Last year, Shauna depleted her meager liquid savings during the first month of a four-month layoff from work. Like millions of Americans with insufficient cash reserves, she then turned to credit cards to make ends meet. In three months, she racked up $8,500 in charges across four credit cards.
Shauna is back at work now, but her new job pays less than her old one, and she’s barely earning enough to service her debts despite making serious efforts to trim her household expenses. Because she understands the negative consequences of bad credit, she’s doing her best not to fall behind on her credit card bills. Unfortunately, she’s only able to make the minimum monthly payment on each card – and even that’s a stretch.
Right now, Shauna is making a total of $260 in minimum monthly payments. If interest rates remain constant, she’s on track to pay $17,193 in total principal and interest payments over nearly 26 years before all of her cards are paid off. In other words, if she maintains the status quo, Shauna – who is currently 35 – will carry her credit card balances through her 60th birthday and pay more interest than principal along the way.
But Shauna doesn’t have to maintain the status quo. She has another option: debt consolidation. It’s not perfect, and it’s not for everyone, but debt consolidation is very often a financial lifesaver for people in Shauna’s position.
What Is Debt Consolidation?
“Debt consolidation” generally refers to the practice of using the proceeds from a single loan or revolving credit line to pay off multiple outstanding credit accounts.
Debts Suitable for Consolidation
Debts suitable for consolidation include any credit account with an interest rate, required monthly payment, or repayment term higher than the consolidation loan’s. That may include:
- High-interest revolving debts, such as credit cards
- Larger installment loans, such as student loans (though the rules around student loan refinancing can be confusing)
- Unsecured personal loans or credit lines taken out early in the credit-building process
- Medical debt
- Predatory credit products, such as payday loans
Debt Consolidation Loans
The most versatile credit vehicle for debt consolidation is a debt consolidation loan through a lender like SoFi. It’s a type of unsecured personal installment loan available to borrowers with fair credit or better (generally, FICO scores above 600 to 620), though some lenders are pickier. A debt consolidation loan effectively combines several existing debts into a more manageable single loan, usually with a shorter repayment term, lower monthly payment, or both.
At first glance, someone like the hypothetical Shauna is an ideal candidate for a debt consolidation installment loan. She’s barely making the minimum payments on multiple high-interest credit card balances and won’t put her debts to bed for decades without a significant change in her financial situation. A lower-interest, shorter-term consolidation loan could slash her total financing costs by thousands and resolve her obligations years ahead of schedule.
“Could” is the operative word here. Shauna’s costly and all-but-interminable debt load alone doesn’t make her a good candidate for a debt consolidation loan. She should also tick some or all of these boxes:
- Suitable Credit to Qualify for a Favorable Installment Loan. Ideally, Shauna’s debt consolidation loan options will carry lower APRs and smaller monthly payments than her current credit card mix. For example, to reduce her current $260 monthly payment to $181, she’d want to aim for a 60-month installment loan at 10% APR. Lenders’ underwriting practices differ, but she’ll likely need prime credit – a minimum FICO credit score of 680 – to qualify for such a low rate and long term. Sub-prime debt consolidation loans verge on the predatory and may cost more than the debts they replace.
- Stable Income and Employment. Shauna’s recent layoff could hurt her standing here, as could her new job’s lower pay. Most lenders like to see at least 24 consecutive months of stable employment and income.
- Reasonable Debt-to-Income Ratio. Again, lenders’ underwriting practices vary, but most prefer borrowers with debt-to-income ratios under 50%. Fortunately for Shauna, only minimum balance payments factor into debt-to-income calculations. It’s her combined $260 monthly minimum payment that matters, not her $8,500 principal balance.
- No Access to 0% APR Balance Transfer Deals. If Shauna qualifies for a 0% APR balance transfer offer of sufficient size and duration to zero out the bulk of her credit card debt load, she should pursue this option first. Balance transfers generally cost no more than 5% of the transferred amount, so she’s looking at a $425 charge to transfer the full balance – significantly less than her likely financing charge under the most optimistic installment loan scenario.
- A Sustainable Long-Term Budget. Perhaps most importantly, Shauna needs a sustainable plan to avoid crippling debt in the future. In part, that means reworking her budget so that she spends significantly less than she earns, pursuing side hustles and passive income where possible and avoiding unnecessary debt – especially high-interest debt.
Borrowers with excellent credit (generally, FICO scores above 700, but lower in some cases) may qualify for a lower-cost option: 0% APR credit card balance transfers. This option is better suited to small or moderate debt loads, as balance transfer size is limited by approved credit and 0% APR promotions rarely last longer than 18 to 21 months.
