Editorial Policy

When to Consolidate Debt (And When Not To)

Eva Norlyk Smith Ph.D.

December 5, 2012

Stuck on the debt treadmill? A tempting solution is to consolidate all your credit card balances into a single loan with a lower interest rate or lower minimum payments.

Yet, while debt consolidation can help, it can also hurt. If you don’t tackle the underlying issues that created the problem in the first place, you might find yourself even deeper in debt.

Should I consolidate?
Consolidating your debt can help you zero out your balances faster — just don’t expect it to work miracles.

“There are really only two compelling reasons for consolidating debt,” says Mike Sullivan, director of education for Take Charge America. “If your monthly debt payments are too high, debt consolidation can help lower those payments. Similarly, for loans with high interest rates, people with good credit can save money by transferring the balances to an account with a lower APR.”

To find out if you are a candidate for credit card consolidation, take this quiz:

  1. Do you have multiple credit cards with long-term outstanding balances?
  2. Do you frequently struggle to make the monthly payment on your cards or pay little more than the minimum due each month?
  3. Is your credit card debt increasing instead of decreasing?
  4. Are you close to or over the limit on any of your credit card accounts?

If you answered yes to even one of these questions, you’re in the danger zone. If more than one of these situations describes you, it’s a clear indication that you need to take steps to tackle your spending problem before considering debt consolidation.

When consolidation works, and when it doesn’t
Keep in mind that lower minimum debt payments and a lower interest rate may not necessarily make your debt less expensive in the long run.

“When most people look to lower their debt payments, they are really looking to stretch out terms by a combination of a longer loan payment period and lower interest rate,” says Sullivan. “But in most cases, lowering loan payments just means stretching the loan out longer, and the upshot is that you’ll be paying a lot more to pay off the debt.”

Taking out a home equity loan, for example, can stretch out debt payments on a car loan from five years to 15 years. While you may get a lower interest rate, you’re now carrying the loan for three times as long, making the total cost of the loan much higher.

Also be wary of using the lower monthly loan payments as an excuse to get deeper into debt.

“We see way too often that when people lower their loan payments by consolidating debt, they don’t stop using their credit cards,” says Sullivan. “There’s a reason the credit card debt is there, and just taking out a loan doesn’t stop the behaviors that created it. The debt is a symptom, and to truly tackle your debt issues, you need to address the underlying causes.”

The key to successful credit card consolidation? Use the money saved to pay down your debt faster. In addition, look for ways to cut your expenses, and apply the savings to pay down your debt.

Best debt consolidation loan options
While there are many different options for consolidating your credit card debt, the best options are available only to people with excellent credit. This is why it’s important to act early, before your debt levels undermine your credit score. Here are some of the main options for consolidating your credit card debt:

Transfer balances to a low-interest credit card: The interest rates on this type of credit card can run as low as 7.49 percent for people with excellent credit.

Use 0 percent balance transfer offers to consolidate credit card balances: Balance transfer cards have interest-free introductory periods for any debt you transfer over from another card. If you can pay off the debt before that introductory period expires (the best 0 percent APR offers last 12 to 18 months), a balance transfer can be a great way to save money on interest. Most come with a one-time 3 percent balance transfer fee, but that’s a small price to pay for the savings. But just to make sure paying the fee is worth the trouble, do the math first to see if it makes sense. For example, to transfer a $5,000 balance would cost you $150 (5,000 x .03), which would bring your total balance to $5,150. If your current credit card has an APR of 15 percent or more, then you could save up of $600 in interest charges, provided you pay it off within a year.

Take out a home equity line of credit (HELOC): Homeowners can take advantage of the equity built up in their homes by taking out low-interest home equity line of credit to pay off their credit card balances. Once you’ve zeroed all your card balances out, you’ve just got the (probably lower) interest from the HELOC to worry about. Keep in mind that getting a HELOC often requires a home appraisal and paperwork, but the nice part is that the interest charged is tax-deductible (for now) and payment amounts can vary. If you take out a home equity loan rather than a line of credit, however, those payments are a fixed amount every month.

All of the above credit card debt consolidation strategies work best for people with excellent or good credit. People with fair or bad credit may need to explore other ways to consolidate debt and reduce their payments. At this stage of the debt spiral, the options become fewer and harder to navigate.

Consider using a good credit counseling agency to put together a debt management program and negotiate with creditors on your behalf. Before using a credit counseling agency, check its Better Business Bureau rating, and check the banking department for your state, which will have a list of all the accredited agencies for that state.