Debt Consolidation: When It Lowers the Cost

Debt consolidation means replacing several debts with one, ideally at a lower rate. Done well, it cuts the interest you pay and gives revolving debt a fixed end date. Done badly, it stretches the debt out, adds fees, or turns unsecured card debt into a loan secured by your home, and the cards fill up again. This chapter explains how to tell which situation you are in, compares the four main ways to consolidate on the same balance, and lists the conditions that make consolidation work.

Start with the rate you pay now

Consolidation only makes sense if the new rate, after fees, is meaningfully lower than what you pay today. With several debts, the number to beat is your weighted average rate: multiply each balance by its rate, add the results, and divide by the total balance. A large card at a high rate pulls the average up more than a small one.

Leave some debts out of the calculation entirely. A car loan or mortgage at a low rate usually should not be rolled into anything. Federal student loans should not be consolidated into a private loan without understanding what that gives up (chapter 8). The usual candidates are credit cards, store cards and high-rate personal loans.

Two more checks before you apply:

• Can you stop adding to the old debts? Consolidation frees up the limits on your cards. If spending continues, you end up with the new loan and new card balances. Many people who consolidate are back where they started within a few years for exactly this reason.
• Will the new payment fit, every month, for the whole term? A lower payment is only progress if the total cost also falls.

Four ways to consolidate, on the same balance

The examples below use the same card debt throughout. The baseline is keeping it on the cards and paying it off over four years.

Paying it down at 22.0% over 4 years takes $473 a month, and $22,684 in total.

1. A personal consolidation loan. A fixed-rate installment loan pays off the cards, and you repay it on a set schedule. Rates depend heavily on credit. Many lenders charge an origination fee, usually deducted from the loan, so you may need to borrow a little more than you owe.

Even after borrowing extra to cover a 5% fee, the loan at 11.0% costs $407 a month and $19,539 in total, against $22,684 on the cards over the same four years. The fixed end date is part of the value: the debt cannot drift.

2. A zero-interest balance transfer. A new card offers a promotional rate, often zero, for a set number of months, in exchange for a transfer fee charged as a percentage of the amount moved. It is the cheapest route when you can clear the balance before the promotion ends, and it usually requires good credit. The required payment is simple to work out: the balance plus the fee, divided by the promotional months.

Clearing the balance and a 4% fee in an 18-month promotion takes $867 a month, and the total is $15,600, all of it fee and principal. The catch is the size of that payment. Anything left when the promotion ends starts accruing interest at the card's regular rate, and the limit you are offered may not cover the whole balance. Late payments can end the promotion early. If you cannot afford the payment that clears the balance in time, compare the transfer's likely cost against a fixed-rate loan.

3. Home equity. A home equity loan or line of credit (HELOC) usually has the lowest rate, because your home secures it, and the long term makes the payment small.

At 8.5% over 10 years the payment drops to $186, but the total climbs to $22,317, more than the personal loan and close to staying on the cards, because the debt lasts more than twice as long. Paying it off on the personal loan's four-year schedule would cut that sharply. The larger change is the risk. Card debt you cannot pay damages your credit; home equity debt you cannot pay can cost you your home. Most lines of credit have variable rates, and there are closing costs. Interest on home equity borrowing used to pay off cards is not deductible, because the money was not used to buy, build or improve the home.

4. A debt management plan. Nonprofit credit counseling agencies can set up a plan in which you make one monthly payment to the agency, and it pays your creditors at reduced interest rates that card issuers have agreed to for its clients. There is usually a small monthly fee, and the enrolled cards are normally closed. A plan does not require good credit, which makes it the main option when a loan or transfer is out of reach. It is different from debt settlement, which is covered in chapter 7 and carries far more risk to your credit.

Applying without damaging your credit

Many lenders offer prequalification with a soft credit check, which does not affect your score; use it to compare offers. A formal application triggers a hard inquiry, which can lower a score slightly for a while. Compare offers on APR and total repayment, not the monthly payment alone, and ask whether there is a prepayment penalty. When the loan funds, pay off the old accounts immediately, and confirm each one shows a zero balance.

Closing old cards after consolidating is a judgment call. Closing reduces your available credit, which raises utilization and can lower your score; keeping them open keeps the temptation. A common middle path is to keep the oldest card open with a small automatic charge paid in full each month, and remove the rest from your wallet and online accounts.

When consolidation is the wrong tool

• The new rate, after fees, is not clearly lower than your weighted average.
• The lower payment comes only from a much longer term, and the total cost rises.
• The cause of the debt, such as spending above income or no emergency fund, is still in place.
• You would be turning unsecured debt into debt secured by your home without a firm plan to repay it quickly.
• The debts are already in collections or far past due. Negotiation (chapter 7) usually fits better.