Borrowers with certain assets or account types may have additional debt consolidation credit products at their disposal:
- Home Equity Products. If you have sufficient equity in your home – typically at least 15%, or an 85% loan-to-value ratio – you can open a home equity loan or home equity line of credit (HELOC) through Figure.com. Since home equity credit products are secured by the equity in your home, they generally have lower interest than unsecured loans and lines of credit, including unsecured installment loans for debt consolidation.
- Cash Value Life Insurance. Cash value life insurance, also known as permanent life insurance, has a lot of drawbacks; far better long-term investment products exist. However, if you already have a policy that’s accumulated significant cash value, you can borrow against it at lower rates than you’re likely to get on any unsecured alternative because the policy’s cash value secures your draw. However, since borrowing against your policy’s cash value reduces the death benefit, timely repayment is in your beneficiaries’ best interest.
- Tax-Advantaged Accounts. Under normal circumstances, you can borrow up to the lesser of $50,000 or 50% of your qualified retirement plan’s assets over five years. Though eligible plan loans accrue interest, the finance charges eventually end up back on your balance sheet, which may result in a wash or net gain.
Using an Installment Loan for Debt Consolidation
Using an installment loan for debt consolidation is pretty straightforward. If you’re considering this route, here’s what you should keep in mind.
Before You Take Out the Loan
- Set a Target Loan Size and Monthly Payment. First, you need to set two targets: loan size and monthly payment. The loan principal should be generous enough to pay off all the debts you want to consolidate. The monthly payment must fit within your revised long-term household budget and ideally be lower than your combined monthly credit card minimums. A free debt repayment calculator, like this one from Credit Karma, makes these calculations much easier.
- Research Loan Options. Your borrower profile – especially your credit score and debt-to-income ratio, may affect your loan options. Solicit offers from multiple lenders – at least six, if possible – and choose the offer that most closely matches your targets. Soliciting loan quotes usually doesn’t require a hard credit pull, so there’s no credit downside to this process. You’ll want a loan that consolidates the bulk of your problem debts while reducing your monthly payment, total finance charges, and ideally, your repayment term. If you don’t qualify for such a loan, it’s time to explore other options.
- Pay Off Each Balance in Full. Once your loan is funded, pay off each problem balance in full. If the loan principal doesn’t cover all of your outstanding credit card balances, prioritize accounts in descending interest rate order.
- Keep Card Accounts Open (for Now). For the time being, keep your zero-balance credit card accounts open. Closing multiple credit accounts at once may increase your credit utilization ratio, a potential credit negative.
During the Loan’s Term
- Make Timely Payments. You must stay on top of your debt consolidation loan installments. Autopay is your friend here, and many debt consolidation lenders offer autopay discounts.
- Stop Using Credit Cards for Non-Emergencies. Stop using credit cards for discretionary spending, at least until your debt consolidation loan is paid off. Racking up new balances is counterproductive.
- Avoid Carrying Credit Card Balances in the Future. If and when you start using credit cards again, resolve not to carry monthly balances except for emergencies.
- Avoid Unnecessary Unsecured Debt. Other than your debt consolidation loan, avoid unsecured debt – not just credit cards, but personal lines of credit and non-consolidation personal loans too.
- Follow Through on Your Personal Budget. Most importantly, you need to stick to your budget, which should reflect your commitment to spending less than you earn and using credit wisely.
Pros & Cons of Debt Consolidation Loans
Taking out a debt consolidation loan isn’t always a slam dunk. For every benefit of borrowing to pay down your debts, there’s a drawback or caution to keep in mind.
Pros of Debt Consolidation Loans
First, the sunny side of debt consolidation loans:
- Easier to Manage Debts. One loan is easier to manage than several. With just one due date to remember, you’re less likely to incur a late payment fee or credit blemish due to a missed payment.
- Potential for Lower Interest Rate. For qualified borrowers, installment loans usually carry lower APRs than credit cards, even when they’re not secured. The difference is particularly notable for borrowers whose credit has improved over time. Lower rates mean lower financing costs.
- Potential for Significantly Lower Monthly Payments. For qualified borrowers, debt consolidation loans’ monthly payments may be significantly lower than the cumulative monthly payment on the debts they replace. That’s more likely to be the case for consolidation loans that replace high-interest credit cards and predatory credit products. Bear in mind that a consolidation loan’s total financing cost can still be lower than the debts it consolidates, even when the monthly payment is higher.
