credit scores.

You’ll need to pay off your new zero-interest card within the promotional period — because after that, the interest rate could end up being even higher than it was with your old cards.

Pros:

  • Very low-interest rates for as many as 21 months.
  • You’ll only have one credit card bill to deal with, as long as you don’t make new purchases on your old cards.
  • If you pay off the card within the promotional 0% interest period, you won’t pay interest, which could save you thousands.

Cons:

  • Interest rates can soar after the introductory period.
  • Watch out for balance-transfer fees — they generally average 3%, but can be higher.
  • You’ll lose your ultra-low rate for the transferred balance if you miss payments.
  • Purchases are subject to a higher interest rate.
  • If you continue to rack up debt on your old cards, you could find yourself in a worse place than you began with.

Home equity loan

In this case, you borrow against your home’s equity — how much of your home that you own — which you use to pay off debt. Then, you repay the home equity loan.

However, Adams did warn about borrowing against your home to pay off credit cards; it isn’t a great idea, as you’re shifting unsecured credit card debt to secured debt, using your home — “if you don’t pay your credit card debts, your credit card company can’t come after your house,” she said.

It is, however, important to note that if you don’t repay your home equity loan, your lender could foreclose on you.

Pros:

  • Using your home to secure the loan may garner lower interest rates.
  • Repayment terms are often more lenient than a personal loan — you’ll have longer to repay the loan.
  • Applicants with good or high credit scores should be able to qualify for a loan.

Cons:

  • If you don’t repay your loan, you could lose your home to your lender.
  • You must have enough equity to draw from, and realize you’ll end up underwater if the value of your home falls due to poor market conditions.
  • You can’t access your equity for other projects or emergency situations, if necessary.

Cash-out refinancing

Cash-out refinancing is a refinance of your first mortgage, and provides a lump cash sum for the equity you’ve accrued so far. Refinancing can lower your payments if your new loan’s interest rate is 1% to 2% lower than your current mortgage rate, but if your home has increased in value, you may have higher payments. As well, you’re restarting the repayment process, with a new 30-year mortgage.

Pros:

  • A fixed interest rate means your monthly payments shouldn’t fluctuate.
  • You could see a lower monthly payment if your new interest rate is lower.

Cons:

  • Any loan using the equity of your home typically requires an appraisal, and possibly closing costs or other fees.
  • You could end up underwater if your house value falls.
  • If you can’t repay your new mortgage, you could lose your home.

Home equity line of credit (HELOC)

A HELOC uses your home’s equity to provide a line of credit. If your debts are limited, there’s no need to withdraw the entire line of credit. However, of the three home-related equity options listed here, a HELOC can make the most sense — as long as you’re able to access the money at a very low interest rate (3% or 4%), and you’re only borrowing against a small percentage of your equity, Adams said.

With a HELOC, you’ll have a variable interest rate. You’ll borrow against the line of credit and make interest-only payments for the “draw period” (usually five to 10 years), much like using a credit card. After the draw period ends, you’ll no longer be able to borrow and will repay the principal and interest.

Pros:

  • Take out as much or as little as necessary, and only pay interest on what you borrow.
  • Interest rate should be lower than with a credit card or an unsecured personal loan because you’re using your home as collateral.

Cons:

  • HELOC interest rates can increase, so your payment this month may not be what you’re paying a year from now.
  • Low, interest-only monthly repayments are typical for HELOCs during the draw period. The payment will jump once principal and interest become due.
  • Closing costs and other fees can be high.
  • You could lose your home if you don’t repay your loan.

401(k) loan

A 401(k) loan is “more expensive than other options,” according to Adams, as you lose the earnings your account could be accruing, and you’re responsible for paying back the loan right away if you get fired or quit. But this route may appeal to those currently suffering from poor credit — a good credit score isn’t required.

Pros:

  • An option for those without any other collateral.
  • You can set up payroll deductions for loan payments.
  • This strategy is available to those with poor credit.

Cons:

  • The amount you borrow from your 401(k) account no longer earns interest until you’ve repaid the loan.
  • If you’re laid off, quit, or are fired, you must repay the entire loan within 60 to 90 days.
  • If you default on the loan, the loan will be considered an early distribution, subject to income tax and a 10% penalty.

The bottom line

If these debt-consolidation possibilities are out of reach due to your income, debt load or credit history, consider meeting with a nonprofit credit counselor to take a holistic view of your financial situation and find solutions.

But debt consolidation is right for some people and can have multiple benefits. As your debt starts to drop, you’ll watch your credit score rise. Long term, you’re building credit, reducing debt and freeing up money for beneficial uses such as contributing to retirement or an emergency fund, Adams noted. Instead of drowning in debt, you’re growing your net worth.

Comments and Questions

The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.