- Little Inherent Risk of Credit Damage. Unlike the more radical alternatives outlined below, debt consolidation loans present a low inherent risk of credit damage when used responsibly. For borrowers in danger of falling behind on required payments, debt consolidation loans that reduce monthly debt service costs may be a net positive for their credit scores. To avoid self-inflicted credit damage from spiking credit utilization rates, borrowers should keep credit accounts open if possible, even after zeroing out their balances.
Cons of Debt Consolidation Loans
Keep these cautions in mind as you weigh your debt consolidation options:
- Some Loans Have Prepayment Penalties. Prepayment penalties aren’t as common as they once were, but they remain a factor in debt consolidation decisions. Where they exist, prepayment penalties may erode the case for consolidation. Always crunch the numbers to determine the net cost of an early payoff.
- Subprime Borrowers May Struggle to Find Affordable Loans Without Collateral. Credit-impaired borrowers may struggle to qualify for unsecured debt consolidation loans with suitably low monthly payments, finance charges, or both. Such borrowers may need to put up valuable collateral, such as car titles, to qualify for secured debt consolidation loans.
- Secured Debt Consolidation Loans Risk Asset Loss. Although they invariably carry lower APRs than comparable unsecured loans, secured debt consolidation loans present a unique risk for delinquent borrowers: potential asset loss.
- One Loan Can’t Change Unhealthy Financial Behaviors. For Shauna, racking up credit card debt during an extended period of unemployment was the least bad option. Others in similar straits may have more insidious patterns of overspending and poor money management to blame. In these cases, using a debt consolidation loan to wipe out high-interest debts may actually reward unhealthy financial behaviors. While all debt-ridden borrowers stand to benefit from debt consolidation, those who inched into debt through poor money management must take concrete steps to avoid a repeat in the future.
Alternatives to Debt Consolidation Loans
Taking out a secured or unsecured debt consolidation loan isn’t your only option for dealing with unruly, high-interest debt. Before formally applying for a debt consolidation loan, weigh these alternatives:
1. Negotiating With Your Creditors
You’re always free to attempt to negotiate with your creditors. Many lenders have formal hardship programs that temporarily reduce required payments or even pause payments altogether. Qualifying hardships typically include:
- Involuntary job loss (with caveats; termination for cause may not qualify, for instance)
- A major illness or injury that prevents you from working
- The death of a spouse or an immediate family member
- A natural disaster or other event that renders your home uninhabitable (significant exceptions may apply here as well)
- Divorce or domestic separation
Claiming hardship dramatically increases your chances of successful debt negotiation. But even if you don’t qualify for hardship under the precise terms of your borrowing agreement, there’s no harm in making a concerted effort to negotiate. Keep these tips in mind for the greatest chance of success:
- Get Your Story Straight. Clearly, compellingly explain your story to your creditors. Don’t be bashful or evasive; honestly explaining why you can’t make your payments in full right now is the best strategy.
- Present a Realistic Payment Plan. Don’t just ask for a break; tell your creditors what you can do for them and when. For instance: “I can’t pay $200 per month right now, but I can pay $100 per month, and I’m willing to pay interest on the deferred balance until my situation improves.”
- Document All Interactions. Save all written correspondence and take notes on verbal communications in real time. Or, better yet, record phone conversations if local law permits; your creditors will be.
- Get Your Payment Plan in Writing. If you’re able to come to an agreement with your creditor, get that in writing too.
2. DIY Debt Payoff Strategies
If you’re not confident in your negotiating skills, or you’ve already tried and failed to negotiate modified payment plans, take matters into your own hands.
Consider these three popular debt payoff strategies:
- Debt Snowball. This method prioritizes debts in reverse size order. You make the minimum required payments on all outstanding debts save one: the smallest currently outstanding. Make additional principal payments to that balance – whatever you can squeeze out of your budget, but the bigger, the better. Once that balance is paid off, move on to the next smallest balance.
- Debt Avalanche. This method prioritizes debts in descending rate order. You pay off the highest-interest account first, then pay off the second highest-interest account, and so on until you zero out your lowest-interest account. Along the way, you accelerate your payoff by making an additional principal payment each month.
- Debt Snowflaking. This method works as a variation of either method above. The only difference is in the size and origin of your additional principal payments, which can come from things like household budget trimmings, side income, and credit card rewards.
3. Credit Counseling
Credit counseling is a low- or no-cost service that helps clients:
- Manage and pay down existing debts
- Develop sustainable household budgets and cash flow management plans
- Learn how to build, rebuild, and improve credit
- Communicate with creditors
Legitimate credit counseling services boost clients’ personal finance literacy, instill healthy financial habits, and may reduce the risk of future debt troubles. Avoid overcharging and outright scams by choosing a nonprofit credit counseling provider that belongs to the National Foundation for Credit Counseling (NFCC), the niche’s largest nonprofit trade association.
For borrowers with overwhelming obligations, credit counseling by itself likely won’t be sufficient to zero out debt. But that shouldn’t stop you from using it in conjunction with loans or other debt payoff strategies, provided you can afford any out-of-pocket payments.
4. Debt Management Plans
Many credit counseling providers offer debt management plans, in which the credit counselor serves as a middleman between the borrower and their creditors. The credit counselor disburses the borrower’s monthly escrow payments to creditors, usually on a fixed basis for the 36- to 60-month plan term. The credit counselor may also negotiate on the borrower’s behalf to reduce principal balances or required monthly payments.
Most debt management plans carry monthly fees of about $50 to $100, which are payable to the credit counselor. Some charge nominal one-time startup fees. Even accounting for these fees, total plan costs are often significantly lower than only paying the minimums on balances included in the plan, and disorganized borrowers appreciate the centralized management structure.
Remember to choose a nonprofit NFCC-member credit counseling provider. Do additional due diligence as well, such as reviewing complaints lodged with the Federal Trade Commission and your state’s financial regulator or attorney general’s office.
5. Debt Settlement
Debt settlement is nonprofit debt management’s rougher cousin. Debt settlement providers like Pacific Debt and DMB Financial are for-profit companies that serve as middlemen between borrowers and creditors.
The debt settlement model varies by provider, but the process generally looks something like this:
- You stop making payments on your credit accounts and instead make lump-sum payments into an escrow account over several months.
- When the escrow account’s balance reaches a predetermined size, the debt settlement company proposes partial “settlements,” or payoffs, to each creditor included in the plan.
- Negotiations ensue. Hopefully, every creditor accepts an offer.
- The debt settlement company takes a widely variable cut of your escrow payments.
- The total payoff period takes anywhere from two to four years.
Since debt settlement plans usually require you to cease payment on multiple open credit accounts, they’re almost as bad for your credit as bankruptcy. You should consider working with a debt settlement provider only when your debt becomes so overwhelming that you can see no alternative to declaring bankruptcy. Alternatively, you can cut out the debt settlement provider and propose settlements directly to your creditors, though you’ll still take a significant credit hit.
On the bright side, successful debt settlement usually takes no longer than four years to pay off participating debt balances and allows you to avoid bankruptcy.
Declaring bankruptcy is a last resort for addressing truly overwhelming debt. Consumer bankruptcy comes in two forms:
- Chapter 7. Chapter 7 allows for the full discharge of most unsecured debts and many secured or court-enforced debts. When you declare Chapter 7 bankruptcy, you must consent to the surrender or liquidation of any property that can be used to satisfy your outstanding obligations, subject to personal property exemptions that vary by state. You won’t be held liable for further payments on debts that you legally discharge through this process. Debts not eligible for discharge may include – but are not limited to – student loans, federal and state taxes, alimony and child support, and legal judgments. A Chapter 7 declaration remains on your credit report for 10 years from the discharge date.
- Chapter 13. Chapter 13 is a less draconian approach that allows you to retain your assets, at least initially. When you declare, you must consent to a court-supervised repayment process that generally takes three to five years and results in partial satisfaction of your outstanding debts. Any balances remaining are forgiven. Chapter 13 bankruptcy remains on your credit report for seven years from the discharge date.
In either case, declaring bankruptcy causes significant, long-lasting damage to your credit. The precise hit to your credit score is a function of your prior credit history. Ironically, consumers whose bankruptcy declarations punctuate largely unblemished credit histories may see their scores drop by more than filers with already-impaired credit.
Regardless, rebuilding credit after bankruptcy takes years. You’ll need to wait at least 12 months before applying for new credit from reputable lenders. And, even after your bankruptcy declaration drops off your credit report, you may be asked by employers, landlords, and lenders if you’ve ever declared.
Shauna’s hypothetical debt morass is by no means unique. Nor is it particularly severe. Graduate or professional school grads who rely heavily on private or federal student loans to cover tuition, fees, and living expenses face four-figure monthly payments and six-figure total financing costs
Federal student loan borrowers who don’t qualify for accelerated student loan forgiveness programs, such as Public Service Loan Forgiveness, can anticipate 20 years of income-driven repayments at 10% to 15% of their discretionary income. Private student loan borrowers may face even bigger bills.
Gargantuan debt loads like these test the limits of single-shot debt consolidation loans. But regardless of the scale and composition of your personal balance sheet, you owe it to yourself to weigh all realistic options and adopt those most likely to shorten your journey out of debt.
Are you considering your debt consolidation options? Do you plan to use a personal loan or another strategy?